Of Risks and Rewards

Caution and verve rarely travel in tandem, but the six members of TIME's Board of Economists called for hefty measures of both last week as they looked ahead at a world economy that offers immense opportunities and unfathomable risks. Global megamergers, lofty stock valuations, the exponential growth of the Internet--it all adds up to a welter of wakeup calls for the world's investors, bankers, business leaders and workers. No one doubts that the future is volatile. The question is whether--and for whom--volatility translates into vulnerability.

The sheer urgency of change is inducing an unprecedented vigor in the U.S., Europe, much of Asia and pockets of the developing world. Some regions, like a Latin America buffeted by natural disasters, are up against forces they can perhaps parry but never control; others, like Japan, appear dangerously prone simply to hunker down or at best lumber forward at their own pace. Only the deft prevail in the new supercharged economy--and even the most nimble are ultimately at the mercy of American shareholders, who could wake up one morning soon and decide that the market is for the birds.

But Time's economists were unanimous in arguing that present pressures should not divert attention from future shocks: aging populations that can't expect adequate support in retirement from moribund social security systems. Embracing change means accepting risks, for not acting now is the riskiest strategy of all. That linkage is likely to become even clearer in the year to come.

Many companies are girding themselves for that volatile future in a way few countries can: by bulking up. The advent of the euro last year has set off a boom in cross-border megamergers in Europe, up by 87% from 1998 to '99 alone, according to Robert Hormats, vice chairman of Goldman Sachs International; last year more than 60% of all the world's mergers valued at $1 billion or more involved European companies. "We're likely to see more megamergers and more countries involved," he predicted, "because the Asians haven't gotten into the game yet, and they have to." Aiding the trend, Hormats argued, will be renewed progress in ironing out some of the differences in international accounting standards that have inhibited cross-border mergers (see separate story). Said he: "All over the world there is a real strengthening of the equity culture."

The fat fees that flow to the investment banks from those deals will continue to beef up their bottom lines. But all elements of the financial services sector--as is the case for every other intermediary in the economy, from auctioneers to arbitragers--would do well to remind themselves daily that their hallowed brands and broad service palettes will not inoculate them against the competitive challenges of the Internet.

Laura D'Andrea Tyson, dean of the Haas School of Business at the University of California at Berkeley and senior presidential economic adviser in the first Clinton administration, pointed out that big brokerage houses like Morgan Stanley Dean Witter and Merrill Lynch are finally launching their own online services against burgeoning upstarts like Charles Schwab and E*Trade--just as Internet-based brokers start broadening out to offer subscribers customized services, like interacting with financial advisers via Internet-based video. The losers? Maybe neither. "These new approaches aren't displacing anyone," said Tyson, "but allowing more of this to occur than could otherwise."

That's the idea, anyway--a new economy that adds value rather than supplanting it. It has worked in spades in the U.S., which last week marked its longest period of expansion in history, with unemployment figures most European countries can only envy. Hormats foresaw the boom continuing, predicting around 4% growth for the American economy in 2000. With deference to Tyson, he gave a share of the credit to the Clinton administration's drive to pare the U.S. budget deficit, which has succeeded beyond anyone's wildest fantasies. That fiscal policy has turned what government economists in the mid-'90s projected would be a deficit of $400 billion in fiscal 1999 into a whopping $120 billion surplus. Funds that elsewhere go to bankroll government debt are funneled into private investment in the U.S., and that money has only multiplied with the stock market boom. "The big impact of the wealth effect," said Hormats, "is that entrepreneurial investors are willing to take risks they won't take elsewhere."

Unfortunately, another effect of the consumption-led boom has been to raise U.S. private sector debt and the U.S. balance of payments deficit to alarming levels. Thus this virtuous circle could snap, if inflation concerns move Federal Reserve Chairman Alan Greenspan to jack up interest rates and thus spook an increasingly jittery stock market. Though investors took last week's short-term interest rate hike of .25% in stride, the pressure for a bigger boost remains strong. U.S. corporate and personal debt loads are at historic highs, so much of America's storied current wealth could evaporate with stunning speed. Despite big average increases in disposable income, pointed out Tyson, "savings rates are still declining, and no one knows what to do about that in any country."

Those problems could be further compounded if investors around the world decided that they are holding too many dollars. "There's been a substantial flow of willing capital from abroad, and the U.S. is dependent on that money," said Hormats. Inflation fears--or perceived better opportunities elsewhere--could "fuel a risk," he says, of foreign investors pulling out.

Those new opportunities could materialize in Europe, which is on track to offer the world economy more help this year than it has in recent times, said Horst Siebert, president of the Kiel Institute of World Economics. He predicted almost 3% growth for the E.U. economy owing to its favorable stage in the business cycle. But, worried Siebert, "The key question for Germany, France and Italy is whether they can get on a higher growth path." He contended that the Continent's major weakness is a comparative lack of private non-residential investment, which grew in Germany less than a quarter as fast as it did in the U.S. over the last five years. He argued that the proposed tax reforms of German Chancellor Gerhard Schrder, aimed at firms rather than individual entrepreneurs, would stimulate physical capital investments over the human capital that fuels new and supple start-ups. "If you want to reward entrepreneurial effort," said Siebert, "you should look to reforming personal income tax." MORE>>

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Nor is that the only human resource problem he saw on Europe's horizon. The most ominous is an aging population relying on pension schemes that aren't sustainable; at the other end, in Germany particularly, a higher education system that ties students down for too long and doesn't prepare them sufficiently for a competitive economy. "Flexibility is still a mot tabou in France," warned Siebert, "and in Germany we still cannot imagine that wages can be set in the marketplace like the price of a loaf of bread."

