Market Advisory Features

The Weakness of the Strong Dollar
Argentina and Brazil : Elections and Economics

Watching Out for the Great Bear
Corporate Scandals and Politics
Asian Industries Threatened by US Financial Woes


Tuesday, July 9, 2002

The Weakness of the Strong Dollar

Project Syndicate

(Joseph E. Stiglitz is professor of economics and finance at Columbia University and the winner of the 2001 Nobel Prize in Economics.)

It is always risky to write about exchange rates.

If a currency's exchange rate is falling, it may well be rising by the time one's article appears. But the issue of how we should think about exchange rates and their appropriate management is a perennial one.

So what is at issue now is not just the falling dollar, but rather what US officials intend to do about it.

Paul O'Neill, the outspoken US Treasury Secretary, suggests that there is little the US could or would do to sustain the dollar. His remarks were criticized by some as abandoning the strong dollar policy that was the Clinton Administration's hallmark.

One responsibility of economic leadership is to dispel economic myths -- certainly not to create them.

The "strong dollar" policy represents an especially egregious example of an economic myth; it seems to suggest that the US Treasury could, and would, maintain the strong dollar, and that a strong dollar is good for the US.

When I was chairman of the President's Council of Economic Advisers, I was often asked if I supported the strong dollar policy. I replied that I believed in an "equilibrium dollar."

In other words, exchange rates are no different from other prices. Like the price of apples and oranges, market forces should determine them. Anyone who says he believes in a "strong orange policy" would be ridiculed.

Yet some of those who seem to have the greatest faith in market forces treat exchange rates as if they were governed by laws other than those of standard economics, so that a word or even a look from a finance minister could lead currencies to soar or plummet.

Of course, there is considerable irrationality in currency markets. Keynes once described asset markets as beauty contests, in which the objective is not to ascertain who is the most beautiful person, but whom others will think is the most beautiful.

The objective in currency markets is, indeed, often to guess what others will be thinking.

But even if government intervention can affect exchange rates in the short run, in the longer run, it is market fundamentals that matter.

There may be a legitimate role for government in limiting excessive volatility, but if underlying economic fundamentals do not drive the exchange rate, what is the basis of our confidence in the market system?

Belief in misguided notions inevitably leads to further nonsense. On one occasion, a reporter queried the US Treasury on the adverse effects of the strong dollar on exports (at the time, car sales and other exports were suffering.)

The response was that the strong dollar meant a strong economy, and a strong economy strengthens the ability to export.

But of course, even the US Treasury, as powerful as it may be, cannot repeal the laws of economics. Demand curves are downward sloping: typically, at higher prices, others will demand less of American goods, and a strong dollar means that American goods are more expensive.

Perhaps the most important objection to the strong dollar policy is that it encourages precisely this confusion between a strong dollar and a strong economy. We should no more be emotionally attached to the exchange rate than to any other price.

A stronger exchange rate discourages exports, and when an economy is facing rising unemployment, it can make a bad situation worse. On the other hand, a higher exchange rate may also lead to lower inflation, as import prices fall. When inflation is the primary concern, a strong exchange rate may be good for the economy.

The strong dollar policy reeks of an economic nationalism that is out of step with the era of globalization. If the dollar is strong, then the euro or the yen is weak. But how are political and economic leaders in other countries to respond? Should they simply agree to the strong dollar policy, even though it implies a weak yen or euro policy?

What is required is a debate with the US, for the strong dollar has led to an anomalous situation: the world's richest country seems unable to live within its means and must continually borrow hundreds of billions of dollars from abroad to finance its huge trade deficits.

The strong dollar -- far more than Japanese protectionism -- fuelled the bilateral deficit with Japan. It also contributed to protectionism at home, reflected in the new US steel tariffs.

It is high time that the nonsense of the strong dollar policy be laid to rest. Paul O'Neill should be commended for helping in this effort.

Perhaps we can now begin to think more seriously about creating an international economic system that acknowledges the devastating effects that market volatility among major currencies has on less developed countries, and that ensures greater stability.

For too long, we have blamed the victims. That has merely permitted us to avoid taking a hard look at the system itself.



Argentina and Brazil : Elections and Economics
Jul 5th 2002
From The Economist Global Agenda

With Latin American leaders in Buenos Aires for a summit meeting, frustration at the lack of outside help for the shattered Argentine economy is beginning to mount. President Eduardo Duhalde has unexpectedly brought forward the presidential elections to try to end the political stalemate hampering economic reform in his country. But as Brazil is discovering, even when a poll is pending it is far from plain sailing

PATIENCE is beginning to run out. Latin American leaders, in Buenos Aires for a summit meeting, are beginning to rally round Argentina's beleaguered president, Eduardo Duhalde. President Vicente Fox of Mexico said on July 4th that he would be an advocate for Argentina in urging the rest of the world to be more generous towards the crisis-ridden country. Mr Fox was supported in his call for more help by the Brazilian president, Fernando Enrique Cardoso.

There has already been a change of tone from both the International Monetary Fund (IMF) and the American government in recent days. After months of fruitless negotiations between the IMF and the Argentine government about a rescue package the for Argentina, the Fund said on July 2nd that the talks were enjoying “new momentum”. Even Paul O'Neill, America's treasury secretary and no fan of emerging-market bailouts, started to make more encouraging noises. But comments from Latin American leaders suggest they are starting to link the reluctance to help Argentina with American attitudes on trade and farm support, both of which have drawn international criticism.

With signs of progress in negotiations with the IMF, Mr Duhalde decided to grasp the political nettle. On July 2nd, the president announced on national television that the elections due in September 2003 will now take place six months early, with the new president taking office in May next year. That shortens the period during which Mr Duhalde has to cope with the political infighting that has made economic reform almost impossible.

For months, Mr Duhalde, has struggled to restore something approaching order to the country’s shattered economy. His efforts have largely been in vain. Six months after the disastrous collapse of the peso and the financial system, there has been virtually no progress. The economy is in its fourth year of recession, unemployment is about 24%, and, on June 26th, riots returned to the streets of Buenos Aires. Mr Duhalde, an interim president whose poll ratings have fallen to 8%, had nowhere to turn.

Sorting out the economic mess after the upheaval the country went through at the beginning of the year would have been a tall order for anyone. Within a few weeks, Argentina saw the abandonment of the link between the dollar and the peso, the virtual collapse of the banking system, the overthrow of the previously-elected president, Fernando de la Rua, and three other presidents come and go in a matter of weeks. Mr Duhalde, who had no electoral mandate and who has shown no relish for political confrontation, has never managed to cope with the difficulties.

One clear obstacle to reform has been the reluctance of politicians, in the legislature and the provinces, to sign up to politically unpopular measures. And Mr Duhalde has lacked both the stature and the popular support to force them to accept the changes needed. But his new strategy is potentially risky. No deal is yet on the table. As electioneering gets underway, the inevitable jockeying for position could make reform even more elusive.

While in Brazil...

Mr Duhalde only has to look north of the border to see how destabilising elections can be. In recent weeks, Brazil’s economy has come under pressure as the financial markets have become nervous about the outcome of the presidential elections due in October. It is hard to find anything in common these days between Argentina and Brazil: Brazil has pushed through reforms in its banking and corporate sectors; it has brought inflation down sharply; and it has a budget surplus.

