A drop in the value of the U.S. stock market may do more good than harm

By ADAM ZAGORIN

conomic booms do not die of old age. The Reagan-era surge met its fate in the Gulf War, which brought not only carnage on the battlefield but higher prices for energy and consumer goods that snuffed out prosperity. Most other expansions have been killed off by central banks forced to raise interest rates to cool runaway inflation.

Until last week, Americans seemed as oblivious to such dangers as beachgoers frolicking in the surf who ignore a tidal undertow. With hot summer weather blanketing much of the country, U.S. consumers sought refuge in shopping, a binge that has boosted receipts by 6% over last year. And, according to data just released by the Federal Reserve Bank, there is little sign of slow-down. Buyers are snapping up everything from fancy family vacations to big ticket items such as new cars and houses. As long as the spree continues, the impact of the Asian crisis will not be fully felt. As Deputy Treasury Secretary Lawrence Summers boasted last Monday before a conference of U.S. state governors in Milwaukee: "The American economy today is the strongest it has been in a generation: 16 million new jobs in the past five and a half years, stable prices, real wages increasing at their fastest pace in 25 years and the budget deficit is no more."

Then on Tuesday came the third largest one-day drop in stock prices in U.S. history. The decline of nearly 300 points in the Dow Jones Industrial Average, even after a mild recovery later in the week, means the benchmark has lost nearly 8% of its value since hitting an all-time high of 9,337.97 on July 17. However unnerving, the skid in equities was greeted with relief in some quarters. Federal Reserve chairman Alan Greenspan has been grumbling that stocks are over-valued. Greenspan was at it again just last month, informing Congress that lower Asian demand for American exports has done little to ease a worsening U.S. labor shortage. Indeed, tightness in the labor market has produced unemployment of 4.5%, a level not seen in a generation. As a result, Greenspan said he is less concerned with the threat of a recession than the risk of renewed inflation, which could force the Fed to raise interest rates--something it has not done since March 1997.

Last week's deluge of sell orders on Wall Street has awakened Americans to the fact that good times may not last forever. Slower growth almost certainly lies ahead. That, at least, is the view of Joel Prakken, chairman of Macroeconomic Advisers, a St. Louis forecasting firm, who has studied the so-called "wealth effect"--the tendency of consumers to spend more as their portfolios grow fat and considerably less when stock values shrivel. According to Prakken, the value of stocks held by American households has risen in the last 10 years to nearly $12 trillion from $3 trillion, with more than half the gain accomplished between 1995 and 1997. This surge, in turn, accounts for more than one-third of last year's jump in consumer spending, and a similar figure so far in 1998. So what if shell-shocked investors now suddenly stop spending? Macroeconomic Advisers predicts that the Dow's recent decline will translate into nearly $50 billion in reduced outlays, and as much as $70 billion once the effects ripple through the economy. That, in turn, could produce U.S. growth of little better than 2% for the remainder of 1998.

Call that the rosy scenario. A less optimistic outlook comes from Standard & Poor's DRI division in a just-released analysis bearing the happy title "Asian Depression--World Recession: the Implications of a Worst-Case Scenario." Author Nariman Behravesh, S & P's chief international economist, calls the odds of a significant U.S.-European slowdown as early as 1999 roughly double what it was last fall. "The economic crisis has taken an unrelenting hold over Asia's economies," contends Behravesh. "As a result, we are forecasting a one-in-four chance that Asia's problems will continue to worsen over the coming months, bringing about a 1930's style depression in the Pacific region that will significantly impact the world's economies."

Stressing that such a disaster is not inevitable, the study says a major downturn would be triggered by a further collapse of the Japanese yen, falling global trade and, in the U.S., a 25% drop in the value of stocks by 1999. In Europe, which exports less to Asia than does the U.S., the impact would be less severe but still far from negligible. Scared investors would seek refuge in the euro, bolstering the new currency, even as E.U. growth stalled, with unemployment in Germany rising to 12% from 10.7% by 2000.

As long as the crisis in Asia can be contained, however, the Clinton administration expects no significant U.S. downturn. And while no one in the Administration will publicly admit as much, there are even hopes that last week's stumble on Wall Street could turn into a plus down the road. The White House argues that the U.S. economy can only grow at a 2.5% annual rate without risking a dangerous reemergence of inflation. That is well below the 5.5% growth rate logged earlier this year. As Janet Yellin, chief of the President's Council of Economic Advisers, told TIME: "We can now look forward to more moderate and sustainable growth." If the cost of achieving that cherished goal includes an Asian economic crisis and a lower stock market, then so be it.