Can Anybody Here Play This Game? by Fareed Zakaria

July 23, 2001, U.S. Edition

Can Anybody Here Play This Game?
The good news about the U.S. economy is that we're in bad shape, but everyone else is worse off.
By Fareed Zakaria

The American economy just isn't looking up these days. The growth rate for this quarter will probably be close to zero. Unemployment is rising. The stock market remains sluggish. And now many worry that the growing economic stagnation abroad will affect the United States. It will, but not in the sense most people seem to think. As in 1997-98, when financial turmoil raged across emerging markets, America will benefit from the world's woes. With trouble spots multiplying around the globe, investors are already coming to the conclusion that the safest place to put their money is in the U.S. of A. You see, the American economy is the worst in the world--except for all the others.

How else to explain the gravity-defying feat of the dollar? By all economic logic, the dollar should fall when the Federal Reserve cuts interest rates. But as any American tourist knows, the greenback has been firming up against the euro and the yen despite six rate cuts this year. European and Asian investors are using their savings to buy American bonds even though they can get higher interest rates in their own countries.

To understand why investors are doing this, I picked up a copy of last Friday's Financial Times, the daily dietary supplement of the Davos set. Its section on Europe had the following stories: Italy's budget will be three times the predicted size, making a "mockery" of Europe's common fiscal policy; the IMF warns France that its economy remains too regulated and uncompetitive; the European Central Bank quashes expectation of further interest-rate cuts despite slow growth all over Europe, and finally, Germany's chancellor announces that his country will not make it easier for firms to hire and fire workers in response to economic conditions.

There you have it on one page in one day. Bad fiscal policy, bad monetary policy, bad regulations and an unwillingness to change any of it. If you turn to the Asian section of the paper, the lead story is that Moody's, the global credit agency, is unimpressed by the latest set of Japanese reforms and will maintain its negative outlook on that country's economy. And emerging markets are weakening everywhere because of slow growth in the advanced world. In such a climate, is it really so surprising that money keeps pouring into America?

People can now invest their money just about anywhere, and this fluidity creates a winner-take-all effect. The winner by default is the United States. America's dependence on foreign capital worries economists. But Lawrence Lindsey, President Bush's special assistant on economic affairs, argues it simply reflects the fact that "investors around the world believe that America is the best place on the planet to invest for risk-adjusted returns." It means the dollar stays high but interest rates and inflation stay low. That's a trade-off the Bush administration seems comfortable with. At the upcoming G8 summit, the administration will continue to insist, despite European irritation, that the key weakness in the global economy is that Europe and Japan have not undertaken enough reforms.

Don't get me wrong. America's troubles are real--particularly the soaring personal- and corporate-debt numbers. "America has problems," acknowledges MIT economist Rudi Dornbusch, "but it also has solutions." Look at how the country has reacted to its slowdown. The Federal Reserve began cutting interest rates aggressively; the administration and Congress passed a tax cut that will boost both consumer spending and confidence; corporations are already shedding jobs and restructuring on the basis of six months of weak profits. In Japan, it's been 10 years of stagnation and still no private-sector restructuring. In Europe, as things get worse, unions get more powerful and governments less committed to reform. It's a vicious cycle.

None of this means that the American slowdown isn't going to persist for a while. Or that the stock market isn't still overvalued. Lindsey, who got out of the market two years ago, admitted to me that he has not dipped his feet back in. But the slowdown has been exaggerated. The telecommunications and Internet boom has turned to bust, and that sector has lots of excess capacity. But real estate and banking, bellwethers of the economy, are in good shape. They didn't feast during the boom, so they are not fasting right now. Home prices in particular are strong, which has a powerful effect on consumer confidence. (Most people's biggest asset is their house.) And cars are selling briskly.

The administration and Federal Reserve have adopted a strategy of coupling their actions (rate and tax cuts) with sunny talk about the economy to keep consumer confidence high for the next six months, by which time they believe the economy will have turned around. It's a strategy that has a good chance of working because two large and powerful groups of people, American consumers and foreign investors, seem willing to bet on America's growth prospects--especially when compared with the alternatives. Lindsey argues that this is itself powerful evidence of America's fundamental strengths. "Economists believe that people act in their self-interest. Well, American consumers and foreign investors, by their actions, seem very optimistic about America's long-term health," he says. "Maybe they know something."