But Brazil also has a candidate in the presidential elections who makes investors nervous. Luiz Inacio Lula da Silva, the leftist candidate and member of the Workers’ Party, currently has a comfortable lead in opinion polls. This, coupled with doubts about Mr da Silva’s commitment to low inflation, fiscal conservatism and market-friendly policies, has seen the Brazilian real come under enormous pressure. That pressure intensified again on July 2nd, when the real fell to a new intra-day low against the dollar, before recovering slightly. The risk premium above American treasury bonds which Brazil is forced to pay has also risen sharply.

The IMF recently provided a public endorsement of Brazil’s economic policies. But there is domestic and international concern about the country’s large public debt. That has now reached about 55% of GDP; interest payments are currently around 9% of GDP. Persistent weakness in the real could also push inflation up. And since a large slice of Brazilian debt is indexed to the dollar, it could also raise the percentage of debt as a share of GDP.

Servicing this debt already requires the government to run a primary fiscal surplus (that is, before debt-service costs) of around 4% of GDP, and some economists think it will need to be even more. That’s a tall order for an emerging-market economy: the worry is that Mr da Silva might be more keen to increase government spending. Comments from Mr da Silva’s chief economic adviser last week suggested his commitment to low inflation may also be weaker than the present government’s.

On July 4th, Mexico's Mr Fox gave what some interpeted as implict support to the government candidate, José Serra, when he stressed the importance of continuity in Brazilian economy policy. In any case, despite his comfortable lead at present, Mr da Silva’s victory is far from assured. This is Mr da Silva’s fourth election campaign, and he has been ahead in the polls at this stage in the past.

In the meantime, the head of Brazil’s central bank, Arminio Fraga, is confident that Brazil can cope with the current uncertainties. But whether Mr da Silva wins or not, many Brazilian bankers privately worry about the prospect of default, as do many outside observers. Morris Goldstein of the Institute for International Economics in Washington puts the risk of default before the end of 2003 as high as 70%.

Such is the scale of Argentina’s crisis, it no longer has to worry about the confidence of international investors. It defaulted months ago. It has no prospect of attracting private foreign capital in the near future. But the rocky road to Brazil’s election is an uncomfortable reminder that Argentina is in for several more months of instability and upheaval. Mr Duhalde can at least take some comfort from support from his regional neighbours.



Corporate Scandals and Politics

The backlash against business
Jul 4th 2002 | WASHINGTON, DC
From The Economist print edition

Corporate malfeasance is on the verge of becoming a big political issue—even though the public hardly cares about it yet

DOMESTIC matters have failed to exert much of a hold on American politics since the destruction of the World Trade Centre. The vanishing budget surplus, campaign-finance reform and the rest have come and gone, leaving not a wrack behind. Yet disintegrating confidence in corporate America will surely be different. This week, it reached even the door of George Bush himself.

Following the revelation that worthless WorldCom had padded its accounts to the tune of $3.9 billion—which itself followed a series of other scandals dating back to the collapse of Enron—Mr Bush put himself at the head of a parade of outrage demanding a measure of responsibility from corporate executives. He interrupted the G8 summit in Canada to complain about balance-sheet shenanigans. He gave a radio address demanding that executives should be criminally liable if they give intentionally misleading information. Next week he will give a big speech on Wall Street to explain more policies.

His rhetoric already marks a change. After the Enron affair, Mr Bush talked about a few “bad apples”. Now he is talking about threats to “our entire free enterprise system”. His change was necessary not just because of the mess (to suffer one business scandal may be regarded as a misfortune; to suffer eight looks worse than careless), but also because the scandals have dangerously reinforced the idea that Republicans are soft on business.

Although the WorldCom affair has nothing to do with political corruption (the company did not seek government help, as Enron did), it certainly smacks of corporate corruption. That is the stick Democrats are beating Republicans with. They sneer that the president's rhetoric about tackling white-collar fraud is belied by his earlier reluctance to give the Securities and Exchange Commission (SEC) more money. The leader of the Senate, Tom Daschle, has incredulously contrasted the Republicans' current outrage with their earlier deregulatory fervour. Most alarmingly, eyes are turning to the president's own business record. The SEC investigated some of his share dealings in 1990-91, when Mr Bush, then on the board of Harken Energy Corporation, took 34 weeks to give “timely” notice of an $848,560 stock trade, made a week before bad news was disclosed.

The outrage has already revived a bill on accountancy reform that had appeared dead in the Senate only two months ago. The bill, sponsored by Paul Sarbanes, a Democrat from Maryland, would create an independent regulatory board to set book-keeping standards, limit accountants' consultancy work, discipline dodgy auditors and prevent a senior auditor from working with a public company for more than five years. Mr Daschle says the Senate will vote on the bill next week and forecasts it will pass by a landslide.

Weirdly, the outrage in Washington is not matched by any surge in public opinion about the issue. There are some signs of change. Mr Bush's ratings for handling the economy have begun to fall, from 60% in January to 53% now. Polls also show rising concern about the quality of financial information. In March, a third of respondents thought the problem was confined to a few isolated cases—the “bad apples” theory. Now fewer than a quarter do, and at least two-thirds say they think most companies tell lies. Talk radio, cable television and other barometers of grass-roots political opinion have become incensed.

On the other hand, Mr Bush's overall ratings remain stratospheric. A poll by Stan Greenberg (a former adviser to Al Gore) found people still think Republicans do a better job of handling the economy than Democrats, though they trust Democrats more to crack down on fraud.

Corporate ethics hardly figures in the mid-term elections yet. True, the fiercely competitive race in Mississippi's third district has become a battle of blame between Chip Pickering, the Republican incumbent, and Ronnie Shows, a congressman from a neighbouring district who accuses Mr Pickering of being too close to the disgraced WorldCom, which is based in the district. But that is a special case. Elsewhere, corporate ethics ranks well below other issues.

Karlyn Bowman, an observer of social trends at the American Enterprise Institute (AEI), argues there has been no break in the overall pattern of attitudes to business as a whole. For the past 20 years, 55-65% of the country has expressed “some confidence” in those running big businesses; 10-25% express a great deal of confidence. The numbers are now towards the lower end of those ranges—a decline in confidence, but no backlash against business.

So is the current business-bashing in Washington just a short-term craze? It is possible. The economy still looks reasonably healthy. Share prices are falling, but still hover above the point at which Alan Greenspan worried about “irrational exuberance”. The bubble is deflating rather than bursting. Meanwhile, both sides have political reasons of their own for not ramping up the rhetoric much further. The White House has to balance the need for good business ethics against the risk of panicking the markets. The Democrats fear regaining their reputation, so painstakingly shrugged off in the Clinton era, of being hostile to business.

That said, there are reasons for thinking the worries about corporate America will not conveniently go away. To begin with, there may be a lag in the public response. The scandals at WorldCom, Adelphia, Tyco and the rest may simply be too recent to have had their full effect yet.

Next, it is almost impossible to believe that all the bad business news has now come out. Most of the misbehaviour seems to be related in some way to the huge incentives Wall Street provided in the past decade for reporting rising earnings quarter after quarter (or rather, earnings that exceeded ever-rising expectations). The half dozen firms which responded to this incentive by cooking their books cannot be the only ones. The likelihood is that many more will emerge: as Norm Ornstein of the AEI points out, public prosecutors and the press have incentives of their own to find more malefactors of great wealth.

