An Interview with Dr. Shah M. Tarzi

On the whole I share this view but would leaven it with caution. I expect the U.S. gross domestic product will rise at a 2.50 to 2.75 percent rate in 1999. Economic growth will be less robust than the 3.9 percent in 1998, and the 3.8 percent for 1997. However, for this late stage of the economic recovery, I consider the 1999 estimate to be fairly respectable. I base my estimates on the consumer sector, which has been and will continue to be the driving force beyond GDP growth, and the fact that unemployment continues at near record levels.

Other positive factors include lower commodity prices, limited wage pressure, and a sustained growth in productivity. This combination will keep inflation in check. Further, the interest rate environment is likely to remain reasonably stable.

During 1999, the U.S. Treasury's benchmark 30-year bond yield is expected to remain at 4.6 to 5.4 percent. Short term interest rates have recently declined further, in response to the Fed's actions. Since September 1998 the Fed has cut rates three times.

In my estimation the Fed has the room to cut further if economic growth falls below the target rate of 2 percent.

There are, however, signs of economic difficulties ahead. The manufacturing sector has slowed down substantially, in part offsetting the consumer sector growth. The National Association of Purchasing Manufacturer's data suggests manufacturing has softened for six consecutive months.

Further, amid international economic slowdown and uncertainty, the annual rate of capital spending has decelerated.

The average Peorian doesn't seem to understand or be concerned about the financial and economic problems that are happening on the other side of the world. Should they be?

Absolutely. The Peoria economy is integrated into the world economy in many ways. The most obvious, and perhaps the most important, is that Caterpillar- the largest employer in Peoria and the backbone of Peoria's economy and prosperity-is irrevocably linked to the global economy.

Caterpillar builds parts and machinery in several countries, and sells finished products in Asia, Europe, Latin America, and the Middle East. Consequently, the company has both income and expenses in currencies worldwide. Profitability for Caterpillar, as for many other large world class multinational companies, hinges on the state of the economy, business and government spending, and the transparency and consistency of financial markets in Europe, Asia, Latin America and other parts of the world.

Currently, Caterpillar derives more than half of its revenue and a substantial portion of its earnings from its operations outside the United States. In 1996 and 1997, for example, CAT sales from outside the United States were 51 percent of total sales, or $9.18 or $8.14 billion respectively.

In 1997, company sales in the Asia/ Pacific region declined by 3 percent for the year due to the impact of the economic slowdown and the currency crisis on that region's economy. In 1998, as economic difficulties of Asian economies accelerated, government and industry demand for machines registered sharp declines, and CAT sales from Asia suffered as a result.

It is a tribute to the vision, managerial acumen, and talents of the company's management that the impact of severe economic slowdown in Asia was lower than anticipated, and overall results were better than expected.

I believe most farmers, including hog farmers, would agree they have been hurt by the economic difficulties of countries on the other side of the world. Recession in Asia, Japan in particular, and the subsequent drop in demand for farm products have squeezed profit margins as prices for agricultural products declined.

With the easy accessibility of the Internet, we are a global society. Any size company or any person can potentially do business across the world.

I believe electronic commerce- producers selling directly to consumers over computer networks-will reduce the cost of doing business, increase competition, and as a result the lower costs will be passed on to consumers in the form of lower prices. In the process, electronic commerce will help increase the nation's wealth and quality of life. The Internet has proven itself as an empowering technology.

How do you see the growth of electronic commerce, and what type of competitive advantages accrue to companies that engage in E-commerce?

To date the growth of electronic commerce is outstanding. Starting from zero in 1995, total electronic commerce exceeded $25 billion in 1997; it tripled in 1998. It is expected to reach $330 billion in near term, and surpass $1 trillion by 2003 to 2005.

If forecasts are correct, E-commerce will surpass total catalogue sales in 1999, and account for 15 percent of total retail sales by 2005.

Companies that adopt themselves to these technologies will, I believe, have a cost advantage over those that do not. Cost of business associated with the traditional "bricks-and-mortar" store such as order placement/execution costs, customer support, after-sales service, and staffing costs nearly disappear with E-commerce.

Although the cost of a Web site for E-commerce ranges from $400 for a start-up to millions of dollars for a state of the art site.

Still, it's less expensive for a business to maintain an electronic storefront. The site is always "open" and can be accessed by millions around the globe, and because it has few variable costs, a business can act to meet demand quickly.

