America rides out the shock waves

A Yale finance expert predicts the U.S. economy will withstand global convulsions.


Jonathan Broder
September 2, 1998 11:00PM (UTC)

On Tuesday, Wall Street proved once again it is no place for the meek. A day after the stock market suffered its second worst loss with a plunge of 513 points, the Dow Jones industrial average roared back to life, gaining 288 points to close at 7,827. Broader indicators also rose, with the technology-heavy NASDAQ climbing 76 points to 1,575 and posting its largest gains since Oct. 28, 1997.

The market's impressive comeback appeared to confirm the views of those strategists who refused to be spooked by the losses of last week and yesterday, interpreting the declines as an opportunity for bargain hunters. The resurgence also seemed to bolster comments by President Clinton and Treasury Secretary Robert Rubin that despite the economic turmoil in Asia and Russia, the U.S. economy remains fundamentally sound.

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Such confidence was absent in Asia and Russia, where market slides reflected continued political uncertainty. In Russia, the government blocked trading the ruble for the fifth straight day, undercutting Russian stocks even further. Despite a slight gain by Japanese stocks, Tachi Sakaiya, the country's chief economic planner, dismissed any suggestion of an extended recovery and warned that Japan's economy is "now going through one of its darkest stages."

As Asia and Russia reel and the U.S. market reacts nervously, the direction of the global economy has provoked intense speculation lately, with some analysts predicting massive international dislocations made all the worse because of the apparent lack of any leadership. To assess these predictions, Salon spoke to David DeRosa, a former banker, investment counselor and foreign exchange expert who now teaches finance at Yale University's School of Management.

Are we, as has been suggested, on the verge of massive international dislocations?

We're already suffering them. The Russian economy has collapsed. The economies of Asia and South Korea have literally imploded. The latest from Asia is that last night, Prime Minister Mahathir Mohamad of Malaysia imposed capital controls on his currency. That means that if you're not a Malaysian national, you now have to apply for permission to buy the ringgit. So Mahatir has effectively suspended trading in his currency. Meanwhile, the Korean economy has collapsed, and Japan appears to be falling ever deeper into a recession that won't go away.

What are the ripple effects of these problems?

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All this has caused second-order effects on the commodities markets, which have put countries like Canada and Australia into the tank. Australia and Canada are both major natural resource and commodities export nations, selling everything from metals and minerals to timber and energy. The worldwide market for commodities is showing a drop in demand, and as a result the price of commodities is dropping. So the dislocations have already occurred. The question is whether more will occur. In the meantime, the feeling here in the United States is that the good times are over.

We've read a lot about the so-called global economic contagion. How does that work? How do events in Thailand and Japan affect markets in Russia and Eastern Europe and Latin America? How does it spread?

It spreads in one of two ways. The first is that preconditions exist in these countries that create inherently risky situations, such as fixed exchange rates or current account deficits or huge foreign debts. So for the contagion to spread, there have to be identical or near-identical preconditions. That's why Thailand, Indonesia, Malaysia, Korea and the Philippines all got hit at the same time. The second factor is the sudden withdrawal of investment in those countries from Americans, Europeans and Asians. When trouble hits one country, investors tend to take their money out of the entire region, so you get clustering of selling, which aggravates the crash.

How did the dislocation in Asia spread to Russia?

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I don't think this is like smallpox that spreads from one place to another. The Asian countries had nearly identical economies, all built on credit, all with current account deficits, all with enormous borrowing in dollars. So as these currencies fell, the size of the debt in local terms magnified. And you had either fixed or controlled exchange rates, and all of those broke.

One year later, we have a situation in Russia that really began when the Russian authorities found themselves unable to collect taxes. Yet they had enormous borrowing in dollars and a fixed exchange rate. On top of that, you've got Russia's long history of war, revolution and repression, as well as the fact that the country is flat broke. So Russia was a totally separate pathology.

I don't believe that the Asian economic crisis caused the Russian economy to collapse. If that were true, it would have happened a year ago, not now. What I do believe is that these regional economies were powder kegs, ready to blow.