And if so, that would surely affect America's electoral politics. Bill McInturff, the head of a Republican polling outfit, Public Opinion Strategies, argues that over time a president's approval rating is generally about 20 percentage points above the number of people saying the country is on the right track, which in turn is strongly influenced by consumer confidence. At the moment, Mr Bush's 70% standing is both exceptionally high and 20 points above the right-track question. Since 1945, only three presidents have approached this sort of approval just before a mid-term election, and their parties did well in all of them. But consumer confidence, as measured by the University of Michigan index, fell almost 4.5 points in June.

A few more corporate scandals and a further decline in the stockmarket and the dollar could well push down both the right-track measure and Mr Bush's standing. At that point, the Republicans would be in real trouble. The economy, too.



Watching Out for the Great Bear
Jul 4th 2002
From The Economist Global Agenda

Stockmarkets around the world are unusually jumpy, with dramatic falls in share prices followed by sudden recoveries. But the underlying trend still seems to be down, raising fears that the global economic recovery could yet be undermined

THESE are not times for nervous investors. The recent sharp fluctuations in the world’s stockmarkets have brought the doom-mongers out in force. They point to the relentless downward slide in share values since their peak in 2000 in America, earlier in London and more than a decade ago in Japan. The collapse in share prices has sent many investors scurrying for cover in safer assets like bank deposits or bricks and mortar; and workers due to retire have begun to worry about the safety of their pension funds. Stockmarket volatility has been matched by swings in currency values—if there’s panic around, foreign-exchange dealers don’t like to be left out.

The market hysteria, coupled with a relentless air of gloom among many in the financial and corporate sectors, is enough to make even the most balanced economist pause for thought. Long-time market observers know things are rarely as bad as they seem—but could the current bear market be one of the exceptions? Policymakers are not usually concerned directly with the ups and downs of the stockmarket—or they are not supposed to be. Nevertheless, market gloom is making everyone nervous, and that means that policymakers too will tread warily. For now, their main priority is to try to keep the still-modest global recovery on track, but with one eye on inflationary repercussions.

The dilemma facing policymakers was neatly encapsulated by the European Central Bank (ECB), whose main governing body met on July 4th to decide what to do about interest rates. The bank has done its best to build a reputation as an inflation hawk—it stubbornly resisted most of the pressure applied on it during 2001 to cut interest rates to head off recession in Germany and elsewhere. The ECB continues to be worried about inflation: it has often failed to hit its inflation target (no bad thing say those economists who believe the target is too tight), and Wim Duisenberg, the bank’s president, admitted that “the risks to price stability remain tilted to the upside.” Yet the ECB left rates unchanged because, said Mr Duisenberg “the uncertainties were too large to come to a decisive decision.”

Since, in theory, at least—and in public—the ECB insists that its only target is inflation (and not, unlike America’s Federal Reserve, economic growth as well), the principal uncertainty for Mr Duisenberg and his colleagues is the possible inflationary impact of recent currency swings. Growing concern about America’s economic prospects has sparked a big dollar sell-off. No longer the automatic safe haven of choice, the dollar has lost around 10% of its value against the euro since the start of the year (and has fallen at a similar pace against the Japanese yen).

A strengthening euro should spell good news on the inflation front—for Europe, anyway. Imports become cheaper and thus reduce inflationary pressures. As Mr Duisenberg and his colleagues know only too well, though, what goes up can always come down. The euro, in its short life, has been down more than up—which is why it is too soon to count on its remaining strong. Hence the bank’s equivocation.

The Bank of England also decide to leave rates unchanged on July 4th, just as the Fed had on June 26th. The British and American central banks, though, are explicitly charged with looking at inflation in a wider economic context. Their interest-rate decisions can therefore reasonably be taken to incorporate judgments on the current state of their national economies. Even Britain’s economy—largely immune from the global downturn last year—saw zero growth in the first few months of 2002: the current stockmarket gloom was therefore bound to make the Bank of England cautious. And as America emerges gently from last year’s recession, the Fed is going to take no chances: the last thing its chairman, Alan Greenspan, wants is blame for choking off recovery in the world’s biggest and most important economy.

By themselves, falling stockmarkets do not usually cause recessions. It is now generally accepted that the blame for the Great Depression in 1930s America does not lie with the Wall Street crash of 1929 but the unreasonably tight monetary policy which followed it. And stockmarket volatility can occur when the underlying trend is up, as well as now, when it is down. Research by two American economists, Bradford DeLong and Robert Barsky, looked at very long run stockmarket performance in America, from 1900-1990. Volatility is greatest, they concluded, when investors are most uncertain about the future.

Uncertainty is clearly a major factor in the current bout of market volatility. That uncertainty is itself a reflection of concern about the impact on the real economy of the aftermath of the great American boom of the late 1990s. Accounting scandals at Enron, WorldCom and other big American companies have got investors worried about what else might be in store: how many other companies chose, or felt pressured, to overstate their profits? Is the shake-out of the hi-tech and telecommunications sector over—or will more companies issue profits warnings, unable to maintain the sort of growth they enjoyed at the peak of the boom?

Sharp falls in share prices can develop a momentum of their own, just as big rises can during bubbles. The current decline in share prices, using the year-end levels, is the most prolonged slide since the 1940s in America, for example. For some economists, this represents a necessary and long-delayed correction in share values: by historical standards, many share prices seem overvalued when looked at in relation to corporate earnings (and downward revisions in corporate earnings would make them seem even more overvalued).

So far, the bear market has not had too dramatic an impact on America’s admittedly modest recovery this year. The data is mixed, and there are still worries about business investment levels—which Mr Greenspan regards as key to a sustained upturn—and about wobbly consumer confidence. But unemployment has not risen as far as some had forecast—not yet, at any rate—and labour market figures released on July 3rd showed a further fall in initial unemployment claims from those who have recently lost their jobs.

For those determined to look on the black side, though, the spectre of Japan looms large. In late 1989, the Nikkei share index peaked at almost 40,000: the ensuing collapse was swift—within three years the index had fallen to less than half that, and it hovered around that level for the best part of a decade before plunging again in the middle of last year. Most worrying of all, for those now watching the decline of American shares, the Japanese economy has been in the doldrums ever since its share bubble burst.



Asian Industries Threatened by US Financial Woes
MANILA, PHILIPPINES | Thursday, July 4, 2002

TOKYO -- Malingering financial troubles in the United States have cast a dark shadow over Asian manufacturers and exporters as the current crisis could signal the end of a decades old disinflationary process, one of the world's leading financiers says.

Kenneth Courtis, vice chairman of investment bankers Goldman Sachs Asia, told AFP that Japan, South Korea and others Asian exporters have been the main beneficiaries of that worldwide fight against inflation and would suffer should a new economic paradigm prevail.

Courtis, a Tokyo-based economist, pointed to the reliance of the US ecomomic model during the 1990's on eliminating budget deficit and public debt, worldwide confidence in US firms, geo-political stability, transparency and productivity gains derived from free trade.

"In the Bush bear market, all these conditions changed," said Courtis, referring to financial movements under President George W. Bush.

The events of September 11, the resurgence of public debt, the bursting of the highly speculative dot-com bubble, protectionist measures guarding steel, timber and agricultural exports, and a series of high profile corporate scandals have changed the US economic map, he said.

"Confidence is not there any more and investors have withdrawn their money from American equities and the dollar," he said.

