Quotes of the Day

As it pushes toward an attack on Iraq, the Bush Administration braves political sandstorms along with literal ones. But such courage, if that's what it is, seems to dissipate outside the Beltway. While Washington gears up, the world economy cowers in the shadows. Companies and individuals aren't in anything like a punchy mood, let alone a preemptive one. A "culture of caution" has taken stubborn hold almost everywhere, says Robert Hormats, vice chairman of Goldman Sachs International. He and the rest of Time's Board of Economists, meeting during a heavy snowfall at the close of the World Economic Forum's Annual Meeting in Davos, Switzerland, agreed that even a quick, clean victory in Iraq may not be enough to overcome the timidity, because the prospect of war is only one cause of the global economy's slough of despond. There are plenty more sources of uncertainty, some so acute that the coming year amounts to an "international economics laboratory," says Moisés Naím, editor of the Washington-based journal Foreign Policy. And since we're all guinea pigs, these lab tests are hardly academic. How can companies improve their debt-laden balance sheets when a bearish global stock market has gutted their worth? How will American consumers keep performing their role as the shaky prop of the world economy if their home values collapse? Who else besides that highly hocked group is confident or crazy enough to step in and create demand? And most ominously, are governments merely pushing wrongheaded economic policies as usual — or have they finally lost traction entirely against a world economy that's in serious danger of spiraling into greater debt and deflation?

The answer to many of those questions will come from Washington, but the Board fears that no one there is really minding the world economy's switches. "We're very prepared for war from a military point of view, but not from an economic one," says Hormats. The U.S. government, which quietly slipped from surplus to deficit last year, is heading into a period of "chronic deficits," he contends, even if the Bush Administration gets only part of its 10-year, $674 billion tax-cut proposal through a skeptical Congress. Hormats worries that the weak federal balance sheet makes no provision for unforeseen costs ahead. Yes, the active phase of the war is likely to go off without major hitches, but the U.S. will then face a long-term burden of years of costly peacekeeping and nation building in Iraq. If oil prices shoot up and further degrade consumer confidence and business investment, the U.S. government could find it has no fiscal reserves left to spend on stimulating the economy. Hormats argues that much of the cost of the U.S.'s ongoing war on terrorism — particularly increased security and policing — has to be borne by state and local governments, many of which have all but run out of money. For years the Time economists and others have warned that the U.S.'s insatiable hunger for imported products and capital has made its foreign exchange deficit balloon dangerously. Well, this year it is bigger than ever at 5% of GDP. "There is very little room for mistakes in U.S. economic policy," warns Kenneth Courtis, the Tokyo-based vice chairman of Goldman Sachs Asia. In other words, think hard before you push through those new tax cuts, Mr. President.

All of that is especially disturbing since the U.S. remains by default the world economy's prime driver. "There's been a lot of talk at this meeting about America as the world's military superpower," says Laura D'Andrea Tyson, dean of the London Business School and a former top economic official in the Clinton White House. "But there hasn't been enough talk about the world's excessive dependence on the U.S. as an economic superpower. The U.S. doesn't want this responsibility, and it's not healthy for the world." Instead of scolding U.S. consumers for supposed profligacy, Tyson thinks Japan and Europe should be working harder to fulfill their economic potential so they can comfortably increase consumer demand.

In both places, that's easier said than done. Pascal Blanqué, chief economist for Crédit Agricole, sees little chance of new demand coming from Europe, where he thinks the economy will grow by a meager 1.5% this year. "The determinants of growth for the next three quarters are already known: it's the lagged impact of previous shocks," he says. The most recent of those are the daunting cost of German unification and the valuation implosion of the most promising U.S. corporations. Both are still rippling through a European economy that may not have the dramatic short-term imbalances of the U.S., but has considerably less verve during boom times.

Germany's spectacularly troubled economy, Blanqué points out, is especially weighed down by the eastern part of the nation. Creating jobs there remains a struggle since labor costs — especially nonwage expenses like payroll taxes — have helped make German manufacturing costs among the highest in the world. Both Blanqué and Tyson believe that part of the problem is that the German mark was overvalued in the exchange rate agreed upon for the euro's launch, further hampering Germany's competitiveness. Since that poor start, though, Blanqué thinks the European Central Bank has taken more knocks than it deserves for Germany's sick state. "You can't expect monetary policy to fix Germany's structural problems," says the French economist. And so far, Germany shows no sign of fixing them, either.

While they differed in their assessments of the newcomer among the world's central banks, none of the Time economists expected the U.K. to jump into the euro zone anytime soon. "Everything that's happened in the euro zone is a compelling reason for the U.K. not to join," says Tyson. "An average inflation rate of 2% or less in an enlarged European marketplace, where you have countries with different growth and inflation rates — that's deflationary for Germany. The British look at that and say the ecb can't run a monetary policy — even if it's run well for the group — that works for an anchor player."

The British economy, warns Blanqué, is still in a bubble of inflated asset prices, one that is bound to burst; he sees a similar threat in the Netherlands and Spain. In the core Continental economies, household balance sheets remain sound. That doesn't have much effect, though, if Europeans sit on their savings, as the Japanese have been doing for years. European consumption is likely to be less buoyant in 2003 than last year. European businesses are no more disposed to invest than consumers are to spend, and their balance sheets are not as healthy. Many firms idly hoped last year to piggyback on a U.S. recovery this year, so they stayed overstaffed for too long and only began cutting jobs in the autumn, says Blanqué.

