WILL THE G-8 FIDDLE WHILE THE GLOBAL ECONOMY BURNS?

By Lester C. Thurow

Lester Thurow is a professor of economics and management at the Massachusetts Institute of Technology and has written "Building Wealth: New Rules for Individuals, Companies and Countries in a Knowledge-Based Economy." The G-8 meets in Genoa, Italy, July 20-22.

CAMBRIDGE, Mass. -- With Japan in a recession, the United States very near to a recession and European growth forecasts being lowered almost daily, the timing of the G-8 meetings (July 20-22) can be viewed as either very good or very bad.

The timing is good in that if the meetings came any later, coordinated actions to avoid a global recession would clearly be too late. But the timing can also be seen as bad. Lack of action (the most likely outcome) will make the G-8 look like Nero fiddling as Rome burns.

Japan talks about cleaning up the bad debts in its financial institutions, but Japan's lost decade has not been caused by these bad debts. Rather it has been caused by bad debts in its household and business sectors.

Imagine a young couple buying a house in 1989 at the peak of the property boom for $1 million. They put $100,000 down and took out a two-generations mortgage for $900,000. Today that house is worth $400,000, so they have $500,000 in negative net equity. They will spend two lifetimes paying off the mortgage and in the end will have an asset worth far less than what has been paid for it.

This family is not atypical. Forty percent of Japanese families have mortgages significantly above the current value of their house. Many businesses are essentially in the same circumstances.
In this environment zero interest has no impact. Buried in debt, who wants to borrow more? Similarly, tax cuts have no impact. A reduction in income taxes merely makes it possible to repay that mortgage a little faster. Cleaned-up financial institutions might make them more willing to lend, but who wants to borrow when they are drowning in negative net equity?

In the United States, as we saw in the savings-and-loan crisis in the mid-1980s, there is an answer to this problem. The family moves out of the house, gives the keys back to the bank and economically starts life over again. They have lost their $100,000 down payment, but they are out of debt. In Japan this option does not legally and culturally exist. Put bluntly, families and businesses have to go through bankruptcy to eliminate old debts. Until this happens there is no light at the end of the Japanese tunnel.

Interestingly, none of the reforms promised by Japanese Prime Minister Junichiro Koizumi addresses this central issue. All of his reforms could be in place, and Japan would still be in the midst of its second lost decade.

In the United States business investment has collapsed. In the four quarters from mid-1999 to mid-2000, investment in non-residential business plant and equipment rose $69 billion per quarter. In the three quarters from mid-2000 through the first quarter of 2001, business investment rose only $3 billion per quarter, and in the next four quarters a leading forecasting firm (DRI) is predicting that business investment will fall $6 billion per quarter. Almost all of this downturn in investment is in the telecommunications sector of the economy.

The reasons are simple. There are two ways that firms can make money on telecommunications infrastructure investments. Profits can flow from the prices charged end users. But here the payoff is long term. Or the stock market can in the short-run raise the value of the shares of those firms that are making infrastructure investments on the grounds that those who invest the most are likely to be the long-term winners in the telecommunication wars. And the second was what was happening until the high-tech stock market crashed. Those who invested in telecom infrastructure found that the value of their shares rose more than the costs of the investments.

Today, post-crash, the stock market is doing exactly the opposite. Those who have taken on large debts to finance telecom infrastructure investments are penalized for those large debts. What used to be rewarded is now penalized, and the "right'' level of investment is far below what it was.

Lowering interest rates, as the Fed has done, does not cure this problem. What lower interest rates do, however, is prevent the collapse in the stock market from leading to a collapse in housing prices. The Fed hopes that American consumers, even though they are consuming their entire income (savings rates are slightly negative at the moment), will not cut back on their consumption even though the stock market has crashed. So far this has proven to be true, but if consumption starts to fall, then the United States has a lengthy recession ahead.

For some mysterious reason, the European Central Bank seems to think that the only negative factor affecting Europe is the American slowdown. Since the slower growth in exports to the American market makes little difference in aggregate demand, it has only slowly lowered its 2001 forecast of European growth. But this is not the heart of the problem.

As in America, the heart of the problem is found in telecommunications investment. And here Europe has a much bigger problem than that found in America. The American auction of third-generation telephone licenses has not yet occurred, and as a result, American firms had no opportunity to bid too much -- as the European companies did. Think of British Telecom: first rewarded by the stock market for winning those G3 auctions and now penalized for having too much debt.

The downturn in telecommunications investment in Europe surely has to be bigger than that in the United States. As a result the slowdown in Europe will ultimately be just as big as that in the United States.

But that slowdown isn't being vigorously fought by the European Central Bank. Its motto might be "too little, too late.''
Let us hope the G-8 sessions produce a meaningful and realistic blueprint for leading the world away from the brink of recession.

(c) 2001, Global Economic Viewpoint. Distributed by the Los Angeles Times Syndicate International, a division of Tribune Media services.
For immediate release (Distributed 7/10/01)

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