The indicators of this loss of faith are easy to spot: the major rise of gold and the euro against the greenback and the steep curve of American interest rates. Despite a 73% cut in 12 months of short term rates by the US Federal Reserve, long term rates remain high.

The current lax monetary policy led by the Fed has conformed to standard practices applied since the stock market crash of 1987 and the US savings and loans crisis, Courtis said.

"Since then, each time the system is shaken, they come to the rescue with a very agressive monetary policy, wich amounts to putting off the repayments," he said.

But, he added, "fundamental problems are not adressed, particularly overconsumption in the United States financed from abroad, mainly Japan."

The unstoppable rise in US current account deficits, moving towards five percent of the gross domestic product, is a major symptom of this.

The key issue is knowing if needed adjustments could be made without imposing brutal recession on the US economy.

In such a scenario, said Courtis, "the United States would cease being an imports machine and east Asian countries which did not implement necessary reforms would suffer from the crisis at the core of the system."

The alternative scenario would see a resurgence of inflation in the United States on such a massive scale it would mean abandoning the policy of disinflation that has been the dogma of central banks since 1979, when Paul Volcker took the helm at the Fed.

To this end, said Courtis, despite US officials' insistence, "the strong dollar policy has changed."

So far, countries exporting industrial products, Asia in particular, have been the main beneficiaries of the decades old deflationary process, while raw material producers have been the large losers.

Figures tell the story, said Courtis: In 1980, the price of a car exported by Japan was equivalent to 10 ounces of gold or 160 barrels of crude oil. Today it is the equivalent of 45 ounces or 600 barrels

If inflation returns, the terms of trade would switch to benefit the major producers of raw materials and commodities -- Russia, Australia, Canada, South Africa, the Gulf countries and the United States itself.

The losers would be Asian manufacturers, in particular Japan, and also Europe, which exports capital and imports raw materials.

For America, the return of inflation would have a major benefit. "Americans will not refund the money which they owe to the rest of the world and as they print and distribute the first reserve currency, they can get away with it," said Courtis.

But, he added, in 1979 the collapse of the dollar led to oil exporting countries threatening to demand payments in German marks.

This time, and with more credibility, they have the option of turning to the euro.

"The euro could become a serious competitor of the dollar and for the first time, the United States' room for maneuver would be limited," he said.

At a time when the financial maps are being redrawn "one always needs to define a new paradigm, but things never turn out quite as planned," Courtis said.

In other words, the hour of judgement can again be postponed, but not indefinitely.




Present at the creation

Jun 27th 2002
The Economist

For the first time at least since 1989, but arguably since 1945, America has both the chance and the motivation to reshape the world, writes Bill Emmott, the editor of The Economist

WHEN Dean Acheson, Harry Truman's post-war secretary of state, wrote his autobiography, he chose a grandiloquent title to describe his dozen years in government. He had been “Present at the Creation”, he said, by which he meant the building by America of a new world, out of the wartime rubble of the old—or, at any rate, of half a new world, the free half, while an ally turned enemy, the Soviet Union, built the other half. He was in turn quoting a 13th-century Spanish king, Alfonso X, who apparently said with equal immodesty: “Had I been present at the creation, I would have given some useful hints for the better ordering of the universe.”

Today, two further lots of rubble are again inviting America to try to reshape the world: that left by the terrorist atrocities in New York, Washington and Pennsylvania on September 11th 2001, but also an older one not yet properly built upon, that left by the fall of the Berlin wall on November 9th 1989. Once more, we may be present at a time of creation, a time for useful hints, a time if not of order then of new responses to the world's habitual disorder.

That is, again, a rather grandiloquent way to describe things. This first decade of the 21st century is not the same as Acheson's period in the middle of the 20th, when Germany and Japan lay defeated and much of Europe and Asia devastated, and when the slate of international arrangements could readily be cleaned to make way for a new lot. America again leads the world in all dimensions of power—military, economic, cultural, scientific (see chart 1)—by a margin out of all proportion to its population. But the world's slate is neither clean nor readily wiped, the uses and users of power have become more complex and varied, and America is itself led by an inexperienced, sometimes jejune president, bent on a narrower (if still daunting) task than was the also-inexperienced President Truman, that of fighting a “war on terrorism”.

Moreover, the officials led by George Bush, seasoned though many of the senior ones are, have not yet inspired confidence that they know what broader set of policies they wish to follow, let alone how they might seek to reshape the world. They have defined their war as one of good against evil, of civilisation against terror, but have then butted their heads against the blood-stained brick wall that is the Israeli-Palestinian conflict. They have spoken about a “regime change” in Iraq, but have done little about it. They have said they favour democracy, but then hesitated to condemn an attempted coup in April against Venezuela's President Hugo Chavez. They have said they favour free trade, but then slapped tariffs on steel imports and subsidies on farming. They have rubbished foreign aid, then embraced it; supported a bankruptcy procedure for countries in financial crisis, then opposed it.

Such behaviour may in time come to show that this administration is inept; or, just as likely, it may come to be irrelevant, for all administrations zig, zag and stumble from time to time. There is, to be sure, no blueprint currently on White House desks for changing the world. But it ought not to be forgotten that even before the terrorist attacks, President Bush had set in train a project—the development of a national missile-defence system—that promises over the next decade or more entirely to alter the way in which the world handles its nuclear arsenals and deters their use. It is possible to argue—and plenty do—over whether this system will ever work. But given America's money and technological record, it would be unwise to bet heavily against it. And on the way to making it work, the effort is likely to change relations between America and the other big nuclear powers, among many others.

Furthermore, two immediate things make change a likelier outcome than stasis. One is that the attacks on September 11th, and the fear of more in future on an even more devastating scale, have given the United States a powerful new motive for global activism, while persuading most other countries, whatever their snarls of criticism or resentment, not to stand in its way—at least for the time being. The second is that the actions implied by that motive are likely then to draw America into new acts and new types of engagement, whether it likes it or not. Even if a blueprint were to exist, it would soon be obselete.

With hindsight, both the tasks and the opportunities that lay before Presidents Roosevelt, Truman and Eisenhower in 1945-55 look fairly clear. But they didn't at the time. Acheson wrote that “only slowly did it dawn upon us” that the 19th-century world structure had gone, and that the struggle to replace it would henceforth be directed from Washington and Moscow. At first, even the need for post-war relief and rehabilitation was under-rated, having been seen “almost as capable of being met by semi-private charity”. It took three years before America developed the Marshall plan to help revive Western Europe's economy, along with other efforts at overseas aid.

An expanding agenda

In today's very different context, a similar evolution is likely to take place. The challenge, as it was defined in the days and weeks following September 11th, is bound to change but also probably to grow. What began as a fight against the perpetrators of those attacks, a task that already looked large given their wide dispersal and insidious nature, has rightly been broadened further to include rogue states developing weapons of mass destruction. Thanks to happy victories in Afghanistan, it has come to take in the stabilising of that unhappy country to ensure it does not again play host to terrorists and—even more important—that it does not destabilise its nuclear-armed neighbour, Pakistan, itself repeatedly on the brink of war with India. And there is the associated task of discouraging violent militancy in other countries in Central Asia.