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Why was there such a frightened reaction in U.S. markets to Russia's economic collapse?

Many people here had invested in emerging market funds or hedge funds that took leveraged bets on these emerging markets, and they got clobbered by the devaluation of the ruble. The other thing that happened was the Russians effectively defaulted on government bonds, which are now worth no more than 10 cents on the dollar, if they're worth anything. Their stock market is now totally worthless as well. On top of all that, Russia has experienced a soft coup. We don't know who is going to run Russia now. So there is an element of political risk that now may transcend the economic risk. That's a combination of factors that markets don't like. As far as the exposure of U.S. banks is concerned, it's going to hurt but it's not enough to sink banks like Bank of America and J.P Morgan. But you have to ask yourself: What's going to happen to the peace dividend?

How so?

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If you believe, as I do, that capitalism and freedom go together, and that command economies and repression go together, then Russia may solve its problems by returning to a command economy and a dictatorship. That's the fear right now. Ever since the collapse of the Soviet Union, we've been living in a fantasy world that the big, bad evil empire is gone. Well, it may come back. Indeed, Russia has every possible condition for that to happen. There is a power vacuum, there's an economic vacuum. You have to assume that someone strong is going to step in there and take over. It affects the peace dividend because suddenly we will have to spend more money on defense and security.

How much are these problems aggravated by the quality of leadership worldwide?

I think the problems are big and the leaders are weak. We don't have any world leaders right now that I can spot. [Japanese Prime Minister Keizo] Obuchi is a disaster, and all the guys before him were disasters. It's not clear whether Clinton can recover. The Starr report could be fatal. Now there are questions of campaign finance clouding Gore's future. Russia's in total turmoil, and Germany may be about to lose [Chancellor Helmut] Kohl. On the leadership front, I must say that it doesn't look too good.

We've heard warnings of the global contagion spreading to our backyard in Latin America. How might that scenario play out?

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The theory is that the crisis will spread to Latin America because there is heavy investment by Asian nations in the region. The idea is that the Asians will pull all the money out, aggravating pre-existing conditions in Latin America, which include a shaky currency in Brazil and a fixed exchange rate in Argentina. But primarily the fear is that if emerging markets become so thoroughly discredited that no one wants to invest in them, then the same people who are pulling out of Asia, Eastern Europe and Russia will yank their money out of Latin America as well.

At one point does all of this begin to lap up on American shores?

The growth rate in the United States may be down right now, but I must say that it looks like we have an internally robust economy and that we are our own biggest customer.

How can you be so optimistic when exports make up 20 percent of the U.S. economy?

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That's true, but there's still Europe. Western Europe, where the wealth, the production and the consumers are, is in very good shape economically. It would be possible to sell United States exports just on European trade. How much do you think the Japanese bought from us? Wasn't that the big American complaint? We primarily import from Japan and the rest of Asia. Sure, all the stock markets are off because of the cumulative effect of Asia's troubles and the Russian default, but it's not at all clear to me that the story is over for the U.S. and Western European economies.

Let's say these massive global economic dislocations spread to Latin America, where U.S. banks and businesses are heavily invested. At that point, might not Americans begin to feel the shock waves?

Obviously we would be better off if none of these crises occurred. But let's not forget that we already went through one major crisis in Latin America in 1994. All those markets collapsed, and here we are today, stronger than ever. Troubles in Latin America, Asia and Russia are not going to cause the U.S. economy to collapse. It looks pretty robust to me. In fact, I have to say, as [Federal Reserve Chairman Alan] Greenspan did, this is a remarkable performance. There's solid growth, there's no inflation and there's low interest rates. What's the problem?

It's true there are problems elsewhere in the world, but I see the latest market correction as healthy for us. I worry about bubbles, and this process of growth and correction is a sustainable solution for some time. I don't believe the American economy is about to keel over like Thailand, Korea or Russia. In fact, I agree with those who say the market will come back. It's already climbing today. The bottom line is that we're in much better shape to weather these kinds of global crises because our economy is basically sound.

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Jonathan Broder

Jonathan Broder is Salon's Washington correspondent.

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