The most remarkable aspect of the global financial crisis--gradually being correctly recognized as a symptom of global excess capacity--is the degree to which it has played out exactly according to script. The 1995 Mexican bailout encouraged a late surge of capital flows to Asia on top of the considerable previous flows (especially from Japan). That surge became unsustainable in mid-1997 as Japan’s returning recession, coupled with the waning ability to service the dollar-borrowing surge, caused the crisis in Thailand. This extremity spread rapidly around Asia and, as the excess-capacity problems escalated, then on to commodity-sensitive economies with poor financial and fiscal underpinnings, such as Russia’s.

Brazil as Victim

The latest victim of the global financial crisis is Brazil, which has succumbed to the inevitable need to devalue in a deflationary world, notwithstanding the odd preference for fixed currencies at the International Monetary Fund and the U.S. Treasury. Brazil was victimized by the IMF’s $41 billion relief package, which provided it with a rapid infusion of cash in exchange for a promise of economic suicide. The Brazilians were asked to reduce their budget deficit by three percentage points of the gross domestic product for each of the next three years. This condition so damaged economic prospects that convincing people to keep money in Brazil required interest rates of 40 or 50 percent and higher. Extraordinarily tight fiscal and monetary policy resulted, fol lowed by a sharp and disastrous recession. As Brazilians desperately tried to move their funds out of the country in the face of considerable browbeating from the government, Brazil’s currency reserves began to leak away.

The Brazilian capitulation on its pledge to maintain a currency peg to the dollar was classic. Strong denials that the currency would be devalued, describing such a move as unthinkable, were followed by ever-rising pressure on Brazil’s IMF-augmented, yet dwindling foreign exchange reserves while the Brazilian private sector desperately tried to protect its assets from a devaluation that surely had to come. When the pressure became too great, the Brazilians relented and allowed the currency to fall, initially by about 8 percent. The insufficient drop gave the markets nasty indigestion. Three days later, when the currency was allowed to float, it settled about 25 percent below its original parity--almost exactly where most commentators had put an equilibrium exchange rate for Brazil.

Nothing guarantees that the Brazilian currency will stay where it is now. Before devaluation officials at the IMF and the U.S. Treasury described Brazil’s currency peg as credible and lumped Brazil with other unfortunate countries that have become a line in the sand where the international financial crisis must be stopped. Once the devaluation occurred, Treasury and IMF officials murmured that it was probably the best thing for Brazil, as indeed it was. More to the point, it would have been far better for the Brazilians not to tie their currency to the U.S. dollar through the currency peg and thereby suffer the additional pain of two or three months of a total collapse of economic activity driven by the extraordinarily tight monetary policy necessary to validate an invalid currency peg.

Of course, the Brazilian devaluation is dangerous for American and European banks and their affiliates in Latin America, whose exposure is not captured in the official Bank of International Settlements statistics. Loans to Latin America equal about 17 percent of U.S. bank capital and 23 percent of European bank capital, according to Goldman Sachs. That relationship explains the importance of Brazil not devaluing.

The Stock Price Fantasy

The other unfortunate byproduct of the November 17, 1998, Brazilian rescue package was the Federal Reserve’s last in a series of three quick interest rate cuts of twenty-five basis points. By underwriting an unsustainable Brazilian package, the Fed gave the green light to U.S. financial markets to toss the existing bubble in the technology sector even higher. The U.S. stock market now willingly prices Internet firms at extraordinarily high and dangerous levels. Yahoo! is a company that offers an Internet search engine, with sales of about $300 million a year. Its 1999 earnings are expected to be 74 cents per share. The company’s share price reached $450 per share, or 608 times estimated 1999 earnings, in mid-January, giving it a market capitalization of $45 billion, larger than the capitalized market value of firms such as Boeing, Anheuser-Busch, Monsanto, Colgate Palmolive, and Seagram’s.