All that is before even mentioning the Arab world, the terrorists' main origin, in which Israel and Palestine provide their bloody complication, and in which the desired “regime change” in Iraq will require America to set to work on helping a new regime to emerge, an effort that may then put pressure on other Arab countries to alter their ways, too. An old taboo, on “nation-building” abroad, will have to be put aside. Then there is the decidedly unsmall business of handling the often prickly relationships with bigger powers such as Russia, China, India, Japan and the European allies, whose interests will be affected, for better and worse, by all this activism. As these tasks lead to others, and as unforeseen consequences occur, the magnitude of what is being attempted is likely slowly to dawn upon Acheson's successors.

Will they succeed? Just as after 1945, the honest answer is: only partially. But there are good grounds for optimism, founded in the nature and origins of the change that is occurring.

For the world did not change all at once on September 11th last year. Rather, the world had gradually been changing since at least 1989 thanks to the demise of communism. Mainly, the changes were for the better: the end to ideological superpower conflict; a vastly increased number of countries wishing to adopt liberal trading rules to join the market economy, and thus aligning their interests mainly with those of the West; technological innovation that made it easier for ideas to flow across borders; a big rise in the number of countries choosing and regulating their governments by means of democracy.

But, in three respects, it had also been changing for the worse: a number of deadbeat countries were falling into war and civil strife when cold-war restraints and props had been removed; technological change was threatening to put new destructive and organisational power in the hands of trouble-makers; and a new sort of trouble-maker—the messianic terrorist—was gathering recruits and strength. The dramatic manifestation of such terrorism on September 11th then brought about a sudden change in America itself. A sudden change in America means a sudden change in the world. A country that had gradually become loth to get involved in foreign entanglements, in the famous terms of George Washington's farewell address, gained a new determination and sense of purpose.

The reluctant sheriff no longer

It was not that it had been idle during the 1990s, nor isolationist. It mobilised 500,000 troops for the Gulf war in 1991. At the end of the decade, it led—in effect, conducted—NATO's war with Serbia over Kosovo. During those ten years, American military interventions overseas were more numerous, if on a smaller scale, than during the whole four decades of the cold war. Its gung-ho economy, which reversed two decades of anguish and under-performance, boosted American self-confidence. In other areas too—trade rules, financial crises, human rights, war crimes, mediation—America played an active international role. But it did so hesitantly, against a backdrop of declining domestic interest in foreign affairs (a decline shared in Europe). It acted by improvisation, with no clear sense of purpose or coherent strategy, and a rather short attention span.

That is what has now changed. There may not yet be a coherent strategy, but there is certainly a clear sense of purpose. There is bipartisan unity on the main elements of foreign policy, which was absent even for the Gulf war. Opinion polls reveal considerable public backing for activism abroad. Few voices can be heard calling for America to withdraw or do less. As long as the sense of threat endures, attention is unlikely to wander. In 1997 Richard Haass, then a think-tanker at the Brookings Institution, wrote a book that called America “The Reluctant Sheriff”. Now the director of policy planning at the State Department and considered moderate by the standards of the Bush administration, Mr Haass says that if he were writing the book now he would delete the word “reluctant”.

Another word, once considered rather daring, is becoming commonplace in policy seminars and on talk-shows: empire. By last September Andrew Bacevich, a military man turned professor of international relations at Boston University, had completed the first draft of a book on America's world role, with a provisional title of “Indispensable Nation”. Now it is to be called “American Empire” (and will be published this autumn by Harvard University Press). Though Mr Bacevich and others talk of American military commanders as “pro-consuls”, no one has in mind colonies or an emperor. But there is a strong, sometimes hubristic, sense that America has the opportunities, obligations and threats associated in the past with empires: that it can set the rules that govern international relations, while at times operating outside them itself; but also that ultimately it alone can enforce those rules, a role which makes it the prime target of anyone who dislikes them.

How much is too much?

After a decade of urging America to do more abroad, plenty of outsiders now worry that this sole superpower may soon do too much. During the 1990s there was much enthusiasm for the idea that, contrary to the United Nations Charter of 1945, countries should intervene in others' affairs, preferably collectively through the UN, when they thought that some other country was doing terrible things to its people. Such beastly behaviour would mean, said solemn international commissions, that the normal rights of sovereignty could be waived. Now America is developing a similar argument for its own pre-emptive intervention in cases such as Iraq, where it suspects a dictator of planning to develop weapons of mass destruction. “Foul!”, “Arrogant!”, “Illegal!”, comes back the international cry.

As well as seeking new rights, though, America is also refreshing some of its sense of obligation. The best example is the changing of mind on a topic once taken to epitomise foreign-policy fecklessness: development aid. In March at a United Nations summit in Monterrey, Mexico, President Bush startled delegates by announcing a 50% increase in America's $10 billion annual aid budget by 2006.

That is a big rise from a small base (it is less than half the European Union's combined aid budget, which at almost 0.4% of GDP by 2006 will remain proportionately three times more generous), but it came with other symbolism that made it feel more like a new beginning than a gesture: a rock star turned aid lobbyist, Bono, was by Mr Bush's side and also persuaded one of the hardest men of the right, Senator Jesse Helms, to back a special fund to help ease HIV/AIDS in Africa; and the general aid will be tied to conditions requiring good governmental behaviour in the recipient countries. If properly implemented, those conditions will represent a fresh form of interference in other people's business, but could also give development aid a new credibility.

Mr Bush does not believe that aid is needed because poverty causes terrorism. The September 11th terrorists were not poor, and most did not even come from poor countries. What the change of mind on aid implies, though, if it is indeed more than just window-dressing, is a strengthened belief that it is in America's long-term national interest to help more countries to take part in the process of international trade, investment and technology transfer that is popularly known as globalisation, and that to do so they need accountable, stable and legitimate governments. Mr Haass, in a speech to the Foreign Policy Association in New York in April, described this as an emerging doctrine of “integration”.

That process, and all the social and economic changes it brings, may actually be part of what the terrorists were enraged by, so reinforcing it would be more a gesture of defiance than of accommodation. In the shorter term, the same instinct has led President Bush to call for “a new Marshall plan” for the reconstruction of Afghanistan, though he has so far been short on specifics about what should be done and who should pay. He has also, however, recently been decidedly anti-integrationist in his trade policies, applying those steel tariffs and signing into law a lavish new farm-subsidy bill. Openness on trade, which includes the leadership of the new worldwide round of liberalisation that was promised in Doha last November, is costlier for domestic lobbies than is aid. Those measures were lamentable, but not irreversible. Leadership on trade is still to be hoped for, and pressed for.

Put like that, it sounds obvious. By promoting integration and acting as sheriff, the United States of America could do a lot of good in the world in the next few years. But since it would be doing so not just by handing out bags of money but by exerting and even extending its power, pressing or forcing people to change their ways, the very idea makes a lot of people uncomfortable. Might there be a backlash against a bossy, unilateralist America?

Hail to the integrator-in-chief?

It is a truism, of course, that if America does bad things or makes bad mistakes, others will criticise it, shun it or even oppose it. It is best, however, to think about this emerging issue of American power and leadership in three ways:

• America's power relative to its rivals' and to other alternatives, including its allies.

• America's power relative to the challenges it faces around the world, and what it might achieve by using it.

• America's power relative to its own willingness to use it, or to keep bearing the costs of maintaining and using it.

This survey will explore those topics, and the questions they raise. Its answers—be warned—will be optimistic, and will generally be favourable to the United States. Certainly, American leadership will produce mistakes. But without American leadership, worse things would happen. And if any other country were in the lead, there would be much greater cause for worry.




