ARCHIVE - November, 2001

Will "War on Terrorism" Save the World Economy?
Don Roper, Department of Economics

Japan was in recession and the U.S. was going into recession prior to September 11.  Arguments that the US will help keep itself and the world out of serious recession through the macroeconomic impact of a large fiscal stimulus (as we move from a budget surplus to a probable budget deficit) naturally appeals to our collective memory of WWII bringing the world out of the Great Depression.  I argue that the Federal Reserve's massive drop in short term interest rates (from 6.5% to an expected 2% in less than a year) together with the government's substantial response to the September 11 events will not be enough to prevent a serious economic downturn. The major reason is unsustainable levels of debt.

US Household Bankruptcies:
Personal bankruptcies have increased from about 70,000 per quarter in 1980 to 390,000 in the 2nd quarter of 2001.  A major trigger for personal bankruptcy is job loss.  The consequences of substantial layoffs on household bankruptcy will presumably be showing up over the next year.

One might wonder why bankruptcies are greater today than in the early 'eighties when interest rates and unemployment were so much higher.  Over the last twenty years home owners' equity as a percent of home property values has fallen from 70% to 55%.  Research at the Federal Deposit Insurance Corporation has shown that the increase in overall indebtedness arising from households borrowing against shrinking home equity positions helps explain the upward trend in mortgage foreclosures.

Emerging Economy Debt:
Moody's credit rating agency argued that for "the first time in fifty years the international bond market is confronted with sovereign defaults." The quarter of a trillion dollars of IMF-led bailouts associated with the 1995-2000 crises of Mexico, Indonesia, Korea, Russia, Brazil and Argentina left those economies with a trillion dollars of external debt.  Argentina is very close to default -- its global bonds currently trade for less than 70 cents on the dollar.

Of the countries with external debt levels sufficient to destabilize world capital markets, Indonesia, with an international credit rating as low as Argentina's, is the next most likely to default.  Indonesia's per capita income is less than their per capita external debt.  The US could do for Indonesia what it has done for Pakistan, viz., provide some debt relief in exchange for cooperation in the war against terrorism.  But Indonesia's external debt is almost five times as great as Pakistan's -- the price is probably too high.

For several years U.S. imports have exceeded  exports by over one billion dollars per day.   This has been the primary source of revenue for developing countries enabling them to service their external debt.  The fall in the U.S. equities market and the post-September 11 drop in consumer confidence has reduced the U.S. trade deficit.  Thus the capacity of developing countries to service their external debt is also diminished.

International Corporate Debt:
The Wall Street Journal has argued that $650 billion of corporate telecommunications debt may become the biggest financial fiasco since the savings and loans disaster.  Moody's expects that corporate bankruptcy rates will continue to worsen until late in 2002.  Just as overcapacity in information technology has depressed prices, liquidations of insolvent corporations and housing foreclosures do the same.

The Commodity Research Bureau's commodity price futures index has been falling during 2001.  Lower prices increase real debt burdens causing marginally solvent firms to become insolvent.  The European Central Bank is reluctant to lower interest rates because they want the euro to emerge as a strong currency. The Bank of Japan waited much too long to drop interest rates.  Now, with deflation, they have introduced a "zero interest rate policy" which has been insufficient to stimulate business recovery.  Meanwhile, Asian banks, from Indonesia to Korea, are loaded with non-performing loans.

The days of large IMF bailouts are over since the IMF has come under intense criticism from both sides of the political spectrum.  The U.S.  accounts for almost one-third of world GDP, but U.S. monetary and fiscal policies can not, alone, reverse the current deflationary forces.

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