Given the dramatic growth in E-commerce, naturally the question arises regarding the role of government. What is the appropriate level of regulatory roles for government?

I believe industry and consumers, not the government, will determine whether this new digital marketplace will grow and prosper. The role of government should be to create an environment to harness the transforming power of the information superhighway.

Government can, and should, help create the right conditions for business and consumer confidence.

Public policy should aim at ensuring access and preserving competition. But if government acts on its own, there is the risk of creating new barriers.

E-commerce is giving rise to a whole new kind of market place, and its potential has no limit. The consequences of public policy mistakes are, in many ways, very serious.

Has there been a 'domino effect' in the mounting economic problems facing so many Third World countries . . . in other words, did the problems surface in a single country and then subsequently spread to other countries?

Yes. One of the major consequences of an integrated world economy is that an economic or a financial crisis in one country or region of the world can spread to other parts of the world with shocking alacrity.

This development is often referred to as the 'contagion' effect. The integration of economies of the world is especially visible in the financial markets. The Asian financial crisis provides a good example.

The crisis began in Thailand last year where the collapse of real estate prices and real estate lending spread quickly to other countries in the region, and precipitated a stock market crash in Hong Kong where 75 percent of the market capitalization of Hong Seng, the stock market index of Hong Kong, is real estate-based.

The crisis in Hong Kong, in turn, aggravated an ongoing crisis of declining currencies in that region. In October, 1997, currency speculators worldwide attacked the Hong Kong dollar, the last Asian currency still tied to the U.S. dollar.

The Hong Kong government found itself between a rock and a hard place. It had the option to ignore this event and see its currency, piqued at $7.80 Hong Kong dollars to U.S. dollars, depreciate in value and thus forsake its top financial priority, and what the government considered the key to the island's future economic health.

Alternately, it could defend its foreign currency, but at a very high price to the economy. It chose the latter option. The financial board of Hong Kong nearly depleted its $88 billion foreign exchange reserves to ward off a run on the currency and protect the exchange rate.

In the process, overnight interest rates in Hong Kong reached as high as 280 percent, and left the stock market's Hang Seng Index with its biggest-ever point loss. In percentage terms, the index plunged 10.4 percent. The rising interest rate put additional downward pressure on Hong Kong's financial market.

For this and other reasons, the contagion effect of the global financial markets quickly materialized as the crisis spilled over to markets in other Asian countries, Latin America, Europe, and North America.

The Dow Jones industrial average lost 2.3 percent, Japan's Nikkei 3 percent, London's FTSE 3 percent, and Germany's DAX index 4.75 percent.

In January, Brazil succumbed to the pressure of competitive currency devaluation, and to weak demand for its export products, and opted to devalue its currency. Since Brazil accounts for about 45 percent of the GDP of that region, Brazil's difficulties will likely depress economic growth throughout Latin America in the near future.

Can you briefly comment on the magnitude of the current economic problems of Asian countries? Without being too complex, is it possible to provide a synopsis of the Asian countries' problems-what caused their economies to crumble?

Many countries in different regions of the world have experienced serious economic declines. The financial crisis in Asia shrunk the economies of Indonesia by 1 percent, Thailand and Malaysia about 6 percent, Hong Kong 2 percent, and Japan 2.5 percent.

Regarding the economic slump in Asia, let me describe the conditions that set the stage for current difficulties.

Due to rapid growth of Asian economies in the 1980s and 1990s, a vast sum-$110 billion-was invested by Western businesses to develop and expand market share and by investors in the stock markets of the fast growing Asian economies-South Korea, Hong Kong, Taiwan, Singapore, Indonesia, Malaysia, and the Philippines.

The flow of such huge sums of investment monies in such a short time was greater than can be profitably deployed with a reasonable risk. In such circumstances of rapid growth and ample liquidity and limited short-term profitable alternatives, the real estate sector absorbed the lions share of these investments, as exhibited by conspicuous construction projects based on marginal economic rationale.

A significant proportion of the assets of domestic financial system were based on real estate portfolios. In order to maintain high rates of return on equity, businesses borrowed heavily, increasing debt leverage which, in turn, added to financial fragility of businesses.

The governments in many Asian countries compounded the problem by extending implicit and sometimes direct guarantees of debt by private companies, and as a result lenders slackened vigilance on loans.