The acceptability of American power
Jun 27th 2002
From The Economist print edition

American primacy will continue to be welcomed by many, and tolerated by others, even if through gritted teeth

“YOU can always rely on America to do the right thing,” quipped Winston Churchill, one of America's greatest 20th-century fans. “Once it has exhausted the alternatives.” That quotation contains both the main components of what remains a typical European view of American foreign policy.

It contains admiration, founded on the experience that when America intervened in Europe's two great wars of the 20th century it did so on the right side, with the right values and with ultimate success. But it also contains a superiority complex, a view of Americans as bumblers or global ignoramuses. Given that Churchill presided over the handing to America in 1941-45 of what little world leadership Britain then retained, he could be forgiven for posing as teacher to America's pupil. Yet the syndrome has endured and even widened, half a century later.

Today's critics, and they are numerous even among its allies, tend to sneer that American activism is reviving only because the United States now itself feels under threat. It is, they say, a selfish, or at least self-centred, reaction to injury rather than a new internationalism; it is being led by an administration that rejoices in rejecting or abrogating international treaties, acting unilaterally rather than in multilateral concert with others; and they say that helpful activism will soon descend into adventurism. Moreover, in its use of military power, America seeks to make others—even its allies—take casualties rather than lose its own troops; and America's leaders are “simplistic” and “absolutist”.

These criticisms are three-quarters true, but they are far from devastating. Indeed, they may even be taken as compliments. In a democracy as open and cacophonous as America's, and with a constitution expressly designed to thwart decisive action by any single branch of government, it is hard to persuade a majority to support costly and risky international activism. Self-centredness is not only natural but legally required. There has, admittedly, long been a deep seam of morality running through American policy, epitomised by Woodrow Wilson's “Fourteen Points” in 1918 and repeated in President Bush's “non-negotiable demands” on other nations in his state-of-the-union address in January this year. But idealism has rarely been enough to bring about timely or sustained action overseas; even Hitler's fascism required Pearl Harbour before Franklin Roosevelt dared enter the second world war overtly.

More will be said in a later section about treaties and their abrogation; there is right on both sides in different cases, and America's constitution queers the pitch by placing domestic law and Congress above all such international obligations. But on the Bush administration's side is the pragmatic argument that treaties are an inter-governmental means to an end, not an end in themselves; if, as with deals intended to counter the spread of nuclear, chemical and biological weapons, the treaties are being flouted (eg, by Iraq), someone has to provide the leadership to ensure that crucial treaties such as these are enforced.

The reluctance to take casualties reflects two things, one good, the other less so. The good cause is democracy itself, which in America makes politicians keen to preserve their citizens' lives and in Europe makes them want to spend as little as possible on defence. Even during the second world war, when nearly 300,000 American lives were lost, it can be argued that America won by using millions of Russian soldiers as its proxies against Hitler, rather as it recently used the Northern Alliance in Afghanistan. Still, given that America has 725 military installations outside its own territory, of which 17 are fully fledged bases, and that of its 1.4m active servicemen 250,000 are deployed overseas, it cannot really be accused of hiding in a continental shell.

The less good cause is the fear of failure that has, since Vietnam, led American generals and politicians to withdraw quickly from military trouble overseas, even when (as in Somalia in 1993) opinion polls support continued engagement. In the 1990s that tendency made the United States look weak and malleable despite its military prowess, and may well have encouraged Osama bin Laden in his attacks.

And simplistic, absolutist? That is how Chris Patten, the European Union's commissioner for external relations, described President Bush's “axis of evil” speech, just as legions of European critics lambasted Ronald Reagan's description of the Soviet Union as “an evil empire” in the early 1980s. It is the reverse of the criticism that America acts in its well-calculated self-interest, for both these presidents were using moral language to rally support and clarify their intentions, to foes as well as friends. Such clarity always comes at the price of simplicity, but the real question is whether it is backed by credibility. Before September 11th, it would not have been. The trouble with European sophistication is that it has been backed by virtually nothing, either before or since that date.

President Bush's moral tone has strength because it is now backed by popular democratic support in the face of fear, and by the credible threat of military force. It is not quite clear that Americans will “bear any burden, pay any price” for liberty and security, as President Kennedy urged in 1961, but it is clear that neither politicians nor generals will now withdraw at the first whiff of failure. If anything, the danger is the opposite: that, as in Vietnam, the need to succeed abroad could in some cases blind them to an emerging reality in which success is unattainable.

Whose side would you rather be on?

The gripes are global. Japanese and Chinese have queued up to buy books that advocate “saying no” to the bossy Americans. Russians have talked approvingly of partnerships with China, India or others to balance the sole superpower. Europeans—and not just the French—have said they must be united in order to provide a counterweight to the United States. Appalling numbers of European pundits, including British ones, alas, argued that although September 11th was dreadful, it was the inevitable result of American policies. And of course there is Iran, to which the United States is always the Great Satan.

The question, though, is what weight to give to such sniping. If you were to take it literally, you might worry, along with quite a few international-relations theorists, that today's American dominance will lead inexorably to global or local alliances against it. American power is not a solution, but a problem in itself. The world, on this view, demands some sort of balance and so, in time, one will form as others gang up against the arrogant hegemon. Or you might worry that a resented America will increasingly have to act alone, as it did in Vietnam, and that it will again be weakened or disheartened when it fails. And then the world will become more dangerous.

Of these, the second is much the bigger risk. To see why, look first at what other countries do rather than what their people say. There is no doubt that America's military lead is huge, and that its economic and technological lead is also large. Table 2, updated from a 1999 article in International Security by William Wohlforth of Georgetown University, shows how America's lead over others on pure economic and military measures is far larger than that held by Britain in 1870, and the lead on military measures is larger than America itself held in 1950.


The military gap, in particular, has been getting larger since 1989, and continues to do so. As chart 3 shows, until recently America was cutting its defence spending in real terms. Others, though, were also cutting theirs rapidly. Even China has hardly been narrowing the gap. And, in terms of effectiveness, the gaps are wider still thanks to America's technological lead and professional armed forces. America's European and Japanese allies have not been trying to narrow it; both have sought at times to retain some independence, by developing their own hardware or satellite systems, but not actually to compete with the superpower.

This is not what you would expect if the ganging-up theory held true. America's power should lead others to spend more, not less. Some countries are, indeed, spending more, but for fear of each other, not of America: India and Pakistan have raced each other on arms, and many countries in East Asia have been bolstering their defences. Most, though, have been—and still are—responding to America's military lead by shrugging their shoulders and cutting or freezing their budgets. To Europeans, and still more to Russians, it is all a trifle embarrassing; hence the European talk about a unified defence force alongside NATO, but not, so far, any extra money. Tant pis, they seem to say: America is not a threat, so why bother to counter it?

It is rather better, in fact, to be on America's side. And that is where, for all the gripes, more and more countries are finding themselves. Even the balance-of-power theorists recognise this tendency of “bandwagoning”. In regions where there is a prospect that one country might come to dominate, the incentive to ally with America is even stronger: hence the enthusiasm in East Asia for American participation, rather than have China or Japan take the lead. When America was ignoring Afghanistan, Pakistan took the Taliban's side; as soon as America returned, Pakistan jumped into its camp. Despite concern over a future attack on Iraq, criticism of America still centres more often on its failures to act or participate than on the threat it, or its adventures, pose to others.

