Recall. After Poland’s defeat in late 1939, Britain and France had declared war on Germany. Yet little combat occurred, and the reigning fiction was that neither side wanted an all-out fight. Similarly, economic pronouncements of recent months have resolutely exuded optimism. The ““worst is over’’; the situation has ““stabilized’’; the U.S. economy has ““escaped.’’ So we were told. In early 1940, the British and French fell prey to wishful thinking. Have we now done the same? Quite possibly.
The powerful forces depressing the world economy continue to rage. Let’s review them:
Capital flight: Foreign investors–banks, mutual funds, multi-national companies–are withdrawing funds from emerging markets. Since April, Brazil’s foreign-exchange reserves (dollars, yen and other internationally usable currencies) have dropped by about half from $73 billion. The loss of funds pushes countries toward slumps, because they can no longer pay for all the imports that faster economic growth would entail.
Collapsing trade: Spreading slumps inevitably depress global trade. Between 1990 and 1995, world trade (measured in dollars) grew an average of 2.7 percent a year. But it dropped 5.8 percent in 1997 and an estimated 4.1 percent in 1998.
Lower commodity prices: Lower demand for raw materials causes prices to plunge and harms major exporters. Since mid-1997 (when the present crisis began), oil prices have dropped 40 percent, hurting countries like Russia, Mexico and Saudi Arabia; coffee prices are down 44 percent, affecting Brazil and Colombia, and copper prices have declined 41 percent, harming Chile.
Brazil’s crisis could accelerate the downward spiral. If foreign capital is fleeing Brazil, it will probably flee other Latin countries. Investors will try to protect themselves against losses by withdrawing funds before other currencies are devalued. (Investors switch out of local currencies and back into dollars.) Moreover, Brazil will import less from its neighbors, and this will hurt them. In 1997 Latin America’s economies collectively grew almost 5 percent. Last year growth was a meager 1.4 percent, and in 1999 Latin economies could actually shrink by 1.2 percent, reckons Standard & Poor’s DRI, a forecasting firm.
The ripple effects spread further. About 20 percent of U.S. exports go to Latin America, as do 6 percent of Europe’s. These will suffer. So will the profits of multinational companies and banks that operate in the region. All this jeopardizes U.S. and European prosperity, especially if weaker profits cause stock prices to drop. ““If you look at the Fortune 500 companies, most are in Brazil,’’ says Francisco Larios of Standard & Poor’s DRI.
Brazil’s crisis also imperils overall confidence by renewing fears that the world economy is being badly managed–or is beyond being managed. The International Monetary Fund and U.S. Treasury have led the crisis management; their detractors are now legion. The main criticism is that, in a futile effort to placate global investors, the IMF and Treasury have forced ailing countries to adopt excessively harsh policies that worsen their economies–and the world’s.
““The Treasury and the IMF have been spooked by the investment bankers and money managers,’’ argues Harvard economist Jeffrey Sachs. Consider Brazil, he says. To Sachs, Brazil’s central problem had been an overvalued exchange rate for its currency, the real. That made Brazil’s exports too expensive and its imports too cheap. The result was a large deficit on Brazil’s current account–overseas trade, travel and services–that had to be covered by inflows of foreign capital. The obvious remedy, Sachs says, was to let the currency depreciate sufficiently (perhaps 20 to 30 percent) to close the current-account deficit.
Instead, Brazil tried to maintain the exchange rates with punitive interest rates (between 29 and almost 50 percent in recent months) that drove the economy into recession. The IMF and the United States supported this. In the end, foreign capital still departed. Investors doubted that the rewards of high Brazilian interest rates outweighed the risks of a large devaluation or debt defaults. ““You cannot defend an overvalued exchange rate that everyone understands is overvalued,’’ says Sachs.
It’s a strong argument. The rejoinder is this: what might have been good for Brazil–an earlier, large devaluation–could have been devastating for the world economy by triggering a panic of capital outflows from many developing countries. The United States and the IMF wanted to prevent this; also, Brazil opposed a big devaluation for its own reasons. The point is not that one argument is clearly right and the other wrong. Both may be right and wrong, and therein lies the danger.
The dependence of so many developing countries on so much volatile foreign capital created an inherently unstable situation. The huge capital flows enabled countries to import more than they can now afford; but those imports helped other economies, including those of the United States, Europe and Japan. As global demand drops, the slump spreads. There is no obvious ““solution’’ that, if adopted, would painlessly spare the world from this process.
Nor is Brazil the only problem. Japan’s recession is still deepening; Europe’s economy is weakening; China’s outlook is murky. Until now, the U.S. economy has seemed immune to the turmoil, and feverish buying by confident American consumers has cushioned the impact of the foreign slowdown. But the threats are multiplying, and the immunity is not infinite. Americans see this crisis as phony, when–even if we muddle through–it is genuine and menacing.