But, say market watchers, the earnings growth of Yahoo! justifies the high price. Not so. Even given its predicted 60 percent annual rate of earnings growth over the next five years, 608 times earnings is more than three times the level justified by the most generous valuation. A company whose earnings grow at 60 percent annually for five years, to be sold at the end of a five-year holding period, is today worth the discounted present value of its earnings stream over the next five years plus the discounted present value of the sale price of the stock in five years.

Some assumption about the price earnings multiple five years from now must be made to determine the future sale price of the stock. A high average of 30 times earnings, above the current level of 27, is generous. A 60 percent annual earnings growth rate is unlikely to persist, especially in view of the ease of entry into the Internet search engine business. A discount rate of 10 percent is about right for a volatile earnings stream like Yahoo’s. These assumptions yield a price multiple of 196 on current earnings of 74 cents, or about $145 per share--just 31 percent of the recent Yahoo! high of $450 per share. To justify $450 per share, one would have to assume a price earnings multiple on Yahoo! of 94 five years from now, nearly five times the long-run average price earnings multiple for all stocks.

These extraordinary assumptions justifying $450 per share for a share of stock currently earning 74 cents per share--even granting the ambitious forecast of 60 percent earnings growth--may be among the reasons that Yahoo! was priced far more conservatively, at about $100 per share, before the fall round of Fed easing. Some of these valuation issues, not to mention the implausibility of the 60 percent earnings growth forecast, may have pushed the company’s shares down to a mere $287 per share by January 20.

Extraordinary valuations aside, a sensible rationale exists for the relative pricing in today’s equity markets. The manufacturing sector (read the tradable goods sector), which must compete in a world of massive excess capacity, is struggling. The stocks that are doing especially well in the U.S. market are those such as Yahoo! and Microsoft, which promise firms an ability to cut costs and save on labor. In a world where the sales pie is shrinking, profits growth can be maintained only by producing the same amount at less cost. The technology offered by many high-priced-stock companies provides just that possibility while adding the chance of cutting labor costs. Regardless, the price is still way too high for Internet stocks like Yahoo! and some others.

It is not the relative price action in the stock market that is surprising, but the absolute level of equity prices. The Yahoo! example is not an extreme in the technology sector. Even the market as a whole (like the Standard & Poor’s index with price earnings multiple of 27) continues to forecast a level of earnings growth that simply cannot exist in a world where prices are either rising less rapidly (disinflation) or are falling outright (deflation).

The usual pattern of a last-minute fall in earnings estimates has developed for fourth-quarter earnings. Between November 27 and January 15, analysts’ estimates of earnings growth for the S&P 500 stocks sagged from a plus 1.4 percent to a minus 3.1 percent. The forecast for the level of earnings during the fourth quarter of 1999, however, remained unaltered; hence the implied year-over-year earnings growth between the fourth quarter of 1998 and the fourth quarter of 1999 has risen to 29 percent, far above a credible level. Even optimists are expecting only 8 percent earnings growth this year; zero growth is entirely possible.

Given a crisis of global excess capacity, U.S. corporate earnings are no exception. Earnings growth has slowed, but the stock market has continued to go up because the stock price multiple attached to lower earnings has simply risen. This rise in price earnings multiples may be partly attributed to falling interest rates, but the drop in interest rates over the past year, while impressive--from about 5.6 percent to 4.6 percent on U.S. ten-year notes--cannot explain the gain in the price earnings multiple of the typical S&P 500 company.

Probably some of the multiple increase is due to the simple fact that the longer the U.S. expansion continues (at 95 months it exceeds the record 93-month expansion of the 1960s), the further into the future analysts are willing to extrapolate positive earnings streams for U.S. corporations. A longer stream of earnings discounted at a lower interest rate does suggest a higher earnings multiple in the price of the stocks but does not fully explain the sharp runup in technology share prices, with earnings multiples far above levels justified even by implausibly rapid earnings growth over extended periods.

If the currency contagion--forced devaluation by country after country--has played out exactly as expected by producing downward pressure on commodity prices and profits of traded-goods companies globally, an obvious question remains. How long can the equity markets of the G7 countries, especially the United States, continue to hold their value or rise further and thereby defy the predictions implied by the growing global excess capacity?