Ganging up is likelier, as well as already more common, in economic matters. America has the world's biggest economy and is the biggest trader, but it is matched by the similarly sized European Union, which speaks with one voice on trade policy, and by the second-biggest national economy, Japan. It cannot automatically get its way in the running of the World Bank and the International Monetary Fund, despite being their biggest shareholder; it has voluntarily (if grudgingly) pooled its sovereignty in the World Trade Organisation; and other countries have happily ignored its objections to international environmental deals or judicial arrangements and gone ahead to set them up themselves (even if the United States then remains outside them).

Such issues are instructive, however. Although ganging up on America is in principle likelier in trade and finance, and does occasionally happen, the prospects for it are limited by one big thing: that if you favour freer trade, or readier access to finance, America is generally the main proponent of both. And many more countries have, in the past dozen years, opted to join the American-led system of liberal trade and capital flows. Where America favours selfish protectionism, notably for agriculture, steel and textiles, the Europeans have favoured it too. A lack of American leadership on trade liberalisation might set back that cause considerably, but it would not bring about anti-American alliances.

Benign selfishness

For sure, the United States is, by its very nature, a selfish superpower. Its sheer power allows it to override objections from others and sometimes to be careless, since it knows—or thinks—it will be able to sort messes out later. Its immigrants went there to better themselves, to escape worse conditions elsewhere, to leave the world rather than lead it. Its constitution is designed to prevent not only strong government but also any interference from outside. When morality and idealism do start to take over the language of foreign policy, they are generally balanced by a more pragmatic search for the national interest, thanks to the discipline of democracy. Wilsonian morality has long tussled with the realpolitik of Theodore Roosevelt and Henry Kissinger, and does so even in the words and deeds of George Bush.

Yet America's national interest is special, and not only to starry American eyes. It offers the closest match there is to a world interest. The desire for unimpeded trade, the rule of law, safety and security, the protection of property and the free movement of people and capital match world needs, not just American ones. Only when captured by the sectional interests of particular business, ethnic or religious groups do those American interests conflict with wider ones, as was recently shown by the steel tariffs, and has also been the case with some environmental laws, including the Kyoto deal. But as long as most American selfishness remains of the benign sort, it is unlikely to be opposed on a large scale, by coalitions of countries.

This does not, and never will, eliminate the niggles and the sniping from within America's growing band of allies, for pride is concerned as well as commercial interests, and the general match between American interests and the world's does conceal many specific frictions. But it limits the sniping's importance.

Even if they do not confront it, however, disgruntled allies can react to American actions in two other unhelpful ways. They can sit on their hands and leave America to get on with things, knowing that in a turbulent world there are limits to what even a superpower can achieve on its own. Alternatively, they can make life even harder for America by accepting its leadership but also surreptitiously selling trouble-makers the wherewithal to cause more trouble, such as missile technology or nuclear materials, or merely doing investment deals with the pariahs. That is what France, China and Russia have been doing, to different degrees, in recent years, in particular in Iraq. Yet America now has the chance to turn at least one of those countries into a far more co-operative ally and perhaps—just perhaps—to open a new chapter in worldwide efforts to contain the spread of weapons of mass destruction.



World Economy
Jun 28th 2002
From The Economist Global Agenda

Better-than-expected consumer-confidence data from America helped stockmarkets take news of yet another accounting problem at a big American corporation, this time at Xerox, in their stride. But the world's financial markets remain in jumpy mood, with the dollar close to parity with the euro. Might policymakers now find themselves struggling to keep the economic recovery on track?

THE American economy never ceases to surprise. Consumer-confidence figures released on June 28th showed better-than-expected revisions. The University of Michigan's consumer survey still showed a drop in June, but a less sharp fall than the preliminary estimate released in the middle of the month. This good news (sort of) followed a spectacular upwards revision to the figures for economic growth in the first quarter of 2002. When the final figures were published on June 27th, they showed a completely unexpected jump. Instead of earlier estimates of growth at an annual rate of, first 5.8%, then 5.6%, the government's statisticians now say the economy grew at a rate of 6.1%.

Besides coming as a surprise, that is also an impressive achievement for an economy just emerging from recession. The economic numbers have helped steady the nerves of traders and investors after the bombshell dropped by WorldCom, a telecoms giant, on June 25th, when it admitted that an accounting fiddle had overstated its reported profits by close to $4 billion over the past five quarterly accounting periods. This spells disaster for WorldCom, which could now be forced to declare bankruptcy. It has also started people worrying about what other revelations might follow: such concerns were strengthened by news on June 28th that Xerox would have to restate $6.4 billion-worth of sales, twice as much as had been expected. The restatement, however, will lead to a smaller net reduction in revenues, of $1.9 billion—still a large number but not one that caught investors unawares.

The Federal Reserve, America's central bank, also played its part in bringing some calm to stockmarkets. At the end of its regular meeting on June 26th, the Fed's main policymaking body announced it was leaving interest rates unchanged. Currency markets, though, remain even more volatile, with the dollar under strong pressure against both the euro and the yen. More than once the greenback has approached parity with the euro and most economists think it will fall further. Some predict a depreciation of around 20% or more, on top of the 10% or so seen since the beginning of the year.


It is easy, but mistaken, to rush to judgments on the back of a few days of unusual turbulence. Shares and currencies can often bounce back in the most unexpected way, and as the experience of recent years has shown, for the most insubstantial reasons.

But there are good reasons to doubt the likelihood of a big early recovery in either share prices or the dollar. Nobody expects the buoyant numbers for American economic performance in the first quarter to be matched in the rest of the year, and the data about the economy's performance continue to be mixed. Many economists have argued that a stockmarket correction was long overdue. The ratio of share prices to earnings, traditionally a measure of whether shares are overvalued, is, for many companies, still at historically high levels. WorldCom's fraud, and reports about the scale of Xerox's problems, have fuelled fears that other unpleasant corporate revelations may be yet to come. Investors are wary.

Even if such corrections are inevitable, there are dangers when adjustments take place in an atmosphere resembling market panic. Investors and traders have a tendency to over-react—shares get dumped indiscriminately, for instance, without investors making judgments about the relative worth of individual shares.

A strong dollar has made life difficult for American exporters and has helped fuel protectionist pressure in America—pressure to which, in the eyes of America’s trading partners, President George Bush has shown himself uncomfortably willing to respond. And America’s soaring current-account deficit has looked increasingly unsustainable without a sizeable downward adjustment in the dollar’s value.

A cheaper dollar could therefore bring benefits if it boosts American exports. Higher demand from abroad for American goods would help compensate for any loss of consumer confidence. But currency markets also notoriously overshoot at times of market turbulence. Once market sentiment starts to push a currency down (or up) it can become relentless.

Too sharp a drop in the dollar could unleash inflationary pressures in America as the cost of imports rises. Most economists at present expect the Federal Reserve—America’s central bank—to contemplate raising interest rates at some point this year. Borrowing costs in America are currently at a 40-year low, and their rapid reduction last year is given much of the credit for the mildness and brevity of America’s recession. But the fall-out from a prolonged weakness in stockmarkets, corporate profits and investment could pose a serious dilemma for the Fed: it will not want to raise rates too soon and risk choking off the recovery, but nor will it want willingly to take too many risks with inflation.

