Recovery At Risk

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Why is the ECB dragging its feet? Because despite the region's subpar growth and high unemployment (8.3%), every one of the 12 euro-zone countries has inflation rates in the red zone, defined as anything above 2%. Higher energy costs, rising wages and the outbreak of livestock disease have plunged the Continent into stagflation, a brutal combination of poor growth and high inflation. That could prove to be the first big test for Europe's 2 1/2-year-old single-currency system. If the ECBfails to respond soon, it will antagonize European governments and possibly influence coming elections in Germany and France.

There could be calls to revisit the Maastricht Treaty, which established the ground rules for the single-currency system. The plan would be not to scrap the entire euro system but to rewrite some of the rules to enable each country to have more control over its domestic economy. "No one is questioning the basic premise of the euro," says Carl Weinberg, chief international economist of High Frequency Economics. "It is here to stay, and it's going to work. But the ECB may be subject to more criticism."

What It Means for the U.S. The growing discontent over Europe's currency system could prove disastrous here, because many foreign investors holding euros would probably switch to dollar-denominated investments. That might help bonds and to a lesser degree stocks, but another consequence would be to thrust the greenback's value even higher, further debilitating manufacturing in the U.S., which has already lost 785,000 jobs in the past 12 months. The record U.S. trade deficit would spiral higher.

JAPAN'S REFORM FAILS--AGAIN The country is in its second decade of economic paralysis. Consumers aren't buying much. Bankers aren't lending much. The government is deep in hock. The only hope of escaping this mess is represented by Japan's newest Prime Minister, Junichiro Koizumi, who is determined to administer economic shock therapy. Koizumi promised he would slash government spending, compel major banks to speed up disposal of bad loans--estimated at nearly $1 trillion--allow unprofitable companies to go bankrupt and restructure the economy to make it more market oriented.

Japan faced critical elections last weekend that will help determine how successful Koizumi will be. "Odds are Koizumi will fail to get through most of his reforms," says Behravesh. "It's an ugly scenario for Japan and for the U.S." Why will he fail? Many in the Japanese parliament are worried that the medicine will be too harsh. Indeed, some analysts predict that this PM won't be around long. "Koizumi is trying single-handedly to take on the Old Guard of the Liberal Democratic Party and one way or another, he's going to get knifed," says Sean Callow, a currency strategist with IDEAglobal.

What It Means to the U.S. Once the chance of reforms diminishes, the yen may tumble toward 160[yen] to the dollar from 123[yen] now. A depreciation of such magnitude would make Japanese goods much cheaper on the world markets. But it could touch off a frenzy of me-too devaluations throughout Asia, including China and Korea. By devaluing their currencies, all these countries risk higher inflation and paying more to service foreign loans. "Remember, the last Asian financial crises got started after China devalued its currency," says Zonis. "So we've been down this road before. I think we'll soon witness the beginning of Stage 2 of the Asian crises."

There's more. Large Japanese companies will begin selling their U.S. assets to raise cash. "We're already seeing this selling in the U.S. stock market and in real estate," says Behravesh. "Treasury bonds may be next." If so, U.S. interest rates could go higher, and that would downshift the economy, no matter what Alan Greenspan does.

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