04-24-2008

THE COMING BATTLE OF THE ATLANTIC: EURO VS. THE DOLLAR

Kenichi Ohmae is author of "The Borderless World" and a co-founder of the strategic management practice at McKinsey & Co.

By Kenichi Ohmae

TOKYO -- If we learn from Japan's mistakes over the past 15 years and quickly pull the fuse from the dynamite of the subprime mortgage crisis emanating from the U.S., the negative effect on global credit markets can be contained.

Though the feverish growth rates of emerging economic engines from Brazil to China will no doubt be dampened in the short run as this crisis is sorted out, they will continue onward and upward with vigor in the coming years. The inexorable, if discreet, flight from the weakening dollar will likely incite a “battle of the Atlantic” with the sounder euro, signifying a power shift away from the United States as the core of the world economy with the key reserve currency.

All these phenomena are linked in a simultaneous process that, if history is any guide, won't stop halfway. The remedies U.S. policymakers are rolling out today to address the subprime mortgage crisis and resultant credit crunch — lowering the prime interest rate, a stimulus package and the singular bailout of Bear Stearns — don't address the real issue.

This reminds me in many ways of the Japanese mistakes after our bubble burst and led to a 10-year long recession. Instead of directly defusing the default risk from 100 or so troubled banks immediately, we strung it out and prolonged the economic downturn despite policies that pushed interest rates to zero and deployed massive public spending. On the one hand, this was not enough to make a difference; on the other hand, it wasn't directed at the core problem, which was insolvent financial institutions holding property assets that had dropped 30 percent from their peak.

Similarly, to reduce the prime rate in the U.S. to 2.5 percent may help IBM borrow money, but it does nothing for the troubled homeowner — the heart of the problem — who is still paying 6 or 7 percent on a loan against a devaluing asset. The stimulus package is far too small per family and too untargeted to those in trouble to make any real difference. Neither policy does anything to address the real issue behind the credit crunch: the potential for investor panic — the fuse in the dynamite — that remains in a global financial system contaminated with securities of uneven and unknown quality.

To do this, as International Monetary Fund Managing Director Dominique Strauss-Kahn has suggested, the central banks from around the world need to join together to make sure that the various institutions holding the $3 trillion mish-mash of securitized products have all the liquidity they need to convince investors there will be no run on their holdings. They need to set up the equivalent of an “emergency room” where any institution with a concern about solvency can come in and get the necessary care. If investors are “shown the money,” there will be no panic.

Then, as was ultimately the case with Japanese banks after much dawdling, we need to work through the troubled institutions one by one, in this case sorting out the good from the bad loans behind the securities at issue, separating the small portion of low-rated DDD loans from the mostly AAA assets which were mixed together, and repackaging and re-rating these securities. As we learned the hard way in Japan, unless this is done, there will be no confidence that the market has hit bottom. The downturn will drag on.

Because Americans are more proactive than the Japanese, they are likely to avoid a depression as they work through this crisis. Nonetheless, with the value of their key assets — their homes – diminished, they will become a land of cautious consumers. This, in turn, will cause China's export growth to slow down, which will then affect Japan and the other East Asian economies that have been driven over the past several years by China's appetite for everything fromtech components, machinery and scrap steel from Japan to minerals from Australia. Already worried about inflation, China's leaders are for the moment wary of over-stimulating domestic consumer demand to take up the slack of the new American caution.

So, a slowdown in the U.S. economy to 1 percent or less will affect us all in the short term.

Several years down the road, however, this will change as the U.S. becomes increasingly less important to Chinese and world growth, in part because of its slowdown. After the Cold War, the U.S. was the locomotive of the world economy. Today, there are dozens of engines from Peru to Turkey to Nigeria to Brazil all going full blast. Europe is already fairly well decoupled from the U.S. economically, with 85 percent of all trade among states in the European Union, Russia and the former Soviet states. And this will be the case with Asia one day as well.

The current weakness of the American economy that has resulted from borrowing abroad to sustain high growth, and of which the subprime crisis is a symptom, is also driving the dollar to historical lows. This is causing China, Japan the Gulf states and Russia, among others, discreetly, but inexorably, to begin fleeing the declining dollar in favor of the sounder currency of the euro. When all is said and done, the European Union will have the world's largest consumer base and integrated infrastructure. If Russia were to one day join even in some loosely related way, the EU will also have its own energy supply.

One so far unacknowledged consequence of this shift is that America will be increasingly forced to engage in "international trade" like the rest of us for the first time since it became a hegemonic power. When the dollar loses its lead role as the world's reserve currency because its trading partners are shunning the greenback, Americans will have to pay for Toyotas in yen, Chinese toys in renmimbi and Louis Vuitton in euros just like everyone else.

This trajectory sets the stage for "the battle of the Atlantic" between the euro and the dollar as America heads for relative decline. It will be very hard for America to control this flight from the dollar as it accelerates. When this happens, all those dollars out there in the world — the U.S. has minted double what it needs for its domestic economy — will head home and stimulate the kind of hyperinflation we once associated with Brazil. This in turn will drive many Americans themselves to seek euros and other currencies beside the dollar that will hold their value.

The only way to restore stability in the wake of this upheaval is for the Americans and the Europeans to sit down and come to an agreement about the value of their currencies in this period of transition from one reserve currency to another, or others. Ultimately, it may make sense for the U.S. and the EU to combine their currencies to create a new reserve unit.

What we are seeing in this tale of financial crisis and reserve currency flight is a power shift that replaces the U.S. as the core of the world economy. A decade from now, the European Union will emerge, along with Turkey and linked to Russia, as the largest economy. The U.S. will remain impressive, but in second place. China will be third. India will be fourth. Japan will be in fifth place. That is the world into which America's current financial crisis affords us a window.

© GLOBAL ECONOMIC VIEWPOINT
DISTRIBUTED BY TRIBUNE MEDIA SERVICES, INC. (4/24/08)