Actually, the process that will lead to a sharp drop in the U.S. equity market, probably by 30ÿ50 percent, is underway. Export growth, or the traded-goods sector, in all G7 countries is slowing rapidly, as are the outlooks for the manufacturing sector in those countries. The survey by the National Association of Purchasing Managers for the United States for December dropped to 45.1, quite close to the recession level of 44 or lower. Employment in the manufacturing sector continues to shrink. Likewise, surveys of the manufacturing sector in Europe all show sharply weakening trends, coincident with falling exports from Europe to Latin America and Asia, as well as within Europe.

The Downward Cycle

The U.S. stock market bubble is the last prop for global demand growth. That bubble has been fueled by a highly accommodative Fed, which in turn has been made more accommodative by the very global crisis that is depressing the prospects for future earnings growth. This circularity has recurred in deflationary crises of global excess capacity. The excess capacity itself results from heavy investment flows from banks and financial institutions in advanced industrial countries to the developing world. These flows create excess capacity, which renders the financial system of the advanced countries vulnerable to defaults and financial crises in the emerging countries of the world. As the symptoms of excess capacity and financial crisis begin to emerge and spread along with chronic currency devaluations, a crisis atmosphere emerges, and the investments of G7 financial institutions are threatened. While the limited shocks from the Southeast Asian crisis could be absorbed, the spread of the crisis to South Korea forced heavy intervention by the U.S. Treasury and the Fed to accommodate borrowing needs.

Continued deflationary pressures, however, led to a crisis in Russia. That led to devaluation and default and thereby jeopardized not only direct investors into the emerging market world but also arbitrageurs such as Long-Term Capital with highly leveraged bets on interest rate spreads that were not adjusted for the kind of shock coming out of the emerging markets and manifested by the Russian devaluation and default.

Throughout this process, the IMF has exacerbated the problem by forcing countries to defend undefendable currency pegs and thus intensify the crisis when the currency peg collapses. The Russian fiasco might have been more containable if the Russians’ response to the pressures from the ill-advised IMF package had been only a devaluation and not a default. The Russian default set off alarm bells in the legal sector of a global system that has considerable leeway to ignore unserviced debts so long as a government has not explicitly defaulted on those debts. The Russians, much to the dismay and consternation of the IMF and the U.S. Treasury, not to mention the large banks, decided unilaterally to break the rules and default on their debts.

The U.S. stock market bubble is the last prop for global demand growth. That bubble has been fueled by a highl y accommodative Fed, which in turn has been made more accommodative by the very global crisis that is depressing the prospects for future earnings growth.

The U.S. equity investors who are chasing technology stocks to astronomical levels can thank IMF bungling and the resultant crises in Asia, Russia, and Brazil for the latest runup in the U.S. stock market. The Russian panic and the virtual default by Long-Term Capital Management forced the Federal Reserve to ease interest rates by seventy-five basis points in just six weeks. The last ease, immediately after the Brazilian package, rightly or wrongly underscored the message that the Fed stands ready to cut interest rates whenever an apparent crisis hits the markets.

This cycle--underlying excess capacity, deflationary pressure, an inability to finance external debts, a poorly designed IMF package, and finally a currency devaluation--fits Brazil perfectly just as it does the other countries in the sorry string of financial "crises." The problem is made worse by interventions of the U.S. Treasury, the IMF, and more recently the Federal Reserve that, taken altogether, amount to an elaborate process of denial. The denial comes from helping countries to defend exchange rate parities that are indefensible, as if maintaining a currency parity will somehow make the chronic problem of excess capacity and deflationary pressure go away. It has not and it will not.

What this process has done is to put the Federal Reserve in an impossible position. If, after all the bungling and the resultant panic in financial markets, the Fed fails to ease, it will be blamed for precipitating a systemic global financial crisis. If, conversely, it does ease, the Federal Reserve will contribute, as it has done mightily since last September, to the continued inflation of a U.S. equity market bubble. That bubble in turn adds hundreds of billions of dollars to the paper wealth of U.S. households, which in turn causes spending growth to accelerate to an unsustainable level above income growth.