The weaknesses of the Japanese economy-which had been the main engine of growth for many Asian countries-and the weakness of the yen added to the economic fragility of the region. In these circumstances of high debt, the economy and the private sector became extremely vulnerable to rising interest rates and economic slowdown.

As the economic growth of these countries began to slow, and as the value of the dollar continued to rise relative to the yen and local currencies, the exports of the Southeast Asian economies became less competitive.

Since export figures heavily in the economic growth of these economies, slow down in the export earnings growth, and the resulting excess domestic capacity placed many highly leveraged businesses in an economic tailspin.

In these circumstances, the fear that the governments would be forced to devalue currency grew, vast numbers of domestic Asian businesses attempted to convert domestic currencies into foreign currencies, and tried to delay the conversion export earnings into domestic currencies.

In response to pressures on the exchange rate, governments in Asia tried to raise interest rates.

This potent combination of higher interest rates and slow economic growth made the stock markets vulnerable.

As a result, the rate of flow of investment decreased, and in some instances reversed, triggering a large scale financial crisis and accelerated economic decline of the Asian tigers region.

There are differences in the challenges each country faces to get back on track. Can you briefly highlight the specific steps these countries, and their governments, need to take to affect economic recovery?

In the face of this broader common picture I'd like to point out that there are some differences in the general economic fundamentals of each country.

For South Korea the challenge is to restructure the troubled chaebol, open financial markets to foreign investors, recapitalize banks battered by corporate bankruptcies, and rationalize their corporations by freely allowing mergers and acquisitions.

The Philippines need to keep a lid on inflation. Indonesia, Malaysia and Thailand are among the shakiest of the Southeast Asian economies.

These three countries suffer from endemic system-wide economic problems: high debt, and overcapacity. Indonesia should take the IMF's medicine to cut the national budget.

Thailand needs to reduce its trade deficit, put brakes on consumption, and move toward more value-added capital-intensive businesses and adopt constitutional reform to stabilize the government. Malaysia has to reduce both public and private debt.

All countries need to tighten monetary policy to squeeze out excesses in the real estate sector, to cool an overheated real estate sector, and deregulate the economy.

What are the ramifications of the problems of Asia for the American economy? Will it exacerbate trade tensions between the United States and the Asian trading partners?

The economic slow down in Asia took a bite off the rate of economic growth in the United States in 1998, by some estimates, equivalent to .25 to .50 percent.

True to the form, many Asian countries, Japan included, are trying to export their way out of some of their economic problems. As a result some industries, the steel industry in particular, find themselves in a competitive squeeze due to price dumping by some Asian companies.

Thus, Asian economic difficulties have substantially increased the potential for conflict over trade as U.S. bilateral trade deficits with a number of its Asian trade partners increase. In his State of the Union speech, President Clinton referenced the trade in steel as a way of acknowledging the resurgence of instances of trade conflict.

However, there has been a silver lining for the American economy in the Asian and international economic slowdown. These developments have dampened the prospects of inflation in the United States, thereby facilitating the conditions for a longer lasting and moderately growing economy.

Beyond the steps you outlined, what steps can the international community take to get through the crisis, and to set up the correct set of incentives to avoid the next one?

The primary responsibility still remains with the governments and the private sector in each country to undertake the necessary reforms.

Regarding the role of the international community, the first step is to get out from under the crisis. In this regard, the private sector in the West should play a key role, along with IMF, to restructure existing debt.

I do not favor forgiveness of debt for countries and companies in Asia, Latin America, and elsewhere. Most of these countries and corporations that borrowed money directly have the capacity to repay the debt.

The IMF has, and should continue to develop guidelines to reschedule the debt for longer maturities, transfer it into equity, or some combination thereof.

You referenced the IMF. What should be the role of the IMF?

In the short-term the IMF is needed to help put off the "economic brush fires," partly because sovereign nations are involved.

In addition, there is urgent need to restructure debt in some of these countries that currently experience difficulty, and to extend financial assistance to developing countries.

In the long-run, the best thing the IMF can do is to undertake a major reform of itself. First, it has to come to grips with the implications of the so-called moral hazard issue: in effect, bailing out U.S. and foreign investors with taxpayers money.

Second, there is substantial empirical evidence suggesting that countries in which the IMF poured the greatest amount of money underperformed developing countries that were not major recipients of IMF assistance.

