Originally published in The Boston Globe
Tuesday, January 1, 2002

Uncertainties could derail recovery
By Martin and Kathleen Feldstein

Although we are optimistic that the U.S. recession will end in 2002, there are serious uncertainties both at home and elsewhere in the world. Bad economic developments in any single country will not derail the American recovery, but a series of foreign problems happening together could certainly weaken our recovery and possibly cause it to be delayed. As the year begins, it's worth looking at some of the trouble spots. We'll focus on what could go wrong in the U.S., in the developing countries, in Japan, and in the Middle East.

In the United States, confidence is the big risk. American consumers and businesses are generally not as optimistic about next year as we and other economists are. Households see rising unemployment and falling real incomes and ask themselves whether they will be the next to be adversely affected. Their uncertainty could cause enough of a slump in consumer spending to prevent or postpone the upturn.

Business confidence is another major concern. Just as last year's dramatic drop in investment was a primary contributor to the current recession, new business investment in 2002 can spur the economy. But as businesses see continuing weak orders and falling profits, they may hold off on investing in new plant and equipment and on bringing back laid off workers.

If household and business pessimism is strong enough, it will outweigh the positive economic momentum that results from the Federal Reserve's policy of sharp cuts in interest rates, from the major tax cuts enacted early in 2001, and from the big decline in the prices of gasoline and home heating oil. Of course, a major new terrorist attack could add to the worries of households and businesses.

The big risk to the developing countries would be a drying up of credit and investment from the industrial countries. The recent crisis in Argentina is the most likely cause of such a financial contraction. Argentina recently declared that it would abandon its fixed exchange rate with the dollar and would default on its government debts at home and abroad. Fortunately, other countries learned important lessons from the 1997-98 financial crisis. Relatively few countries still have the fixed exchange rates and large amounts of short-term foreign debt that previously dragged them down and that caused Argentina's current collapse. There is therefore no real reason for Argentina's crisis to cause a credit crunch elsewhere and so far it does not appear to be happening.

But we cannot rule out the possibility that portfolio managers and bankers around the world will decide to err on the side of caution by cutting their exposure to emerging markets more generally as they experience the losses from the Argentine meltdown. The fact that the domestic banks in most of the developing countries are loaded with bad loans and lack sufficient reserves or capital could easily trigger a destabilizing run by domestic depositors and foreign bank creditors. So the key indicator to watch in the developing countries is what happens to the level of the interest rates that they have to pay for foreign loans and on their dollar denominated bonds.

Japan is a serious drag on world growth. Since Japan's economy is about one-fifth of the total output of the industrial world, the stagnation in Japan for the decade of the 1990s automatically reduced world growth. Japan's GDP is now actually falling and output is currently two percent lower than a year ago. The structural reform plans proposed by the Japanese government may help in the long-run but will only raise unemployment and cut spending and output in the near term. Since Japan's interest rates are already less than one percent, there is little room for expanding demand through monetary policy. Japan has also tried the old-fashioned Keynesian approach of deficit spending without success, pushing up the annual budget deficit to nearly 10 percent of GDP and the national debt to more than 100 percent of GDP.

Japan can only turn its economy around if it changes incentives for households and businesses to spend. The tax law provides a handle for doing so but so far there is no sign that the Japanese are going to try. We will be watching to see if they finally do shift their tax rules or do other things to stimulate new spending. Continued Japanese weakness is not only bad for the Japanese but also for their Asian neighbors who are heavily dependent on exports to Japan.

Finally, there is the risk that a political explosion in the Middle East could cause a break in the supply of oil. A massive terrorist attack could destroy oil fields, pipe lines or ports. Political instability could topple the regimes in major oil producing countries like Saudi Arabia or Iran. Any such disruption would force oil prices to jump and could drag down the industrial economies that depend on imported oil, including our own.

We continue to believe that an economic upturn and rising incomes are the most likely developments in the U.S. economy in 2002. But because of the risks around the world that are outside the control of U.S. policy makers, there's no guarantee that our optimism will be justified.

Martin Feldstein, the former chairman of the Council of Economic Advisers, and his wife, Kathleen, also an economist, write frequently together on economics.