WorldCom scandal major blow to U.S.

Larry Elliott, Guardian News Service, London

George Bush is in trouble. WorldCom's collapse is one scandal too many. In the United States, it is being talked about as Wall Street Watergate. It's that serious.

Despite his 70 percent approval ratings, Bush knows that there are political and economic ramifications of the perception that corporate America is run by a bunch of greedy crooks, who have been using their money and influence to buy political favors.

That explains why the president went ballistic at the G8 summit in Canada last week when asked about the US$3.8 billion WorldCom fraud, and why he urged that those guilty of corporate crime should go to jail rather than face financial penalties.

The idea of Bush the regulator seeking to use government intervention to prop up Wall Street is hardly convincing. The Democrats are seizing the moment to press for tougher accounting standards and have promised to hound the Republicans on corporate sleaze until the mid-term elections in November.

There is, to be sure, a scenario in which things turn out all right, and where we will look back on mid 2002 as a period when the recovery ran up against a few temporary roadblocks. Monetary policy will remain loose, with no risk that the U.S. Federal Reserve will raise interest rates any time soon. Indeed, if the stock market remains wobbly, there is more chance of a cut than an increase.

The stimulation provided by monetary policy, together with the fiscal boost from tax cuts and higher defense spending, should underpin domestic demand -- the main engine of growth. The lack of any policy support for the dollar means that the American currency will continue to weaken, making exports more profitable and imports more expensive. The long overdue fall in the dollar will allow the rebalancing of the U.S. economy, narrowing the trade deficit and encouraging the rebuilding of personal saving.

Europe will be the mirror image of the U.S., with the stronger euro allowing the European Central Bank to keep interest rates lower than they would otherwise be. That, coupled with the lower cost of imports, will feed through into higher consumption, and the recovery of domestic demand will free the eurozone from its over-reliance on exports as the mainspring of growth. Europe picks up the slack as the U.S. purges itself of its past excesses. Easy.

This may be the one occasion when things go according to the textbook, and no doubt the macroeconomic consequences of WorldCom should be helpful.

It is unlikely that the full impact of the 11 interest rate cuts made in the U.S. last year has yet been felt, but it had been thought until quite recently that Federal Reserve chairman Alan Greenspan would be looking to nudge up the cost of borrowing as insurance against the recovery getting out of hand.

Such thoughts, judging by last week's decision by the Federal Reserve to leave rates on hold, have now been banished. Lessons have been learned from the malign neglect of the Japanese economy in the first half of the 1990s, when the pricking of an asset price bubble was followed by inaction and a steady descent into deflation and slump.

On the other hand, sensible strategists plan for the worst case scenario. Consider the very real possibility of a fresh spate of corporate scandals. No stone is going to be left unturned as policymakers, the American public and the media seek to make amends for their previous gullibility. The mood in the U.S. is angry; people feel they have been taken for a ride and they want heads to roll.

It beggars belief that the bloodletting will uncover no further cases of corporate chicanery. Even if, miraculously, the rest of Wall Street proves to be squeaky clean, it is clear that there has been a colossal loss of trust in the integrity of the U.S. corporate sector.

So what is likely to happen to the stock market and the dollar? You don't need to be George Soros to work out that both will remain under serious downward pressure.

The corporate sector will no longer feel able to gull investors with accounting sleights of hand, and will have to find other ways of restoring profitability.

The squeeze is particularly acute in the new economy, where companies took on far too much debt to finance their lavish expansion plans. Wall Street is awash in corporate junk bonds, and the interest rates on them have been rising sharply.

As developing countries have found, in troubled times the risk premium on dodgy paper goes up. The corporate spread on junk bonds -- the gap between the interest rate on rock-solid treasury bonds and the interest rate paid by companies perceived to be high risk -- has been widening. The higher cost of borrowing means that companies can either save money by mothballing expansion plans or cutting jobs, or go out of business.

A savage bear market will lead to lower investment and a new round of de-stocking. The cheaper dollar will make exports more competitive, but the 10 percent depreciation of the past couple of months has to be viewed against the 60 percent-plus appreciation from the mid-1990s onwards. It will take a much bigger devaluation before there is the remotest prospect of the U.S. enjoying export-led growth.

As far as the consumer is concerned, the beneficial impact of lower interest rates will be offset by the risk of unemployment, the higher cost of imports and the negative wealth effect of falling share prices. Real incomes and consumer confidence are likely to suffer; how far will Americans tighten their belts?

Economic policy will seek to counteract these forces. It is the intense squeeze on corporate finances, exacerbated by brutal competition, that may persuade the Federal Reserve that rates should be further reduced.

But policymakers don't have many shots left in the locker. Bush has already cut taxes once this year, pushing the budget back into deficit, and the Federal Reserve has cut rates to just 1.75 percent. It will then soon become apparent that the strength of first quarter U.S. growth was an aberration.

It would be forgivable if policymakers in Japan and Europe, after having had their noses rubbed in it for so long by the Americans, were to indulge in a little schadenfreude at Uncle Sam's misfortune. But the desperate attempts by Tokyo to prevent the yen rising against the dollar tell their own story. Japan and the eurozone would be seriously damaged by a prolonged U.S. downturn.

There are already signs that consumer and business confidence is weakening. Exports into the world's biggest market will be lower, while competition from those Asian countries in which the currency is linked to a falling dollar will be all the stiffer.

The sinews of globalization mean that there will be strong feedback effects from the U.S. to the rest of the world. Latin America, with riots in Argentina last week and growing fears about Brazil, is an accident waiting to happen.

We are now entering the endgame of the crisis that has been rumbling through the global economy for the past five years. WorldCom's collapse does not mean that capitalism is about to self- destruct, nor does it mean that the American economy is finished. The U.S. was written off in the decade that followed Watergate and the end of the Vietnam war -- only to reinvent itself.

One reason both the U.S. and capitalism have shown such powers of recovery is that they have been quick to learn policy errors. The mistake of the past 20 years has been to surrender the economy to the interests of big finance and allow deregulation to turn Wall Street into the modern equivalent of the wild west.

The more WorldComs and Enrons that come to light, the greater will be the pressure for big finance to be reined in. And quite right, too. It is time for ordinary Americans to win their country back.