While real disposable income has grown at a respectable 3.3 percent rate over the past year, real personal consumption has risen at a 5.1 percent rate. The strength in U.S. consumption growth, above that of U.S. income growth, is in no small part attributable to the financial crisis and excess-capacity problems in emerging markets, together with the mishandling of those problems by the IMF and the U.S. Treasury. While those factors in and of themselves would be negatives, the fact that such blundering has forced the Fed to cut interest rates and accelerate liquidity growth in the U.S. and thereby to push up spending and equity prices has made those negatives into positives--misleading positives indeed, but positives all the same.

The problem with this scenario is the problem of every excess-capacity deflationary scenario, such as in Japan in the late 1980s and in the United States in the late 1920s. Ultimately, the central bank must stop validating absurd equity prices. It may follow the U.S. and Japanese examples when the equity bubbles were more domestically generated and raise interest rates. Today, the Fed has reached the point where it will probably have to burst the equity bubble simply by not lowering interest rates any further because continuing problems in the global economy would require further Fed easings to sustain the U.S. equity bubble.

The Japanese Trap

The Japanese financial crisis has deepened. The world has begun to notice the Japanese government’s $700 billion sp ending spree, undertaken while the economy and its government revenues were still weakening, that has turned Japan into a fiscal disaster. Japan’s budget deficit will exceed the expected 11 percent of GDP in 1999 because that forecast is contingent on the usual optimism about economic performance and revenues. The Japanese are in a classic debt trap. If, as seems unlikely, the economy begins to speed up, interest rates will rise back to levels of 3ÿ4 percent as part of a normal recovery process and thereby choke off recovery and increase the cost of financing the national debt, which is now close to 100 percent of GDP.

Alternatively, if the Japanese economy continues to founder as seems likely, revenue growth will slow further (especially in Japan’s deflationary environment) and push the budget deficit even higher. A simple rule of thumb for a sustainable level of government debt--that is, to stabilize the ratio of debt to GDP--is that the economy’s growth rate in nominal terms approximate the nominal interest rate on the debt. Since

Japan’s nominal growth rate during the third quarter of 1998 (the latest for which data are available) was an annual rate of minus 5.6 percent (3.2 percent year over year), those stable debt-to-GDP ratio conditions cannot be met (nominal interest rates cannot go below zero). In fact nominal interest rates are rising and intensifying upward pressure on Japan’s debt-to-GDP ratio.

Japanese nominal interest rates have begun to climb sharply because the Japanese financial market has begun to search for an interest rate at which investors will buy and hold Japanese government securities. The interest rate on ten-year Japanese government bonds fell as low as 0.7 percent in October after the global market scare associated with the Long-Term Capital Management crisis. Since then, the rates have jumped sharply to nearly 2 percent--still low, but suggestive of an acute reevaluation of Japan’s fiscal picture. Japanese investors, who now know that interest rates can only climb, must be convinced to buy bonds. This will occur only when interest rates in Japan ascend to a point where investors actually expect them to fall.

The level of interest rates required to create this "overshoot" and the expectation of lower interest rates is not known, but when inflation was zero over the past decade, Japanese bonds have carried an interest rate of about 3.25 percent. Concomitantly, however, the Japanese fiscal picture was improving. This consideration, along with the "overshoot" dynamic, suggests that interest rates greater than 4 percent can be expected in Japan. And why not? The market-clearing interest rate in the United States and Europe is 4-5 percent.

Japan’s debt-financing picture is further complicated by the need to roll over a huge amount of government borrowing conducted through its postal savings system. In 1990, Japanese interest rates ranged between 6 and 8 percent, and Japanese savers purchased more than 70 trillion yen of Japanese postal savings deposits carrying a coupon of approximately 6 percent. The interest on the 70 trillion yen in postal savings deposits accumulates over the holding period and is paid out when the deposit matures in the year 2000. The 70 trillion yen in principal plus an accumulated 50 trillion yen in interest means that 120 trillion yen of postal savings deposits will mature in the year 2000. The Japanese government must induce Japanese savers to roll over most of that money back into the postal savings system or directly into Japanese government bonds. Failure to do so would be a financing disaster since 120 trillion yen is more than one-fifth of the total stock of outstanding Japanese government bonds.

