'Fortress America'?

Roger C. Altman, an investment banker, served in the U.S. Treasury Department under Presidents Jimmy Carter and Bill Clinton

Despite last week's tremors, an eerie calm hangs over U.S. financial markets. They reflect a seeming oblivion to the spreading international financial crisis. The U.S. stock market remains at stratospheric highs, interest rates have hit 30-year lows and Wall Street sees the U.S. economy as impregnable. It is America as a financial island.

But this isolation is increasingly untenable. There is a financial firestorm spreading across East Asia, Japan, Russia and parts of Latin America. Currencies have collapsed, capital has fled and economies have sunk into recession on an unprecedented scale. The International Monetary Fund dangerously has depleted its resources trying unsuccessfully to contain it. These events constitute the worst financial crisis since the birth of the modern, international monetary system in 1944, and they seem to be accelerating.

Our Federal Reserve and Treasury are increasingly worried about a world market meltdown. Indeed, their latest warnings were particularly ominous. Treasury Secretary Robert E. Rubin hinted that the crisis may spread to Europe. Federal Reserve Chairman Alan Greenspan said financial conditions in Asia are worsening. How would such a meltdown happen? We saw a glimpse of that last October.

At that time, the Asian financial crisis was just coming into full view. Currency and stock markets in four of the leading Asian nations had been crushed, and then the mighty Hong Kong market suddenly plunged. This triggered huge, same-day declines across Europe and a stunning 554-point drop in New York. The next morning, the financial world held its breath. Luckily, markets stabilized. But, like the blinding flash of a nuclear test, everyone saw the global linkage and the overwhelming risks in these markets.

Could the U.S. economy be damaged by such a market meltdown? Yes. Indeed, Greenspan obliquely refers to a financial shock as the one threat to continued U.S. economic strength. He means that a truly steep fall of our stock market, or the collapse of a large U.S. financial institution, could torpedo consumer and business confidence and stop our economy in its tracks. That is precisely what is happening now in Japan: Consumers and businesses are frightened and have stopped spending.

In this unstable setting, there are five reasons why the U.S. financial markets and our economy are dangerously exposed. First, our stock market is already at Himalayan levels and poised for a correction, even apart from the international crisis; it has tripled over the past six years. Most valuation measures, like price-to-earning ratios, are at record levels. It is said that the colossal amounts of available money must be invested somewhere and can only flow into stocks. But that nostrum belies any grasp of financial history.

Second, the financial crisis is threatening U.S. corporate profits, a foundation of our market strength. After eight years of domestic expansion, profit gains already are down to low single-digit rates. But, Asian demand for U.S. goods and services, is dwindling, signaled by the sharp declines in 3M and IBM shares last week. Moreover, the sliding Japanese currency is badly undermining the overall international competitiveness of U.S. products. While the evidence is just coming in, these events can only further impair corporate earnings.

Third, the international financial crisis is worse than it looks. Some of the former East Asia "tigers"--Malaysia, for example--still officially project growth for 1998, but the reality is that all their economies are contracting. The economy of Indonesia, the fourth most populous nation in the world, could shrink at the terrifying pace of 20% in one year. Hong Kong, the economic paragon, may itself be on the verge of recession.

Conditions in Japan, the world's second-largest economy, have deteriorated to alarming levels. Last week, the data signaled not just recession, but a sharp one, perhaps the worst since the oil crisis of the early '70s. The country's banking system is still laden with hundreds of billions in bad loans and thus frozen. Also, its unemployment rate, usually negligible, is about to surpass the U.S. rate. The Japanese currency, the yen, plunged to a 10-year low against the dollar.

This decline is particularly grim because Japan usually serves as the engine of growth for Asia. It has long been the biggest single market for East Asian products, but that market is now slumping. The yen's plunge also means that Japanese products will be far cheaper and more competitive compared with Asia's. It is also problematic for the United States, particularly in the auto and capital-equipment sectors, for the same reason.

Russia, meanwhile, has become a basket case. In recent weeks, its currency has come under heavy selling pressure and short-term interest rates were raised to 150%, an unheard-of level, to defend it. Its tax system is dysfunctional, labor strife is rampant and one always wonders about the security of its nuclear arsenal. Mexico and Brazil have now fallen back into disfavor with the international markets.

Fourth, the world's recognized emergency lender, the IMF, is financially depleted and facing heavy criticism. Over the past year, it negotiated $120 billion of emergency financing for East Asia and $57 billion for Russia, including huge chunks of its own funds. But the IMF is running out of money, and the United States seems unwilling to contribute its share to replenish it. The fund is apparently down to $15 billion of hard currency and $23 billion in a special borrowing facility. These amounts are far too small to protect against another regional crisis, say Latin America.

Finally, there is the sheer strength of the global financial markets themselves. Apart from nuclear weapons, they are the most powerful force the world has experienced. In recent months, the markets have obliterated governments overnight and imposed previously unthinkable changes on one nation after another. One day President Suharto of Indonesia is still omnipotent after 35 years and then, after the markets rendered their verdict, he is gone. If they somehow boycotted India for its recent nuclear exploits, that would be the end of its testing program. Those who think the mighty United States is immune to such forces are wrong.

What can be done to protect against such financial risks? For starters, the IMF must be replenished. It is the one true bulwark against international financial chaos and has a long history of successful, emergency interventions. While East Asia is in severe distress, it would be bankrupt without the fund. In fact, even the appearance of an IMF rescue package often stems market declines.

But the House of Representatives, in an isolationist mood, is refusing to authorize a fresh U.S. commitment to the IMF. Other leading nations can't execute their infusions unless we do. This is the height of foolishness on our part, equivalent to watching the town burn while refusing to pay the local firemen their back wages. We must restock the IMF and permit it to intervene again, where necessary.

In addition, the biggest Western nations, led by the U.S., must periodically participate directly in these turbulent financial markets to stabilize them. Last week, the U.S. and Japan jointly and dramatically intervened in the currency markets to support the value of the yen. This sent a strong message of leadership and concern that, at least momentarily, calmed the markets.

Our banking and other financial regulators must be extra-vigilant. Right now, lenders in the U.S. and Europe are lowering their credit standards and throwing money at any borrower who shows up. This always happens at the top of the cycle. But the longer such indiscriminate lending continues, the greater the exposure of our financial system to a sudden shock. In this era of global finance, even the collapse of a large Japanese bank, for example, could trigger liquidity problems in Western financial institutions.

Finally, this is not a propitious moment for consumers or businesses to be highly leveraged. When times are good, it is always easy to believe that stock prices or residential real-estate values or corporate earnings can only go up. Borrowing even more against them seems the natural thing to do. But after such run-ups in values, and amid the spread of the international financial crisis, that is not wise.

This is a dangerous moment. We have entered the era of globalization and yet are witnessing a dichotomy. In economic and financial terms, much of the East Hemisphere is in flames and the fire is spreading. Yet, our own market and financial system and economy seem disconnected from it, as if in another century. Perhaps this anomaly will continue. But don't count on it.

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