Other members of the board saw more grounds for optimism in Europe. "Europe is at the beginning of a renaissance," predicted Kenneth Courtis, Tokyo-based vice chairman of Goldman Sachs Asia. "The euro is creating a competitive marketplace almost as big as the U.S.--and in effect outside the control of any government," he argued. "The restructuring of assets means that every manager in Europe is on guard that if they don't get sufficient returns they'll get taken over."

The question is whether short-term advantages can be parlayed into deep structural improvements. Courtis saw a virtuous circle emanating from corporate retooling and tax cuts. "If you cut taxes, you can't maintain your social welfare budget," he pointed out. "If you can't maintain your social welfare budgets, you've got to reorganize your labor markets" in order to make them more flexible. But there are other forces arrayed against that pressure. The political appetite for change is not a given. "Schrder has a chance to take a longer-range view and implement some of these changes," said Siebert. "But it won't be easy for him to convince his party and the German public to get behind him."

In addition, though the weak euro--down from $1.17 at its birth a year ago to below $1 last week--has been a boon to European exporters and to economic activity, Hormats worried that its slide has taken some of the pressure off structural reform. Should the dollar fall sharply against the euro before important changes to Europe's competitiveness take place, unemployment could soar even higher than in the last recession.

Still, by any measure, the prospects for adjustment in Europe are better than those in Japan, which is trapped, as Courtis put it, "in a vice of demographics, deflation and debt." He warned against taking too much solace from last year's anemic 1% growth, which came only due to massive spending and worsened an already dismal fiscal picture. "The Japan of today makes the Italy of yesterday look like a paragon of fiscal rectitude," said Courtis. "The country has to engage in a reform agenda of a magnitude we've seen rarely in a modern country."

Courtis was concerned that overall corporate investment in high tech is falling sharply behind that in the U.S. Consumer spending is still trending sharply down and demographic forces are also hurting. In 1998, Courtis pointed out, Japan crossed a threshold anticipated with fear by the rest of the developed world: the point at which there are more retirees withdrawing funds from the pension system than there are workers contributing to it. "It would be really unwise to underestimate the level of political turmoil possible as Japan reforms," Courtis warned.

The only way out, according to Courtis, was for the Bank of Japan to reflate its economy by printing money. That approach to dealing with its debt load, he said, would mean a torrent of money leaving Japan and pushing equity markets higher (or at least putting a floor under their decline). But it would also mean a lower yen and thus more attractive Japanese exports. Though other economies might be leery of that, Courtis suggested they should prefer a low yen to a deeply indebted Japan. "You can't have it both ways," he said.

With Japan enmeshed in its internal problems, the rest of Asia "has come out of the bottom of the valley," claimed Victor Fung, chairman of the Hong Kong Trade Development Council. Export growth is so strong, in fact, that Fung was concerned that "we may have come out of recession too early to get fundamental reforms." The region remains enthralled by a familiar theme: the emergence of China. Its entry into the World Trade Organization later this year, said Fung, "signifies China taking its full place in the world." The prospects for growth are immense--Fung noted, for instance, that services currently make up only 30% of the Chinese economy, as against 85% in Hong Kong. The Internet revolution is a clear vector for change: some 80 million Chinese already have cable access, and the number of Internet users is doubling every six months.

If Asia has begun to search for new paths back up the mountain to prosperity, much of Latin America is still heading downward. No region offers a more sobering picture of how volatility translates into vulnerability than Latin America. In 1999 it was the financial fallout from nature--El Nio, 1998's Hurricanes Georges and Mitch, the floods of coastal Venezuela--that buffeted the region, but a collapse on Wall Street could have a no less devastating effect. Moises Naim, editor of the Washington-based journal Foreign Policy, noted that 1999 set a series of dismal records for Latin America: the highest unemployment rates ever recorded; the highest fiscal deficits in a decade; a near-unprecedented collapse of foreign investment and trade. By necessity, said Naim, "the Latins are now the best in the world at managing crisis."

Mexico is a comparative bright spot in the region, as are other countries directly in the ambit of U.S. foreign investment. But the prospects for the entire region, and emerging markets generally, depend on whether Greenspan and the Clinton administration can engineer a soft landing if there is a major adjustment in the frothy U.S. technology sector. "It is wrong that a crash in the U.S. could benefit emerging markets," said Naim. "Experience shows that a correction leads to a flight to quality--not to emerging markets."

Such a correction doesn't have to mean a world economy left in tatters. A 35-40% slide on the New York Stock Exchange would surely wipe out the wealth effect and decimate public confidence. But, Courtis argued, the fundamental transformations brought about by globalization and the Internet would continue, providing a foundation for another boom. Besides, the Board argued, economic policymakers have fine-tuned their ability to prevent the sort of stock market meltdown that could lead to global dislocation. As Hormats put it: "Investors have a greater sense of confidence that when the markets go down, governments know how to deal with it." But no one wants to see that confidence put to the test.