Of course the most glaring example is the economic meltdown in Russia. The current Russian government is corrupt, inefficient, intrusive, and overbearing. Financial aid to Russia extended through IMF or individual governments did little to correct the notoriously venal process of privatization in Russia.

Finally, authorities at IMF have acknowledged serious mistakes regarding several countries in Asia and Russia it sought to help. In many instances, IMF's conditionality required that the recipient of IMF assistance drastically cut government spending and thereby consumption in the midst of economic slowdown.

As a result host countries were pushed into recession, or as in the case of Indonesia, depression and political chaos.

In the near term IMF is needed because sovereign nations are involved. However, ultimately it is the private sector that has the necessary expertise to undertake the complex internal analysis of the firms in these countries mired in crisis.

The introduction of the Euro, a new common currency, has been hailed as seminal event with far reaching consequence. Can you briefly describe this monetary union?

The Euro is a single currency uniting the currencies of 11 of the 15 European Union members, including Germany and France. Britain, Sweden and Denmark decided to stay out of the Union for now, and Greece failed to meet the criteria for membership.

The EU entails a three-year transition for the Euro. First, it will be an accounting symbol, as nations and stock exchanges use it to record transactions, and companies and banks use it if they wish for paper transactions. It will replace local currencies in three years.

What are the ramifications of Euro for American business, and for the United States in general?

One major benefit for American business interests is that American companies no longer have to deal with currency risks for each of the 11 individual countries. There is no longer the chance that currency in one nation or another will be devalued.

There will be only one currency to worry about. For the financial industry, the impact will be positive. Major banks, investment firms, and mutual fund companies active in Europe will have a much broader, more simplified market. Banks will save money because the need to keep costly record-keeping will be eliminated. However, multiple foreign currency exchange transactions, which are a fat source of profit with high markups, will whittle down.

However, Euroland companies could see some new cost advantages. They will no longer have to hedge their local currency against another, while United States firms will still have to hedge against the Euro.

Generally speaking, European companies will improve their competitive position world-wide because they will find it easier, with Euro in place, to be pan-European.

On balance, the consequences for the United States of growing European economies, as anticipated, are positive. However, the Euro does have the potential to become a rival to the U.S. dollar.

The greenback has been the dominant currency for more than 50 years.

Virtually all worldwide trade in commodities, and the largest percentage of trade in products and services, is quoted in U.S. dollars.

In 2002, as the Euro becomes the only currency to be tendered, nations around the world who may choose not to pay for American deficits anymore will have a viable option in Euro.

One key policy issue highlighted by the intense Congressional battle over NAFTA in 1993, and one that has shaped the ongoing debate over 'fast track' negotiating authority for the President, is whether increased international trade has been responsible for the rise in wage inequality in the United States.

What are your thoughts on this subject?

Income distribution in the United States has become increasingly unequal in the past 20 years. However, income inequality is largely due to difference in the level of education and skill.

Wages of skilled workers defined as those with some college or greater education has risen by 20 percent or more relative to unskilled workers with high school or less education.

However, it is true that trade has mainly raised skilled wages, due to new export opportunities. But it has not lowered unskilled wages.

One reason is that increased efficiency through international trade and specialization created a larger pie to share, largely offsetting downward pressure on unskilled wages. Free trade is good for everyone, although it will disproportionately benefit those who are more educated or better skilled.

The interesting point about the free trade debate is that while the overwhelming majority in the decision making circles of the government, academia, and industry philosophically support free trade, about half of the American people think free trade is not good for America's economic well-being, or for American workers.

This major gap tells me that we need to do a better job of educating the public on the benefits of free and open trade.

Are you, then, in favor of making the fast-track trade authority permanent?

I am in favor of a permanent 'fast-track' trade negotiation authority for the President, because 'fast-track' has served the nation well.

Such trade negotiating authority has made it possible for the executive branch to negotiate credibly on complex nontariff trade measures that require congressional action to implement. A permanent authority will enable the President to use the procedure for market-expanding trade negotiations, without a time limit.

I appreciate the apprehension of many in Congress over trade-related labor and environmental issues. Congress should reach a constructive compromise on most all of these contentious issues by combining authorization with a "close consultation" role for Congress, including a recognition of the need for such consultation for any agreements that are subsequently reached. IBI