The Economy

Although the U.S. economy remains in excellent shape, the situation in the rest of the world is not nearly as benign. In particular, the recent saber rattling of China and its threat to go to war against Taiwan -- coupled with the recent crackdown on spiritual dissidents, the decline in that economy, and the likelihood of further currency devaluations in that part of the world -- raise the possibility of significant unrest in Asia. It does seem clear that Chinese leaders are looking for some scapegoat to divert attention from their faltering economy. It also has been suggested that the shift to a kinder, gentler brand of communism is not working very well, and hence China is on the verge of splitting apart at the seams, as did the Soviet Union 10 years ago. The collapse of Russia, and the subsequent 50% decline in real GDP, had no impact on the U.S. economy, although it probably slowed down European growth somewhat. However, GDP in China is about $4 trillion according to Chinese figures and at least $3 trillion even if their recent overstated growth rate is discounted. Relatively little of this economic activity spills over into the international sector, yet a serious reversal in the country with the second-largest GDP in the world could further derail fragile world growth. I think the most likely economic outcome of all this will be a devaluation of the yuan, followed by declines in the Hong Kong and Taiwanese dollars and the Japanese yen. Recently, though, it has been the dollar that has come under downward pressure, with both the yen and the euro posting significant gains. In the last two weeks of July, the trade-weighted average of the dollar fell 5%. Some see this as a test of whether Secretary of the Treasury Lawrence Summers has the confidence of the world's bankers and speculators. In all fairness to Summers, he has done nothing to suggest the Treasury would like to see a weaker dollar. However, just as Federal Reserve Chairman Alan Greenspan had to be tested back in 1987, the financial hotshots are pushing Summers to see how he will react. Summers has said he believes markets will determine the value of any currency, and he favors a strong dollar. I can understand why some skepticism remains, but in this case, I think the Summers Treasury will end up boosting the dollar rather than letting it drift lower. Across the Atlantic, Willem F. Duisenberg, president of the European Central Bank (ECB), says the next move of the ECB might be to tighten rather than to ease, as previously had been hinted. That statement in turn has led some players to assume that the European economy will be stronger in the second half, although I think the ECB announcement was meant to reverse what had become almost an embarrassing free fall in the euro. Whatever the specific reason, that statement had the effect of causing the euro to rally from what had become an undervalued level. However, I do not expect further gains in the euro over and above the recent 5% improvement, since European growth remains about half that of the U.S. economy. To the extent that either the political or economic situation continues to worsen in China, the normal response in foreign-exchange markets would be a move into dollars. That is likely to occur even if there is no formal devaluation of the yuan. Also, as the third-quarter statistics start to come in, they should show renewed strength in the U.S. economy, hence defusing any move out of the dollar caused by weaker domestic growth. Interest rates are not expected to change very much during the next few months, but any negative impact on the dollar because of stable rates should be more than offset by a pickup in real growth relative to second-quarter rates. Although I don't think China will blow apart, any further bad news from that region of the world will boost the value of the greenback. Thus the dollar should reverse its recent weakness and improve during the rest of the year. Michael K. Evans is president of the Evans Group and professor of economics at the Kellogg School of Business, Northwestern University, Evanston, Ill. His e-mail address is [email protected].