Japan’s fiscal situation, along with the need to push up interest rates to levels that will satisfy Japanese savers confronted with the Japanese government’s fiscal mismanagement, comes at a particularly inopportune time. The fragile Japanese economy hardly needs sharply higher interest rates and an attendant jump in the value of the yen, as occurred since last summer, when the yen was at 145 compared with the current level of 110-115.

As far as global financial markets are concerned, higher interest rates and a stronger yen are signaling that the Japanese government will need to draw more heavily on the resources of Japanese savers. Higher interest rates in Japan have led to repatriation of funds into Japan and a broad desire for liquidity, which caused the yen to strengthen to 108 yen per dollar early in January. That yen level resulted in Japanese intervention to push the yen down to avoid too much deflationary pressure from a strengthening currency.

Japan’s need to use its large savings flow to absorb disruptive additions to government debt means that less savings will be available to finance current account deficits of emerging market countries and the United States. Indeed, the rise in Japanese government bond yields by more than a full percentage point in a month was accompanied by a rise in U.S. government bond yields of twenty to thirty basis points. While the slight increase in real yields in the United States has yet to dent the optimism in the strong sectors of the U.S. equity market, it has created problems for the less-favored sectors. Since Japan’s need to fund larger government deficits will not go away quickly, little relief can be expected in the global deflationary financial problem from Japan.

China’s Problem

In the background China presents another problem for the Fed. The Chinese maintained artificially high growth rates of more than 7 percent during 1998, partly by lying about the numbers and partly by pressing ahead rapidly on government infrastructure investment projects equivalent to 30 percent of GDP. The Chinese government has directed state enterprises to continue to produce goods. Many of these are then dumped into inventory and add to incipient and actual deflationary pressure on global markets.

Unfortunately, China’s accelerated spending on infrastructure is guided not by any market principles, but rather by the perception among the Chinese leadership about what projects are most urgently needed. Rapid execution of government investment projects without any market guidance has a bad history and often leads to useless projects. Japan has forged ahead in this area; the Chinese seem remarkably willing to follow that bad example.

China’s symptoms continue to be accelerating deflation and rising unemployment. China funds its huge infrastructure projects and government bailouts for insolvent banks and enterprises from a flow of household savings. That flow represents about 40 percent of household income, which goes directly into the state banking system. Most Chinese do not know that the state banks are insolvent, and the Chinese government has so far been prepared to underwrite the insolvency.

Should any scare, such as spreading failure of China’s regional government financial institutions, interrupt the flow of household savings into Chinese banks, the country’s financial structure would collapse quickly and with it the Chinese economy. Even without such drama, the accelerating deflation and excess-capacity problems of Chinese exporters (despite substantial increases in export rebates) are further pressuring China to devalue. The problem is the familiar one faced by other countries with the exception that Chinese currency is not convertible so the Chinese are not subject to normal market forces. This situation makes devaluation an expedient decision timed to coincide with the convenience of the Chinese government, not that of nervous Western financial institutions.

Looking Ahead

The answer to the question of what is next in this new year depends on the Fed’s assessment of yet another in the series of predictable crises in financial markets as a harbinger of "systemic" risk and therefore justification for a further e asing. There is a good chance that next time will be different and that the Fed will leave rates unchanged. The surge in the equity markets and the surge in consumer spending above sustainable levels during the fourth quarter after the Fed’s recent easing exercise cannot have pleased the Federal Reserve. Financial markets will be disappointed if the current euphoria is predicated on yet another Fed easing in response to anything other than a recession in the United States. And a U.S. recession would itself be a disappointment to financial markets.

John H. Makin is a resident scholar at the American Enterprise Institute.