"When the cycle runs out of steam, we're left with structure," says Blanqué. If Continental Europe were to tackle labor-cost problems and the onus of untenable pension systems, maybe it could begin pulling its weight toward healing the world economy. "Europe has some easy wins if they remove impediments to growth," Tyson agrees. "But they're easy only in economic terms, not politically." Indeed, the German government has jawed on about making its labor market more flexible, but hasn't done much. And the French government is tackling pension reform as gingerly as possible, since public outrage over that issue is what brought down the last conservative government in 1997.

The Time economists generally greeted the fall of the dollar against the euro as a "win-win" for both sides. Blanqué says Europe can take advantage of dampening inflationary pressures (due to cheaper U.S. imports), and that a lower dollar encourages European investors to look more closely at opportunities at home instead of in the U.S. Washington likes the new exchange rate, too, Hormats says. Not only does it improve the U.S. trade position, but it pressures Europe to face the music of internal reform rather than cheat by letting its exports ride on a cheap euro.

But if the dollar's slide becomes a free fall, everyone could end up a loser. Foreign investors could stop funding the U.S.'s massive external debt, choking off the already sputtering engine of American consumption. Europe's strong showing in exports, vital to its health, would suffer from higher prices. "Remember," says Tyson, "Germany had the highest manufacturing costs in the world before the rising euro."

How bad is Germany's growth? Well, along with Italy, it's doing worse than deflationary Japan, says Courtis. Not that anyone should take any solace from that, since it took a massive fiscal stimulus from the Bank of Japan to get the world's second-largest economy to show a pulse at all — a stimulus that it cannot continually administer. Taking government, corporate and personal debt together, he says Japan's red ink amounts to five or six times the country's GDP — "a Himalaya of debt" twice the size of the one suffered by a bombed and exhausted Britain in 1945. "A lot of that debt is bad debt, so we could have a write-off of $3.5 trillion still ahead of us," Courtis says. He acknowledges that Prime Minister Junichiro Koizumi and Finance Minister Heizo Takenaka have "started saying the right things," but he's far from confident they can pull off the reforms needed to undergird an economy that remains, he says, "the biggest zone of risk" in the world.

If the Forum's Annual Meeting had taken place just west of Japan, the Board of Economists agreed, the level of optimism would have been far higher, because China's emergence as an economic power, says Courtis, "is the kind of phenomenon the world sees once every 300 years." The Chinese economy is now the size of Italy's; in a matter of years, it will be the size of Germany's; in a decade or so, it could rival all of Europe. And recently, Beijing hasn't been making many mistakes. "Good year, bad year, the [Chinese] government continues to engage in the most aggressive, politically difficult and complex reforms," says Courtis. Those policies have assured not only that China's labor force can work for the market, they have also assured that they can read — 94% of them — giving the country a "huge capacity to absorb new technology," says Courtis. Thanks to booming factories, China is now a formidable exporter, as well as the major importer from all of Southeast Asia.

Managing explosive growth by decree is easier than husbanding mature wealth in a democracy. Perhaps that's partly why China is the only major country whose economic policies didn't come in for a degree of harsh criticism by the Board of Economists. But there are still questions about the governability of the world's most populous country. "China will have an accident, whether financial or political," warns Naím. "The question is, will it be a 1990s-style accident, where a country crashes and recovers? Or will it be a 1960s-style accident, like the Cultural Revolution, that could last a decade?"

China has already started actively raiding the maquilas along the Mexican border with the U.S., posing a stark challenge to that country and the rest of the developing world. Courtis points out that 25% of all foreign direct investment into emerging markets currently goes to China; India, by comparison, gets 1%. That concentration is one reason why Latin America is slipping deeper into poverty after showing signs of improvement until 1997, suggests Naím, who once served as Trade and Industry Minister for Venezuela. When he looks to his former homeland, he sees "a new vintage" of oil disruption that could show up elsewhere: "Venezuela could be the first of several oil-producing countries to disrupt supplies not because the government decides, but because there's a mess in the country." Naím sees a positive though vulnerable development in the professional economic team and determined policies of the new Brazilian President, Luiz Inácio Lula da Silva. But what matters is whether "financial markets give him the benefit of the doubt and restore the financing his country desperately needs." The worry for Brazil and much of the developing world, Naím says, is that "the world will be too busy."

Tyson, the top economic advisor in the first Clinton Administration, already senses distraction in Washington. "When we listed our reasons for deficit reduction back in 1993, at the top of the list was the need for the U.S. to have credibility, because it was so dependent on the rest of the world for capital," she says. It's now dependent on the world for more than that. With bigger U.S. deficits now "baked into the cake," Hormats says, "we could find fighting terrorism from a base of a $300 billion-plus deficit harder." Yet Bush could fairly marshal the same basic arguments for an economic stimulus from Washington as he has for the war on Iraq: If not the U.S., who? If not now, when?

A quick end to any war in Iraq would be a big help to the world economy, especially if Iraq's oil assets remain largely intact. But Naím warns that the war's full impact won't be felt until 2004. And global economic courage could be even more sensitive to another major terror attack. "At the end of the day, governments don't know how to change confidence," says Naím. Terrorists do. That well-established fact reminds us, as if we needed reminding, how much harder it is to build than destroy.

• JAMES GRAFF
• Thinking a fast win in Iraq will fix what's wrong with the global economy? Don't get your hopes up