The Fed has decided that the risks remain equally weighted for now: hence its decision to leave interest rates unchanged, without even hinting that an upward move is imminent. The American central bank is not alone in facing difficult policy choices. The counterpart to a weakening dollar is an appreciation in the world’s other most important currencies, the euro and the yen. For those Europeans for whom the weakness of the fledgling single currency has been a source of embarrassment, its current resurgence has been gratifying. But many European economies remain sluggish at best—no sign yet of the European growth locomotive—and an appreciating euro means European exports become less competitive in the rest of the world.

It is possible that a prolonged strengthening of the euro could give the European Central Bank (ECB) more scope to cut rates. More likely, given the ECB’s persistent difficulty in meeting its own inflation target, the bank might see a stronger euro as an aid to meeting that target without raising interest rates as soon as it might otherwise have done. That won’t be much comfort in those parts of the euro area which are struggling to achieve above-zero growth.

At least the ECB has some flexibility to respond to rapid shifts in currency values. The poor old Bank of Japan is in a much tighter bind. Interest rates in Japan are already virtually zero. The Japanese economy has just begun to emerge from its third recession in a decade, and the only bright spot recently has been a rise in Japanese exports. Japan has intervened several times lately to try to halt the rise in its currency, which the government fears could stifle recovery almost at birth.

Of course, Japan’s economic problems are far more deep-seated than an attack of the jitters on world markets. But market volatility can, at best, make life more difficult for policymakers trying to juggle sometimes conflicting objectives. At worst, they could make managing that balance impossible.



Another Cowboy Bites The Dust
Jun 28th 2002
The Economist Global Agenda

WorldCom, one of the brightest stars of the technology boom, is accused of committing a book-keeping fraud on a massive scale, casting more doubt on the integrity of big corporations and the professionalism of accounting firms. Despite the shenanigans, America’s telecoms industry could soon be on the mend

FINANCIAL fraud is supposed to be a sophisticated business. That is why boards of directors, regulators and auditors find it so hard to stop. But the $3.8 billion accounting fiddle that WorldCom, a once-high-flying telecoms firm, has owned up to lacks any of the impenetrable dealings that masked the worsening finances at Enron. WorldCom, it turns out, did not bother with the likes of off-balance-sheet partnerships to hide its problems. It simply made the numbers up.

The rumours had been growing. But nobody had any inkling of the mess that John Sidgmore, WorldCom’s new boss, revealed on June 25th. Following the departure in April of Bernie Ebbers, WorldCom’s founder, an internal audit discovered an “irregularity” in the way the company had been booking capital expenses. A subsequent investigation found that $3.8 billion-worth of costs had been wrongly classified as capital expenses over a five-quarter period from the start of 2001. KPMG, which replaced the firm’s long-standing externalauditors, Andersen (yes, them), in May, is investigating further. Unlike costs, capital expenses are written off against profits over time, so the error boosted reported cashflow and profits. WorldCom reported a profit of $1.4 billion last year, and $130m for the first quarter of 2002. These numbers were, in fact, fictitious.

Companies have been misclassifying costs for years. In 1971 in Britain, Rolls-Royce went under after fooling itself that costs related to the development of a new jet engine were, in reality, capital expenditure. But the problems at Rolls-Royce looked like old-fashioned British incompetence. The motives at WorldCom seem altogether more modern.

So far, everybody is blaming Scott Sullivan, WorldCom’s chief financial officer until he was sacked on June 25th. “Our senior management team is shocked by these discoveries,” said Mr Sidgmore. Nevertheless, on June 26th the Securities and Exchange Commission (SEC), which had been investigating the company’s accounting, charged WorldCom with fraud. President George Bush has said he is worried about the economic fallout from recent financial scandals.

A congressional committee has subpoenaed a number of the firm's executives to appear at a hearing on July 8th, and a panel which has been investigating the Enron collapse has demanded that WorldCom supply it with corporate records. The House Financial Services Committee especially wants to hear from Mr Ebbers, who was often to be seen in his cowboy boots and stetson hat. He was under pressure to raise WorldCom’s sagging share price. Mr Ebbers owes WorldCom over $400m, which he borrowed to bet on WorldCom shares. These loans are secured on Mr Ebbers’s personal assets, including a yacht-sales company, a soyabean farm, and nearly 27m WorldCom shares.

The entire board had a strong motive to keep up the share price. Between them, the 12 directors and executives named in the company’s latest proxy statement, filed in April, own nearly 50m WorldCom shares. Even the outside directors are big owners: Max Bobbitt, a telecoms consultant who chairs WorldCom’s audit committee, has nearly half a million shares.

Mr Sidgmore will now have to rethink his tactics. The company had been hoping to negotiate a $5 billion bank loan, in part to refinance a $2.65 billion loan on which it is now in default (because its accounts no longer comply with GAAP standards). These negotiations now look doomed. That leaves liquidation or restructuring as the main options. Nancy Kaplan of Adventis, a telecoms consultancy, thinks that any attempt to restructure WorldCom will fail. The company is good at selling data and other telecoms services to its corporate customers. This is a business with real margins and growth prospects. But it has lots of weak businesses as well, including its declining consumer long-distance unit and its failed mobile-telecoms arm. This makes it harder to shrink.

The more likely outcome, says Ms Kaplan, is that WorldCom’s competitors will pick off its assets at bargain prices. These include thousands of miles of “backbone” fibre-optic cable, which runs between cities, together with WorldCom’s efforts to upgrade the “last mile” underneath cities so that businesses can connect to this broadband network. Both have problems. The capacity glut in backbone fibre persists. And the patchwork of networks that run beneath the world’s big cities lacks scale and is plagued with technical problems. Top of the list of buyers ought to be AT&T, WorldCom’s only serious competitor in the business-services market. In the present environment, however, it is hard to see how AT&T is going to raise the money to buy anything.

It is these sorts of “doom loops”, says Bill Bane of Mercer, a consultancy, that prevent investors from seeing the bottom for the telecoms industry. Shareholders greeted this week’s news by dumping telecoms shares more enthusiastically than ever. Two things could change that. One, says Mr Bane, is if the fibre-optic capacity glut turns into a supply shortage. Although Enron made markets in it, fibre-optic backbone is not really a fungible commodity. Customers who want to send data from New York to London cannot use the pipe that goes to Washington, DC. That leaves any pair of destinations vulnerable to a capacity shortage.

Also forgotten in the current industry rout, says Mr Bane, is that demand for fibre-optic cable is growing by 75-150% every year. Mr Bane foresees a scenario in the not-too-distant future in which big companies find that their delicate, just-in-time, global electronic supply chains seize up. That will cost them huge sums of money, prompting them to buy or lease their own private, global fibre-optic networks from the telecoms companies. This, of course, would tighten the supply squeeze. Prices would soar. If it were still around, WorldCom might then once again be worth hundreds of billions of dollars.

The other possible outcome is that WorldCom, AT&T and other telecoms companies that serve business customers are absorbed into the Baby Bells, the local telephone operators that the regulators hived off from AT&T in 1984. These bureaucratic, sleepy near-monopolies have found favour with investors recently. America’s regulators and antitrust officials have, until now, viewed their expansion into other markets with caution. After its turbulent experiments with deregulation, however, America craves stability from its all-too-excitable telecoms companies. The Baby Bells could certainly supply that.