Compass Points

Economic Commentary

Hard Land, Soft Landing - What will the impact be on the rest of the world?

by Denise A. Harrison

On a rainy night, driving over the speed limit, on a winding road, the US economy applies the brakes - what will happen? Will it hydroplane and skid off to the side? Will it slow gently, in time to avoid the danger of inflation? Or are we driving a Ford Explorer with recalled tires soon to land upside down on the side of the road?

Slowing the economy is not easy. Last fall people questioned the Federal Reserve with: Have we raised interest rates enough to stop inflation? Did we put on the interest rate brakes soon enough? In January the Federal Reserve Board pulled its foot off the brake pedal and moved to the accelerator by lowering interest rates 50 basis points (.5%) two weeks before its scheduled meeting.

The US economy is slowing from the brisk pace that it achieved during the 1990’s. During the 1990’s the US economy was the buttress of stability. When Russia and Asia had their respective financial crises it was the exports to the strong US economy that stabilized the free fall of these emerging economies.

Now that the US economy is slowing, what will happen in the rest of the world? As we look around the globe we see good news (a little) and bad news (a lot).

First the good news:
Looking broadly at Europe we see that less than 5% of the European GDP comes from exports to the US. Catching a cold in the US does not result in pneumonia in Europe.

In addition to this positive attribute, significant changes are occurring in European economies:

  1. Personal and corporate tax cuts enacted by Germany, France and Italy will take effect in 2001. These tax cuts will act as a stimulus to European economies.
  2. Legislation has been enacted to make European labor markets more flexible.
  3. The wealth effect that led to irrational exuberance in the US was not as prevalent in Europe. The excesses in consumption found in the US are not present in Europe.

The European savings rate is high in contrast to the negative savings rate in the US. An economic slow down in the US will cause many who are over-extended both corporately and personally to go bankrupt sending further ripples through the economy. The high savings rate protects the European economy from this ripple of the slow down.

Now for the bad news:
Asia (not including Japan)
The Asian Crisis, 1998, sent ripples throughout the world economy. The US stepped up with strong demand to drive an export led recovery. When the Asian crisis occurred many suggested that this was needed medicine for the Asian economies that were built on a faulty foundation. This foundation needed to be shored up with structural economic reforms. Banking systems, interlocking corporations needed to change so that the economies would grow and prosper. But the US demand for Asian goods allowed these economies to recover without fully fixing the structural problems that exist. Much like a patient who has the Asian flu and is given penicillin as the cure, if the penicillin is not taken in the required dose for the required timeframe the flu may come back worse and the cure will take longer and require stronger medicine the next time.

The boom in export demand put the structural reform on hold. Now that the demand for Asian goods is slowing the cracks that were present in 1998 will reappear as major fault lines. Look for a “double bottom” in this region.

Japan is a prime example of what might be in store for the Asian economies. Japan has resisted major structural reform for years and has remained in a recession for 10 years. When we look back in history we find this hard to believe. In the 1980’s Japan was the poster child of prosperity. The insular nature of the Japanese economy allowed for stable but protected growth. Other world economies were frustrated by the influx of Japanese goods without having access to the Japanese markets for their exports. But this protected economy led to inefficient business models. Where competition would have weeded out poorly performing companies, protection allowed them to continue draining the economy of the capital that should have been funding emerging and efficient businesses. This poor allocation of resources is still causing a lack of stimulus for growth. Structural changes are occurring slowly in Japan, companies are now being allowed to go bankrupt, but this slow change has resulted in a long period of economic stagnation. Hopefully Japan’s Asian counterparts will take this resistance to structural change as a lesson and get back to work on the tough decisions that change the underpinnings of their respective economies.

Latin America
The GDP in many Latin American countries is dependent in varying degrees on exports to the US. The US downturn will significantly impact this region. The impact will be most prevalent in Mexico where the newly elected president Fox is trying to make the structural reforms that are necessary to build a platform for future growth. Most Latin American countries are ahead of their Asian counterparts on structural reform, but the job has not been completed.

Canada as a member of the NAFTA family will catch the cold from the US. Ripples have been felt through the slow down of the automotive industry and the lay-offs at Daimler Chrysler and GM. Further ripples are being felt with the down turn of the telecommunications industry. Canada will be happy when the US economy is on the mend again.

After many years of prosperity the US economic growth is slowing. The impact of this slow-down will be felt throughout the world in varying degrees. During this period we need to look at our own firms and see if during the good times we developed inefficiencies. Now is a time to look at structural reform internally and assess what medicine is required.

© Copyright 2007 Center for Simplified Strategic Planning

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