With stock prices suddenly in reverse on gloomy reports from abroad, many investors are asking: How did the global economy get into such a jam? More importantly, what can be done?
Simply put, post-Cold War exuberance and other global developments sparked an explosion of investment in underdeveloped countries-which were popularly designated "emerging markets."
Most such nations pegged their currencies to the dollar but also made them convertible in accordance with free market convention. Capital flows and international trade were expedited, but overproduction and the threat of deflation resulted.
Meanwhile, by adopting a "dollar standard" these countries effectively tethered themselves to policies of the Federal Reserve-which concerns itself foremost with business and economic conditions in the United States.
"What the world built in the 1990s was an 'exchange rate condominium' with open capital accounts, linked to the dollar, but without the custodian of the dollar, the Fed, committed to fighting deflation in the dollar price of globally traded commodities and manufactured goods," said economist Paul A. McCulley of Warburg Dillon Read.
"The underlying cause" of today's turmoil "is that the world created too much excess capacity on too many borrowed funds," said economist Lacy Hunt, a partner in Hoisington Investment Management Co., Austin, Tex. "There is now a great glut in the world's ability to produce goods."
"The capacity is so great that a price war is undermining the ability of those who built the capacity to service their debt," he said, "and that is beginning to adversely affect the world's banking system."
Deflationary price trends are even growing in the United States. Friday, the Labor Department reported that the producer price index, an indicator of future inflation or deflation, fell 0.4% and was down 0.8% from a year earlier. "Inflation is dead, and deflationary pressures intensify," said economist Cheryl R. Katz of Merrill Lynch & Co.
What can be done? Several economists said the Fed should start cutting rates soon, and at the same time, they said, new means of dealing with global financial problems need to be devised.
Mr. McCulley said the Fed should "go global," publicly committing itself to ease rates enough to stop and partly reverse the deflation in globally traded commodities and goods prices.
Meanwhile, emerging-market countries should restructure and restore viability to their banking systems, he said. He acknowledged that this would require partly closing their economies to permit lower domestic interest rates.
Mr. Hunt said he thinks the basic regimen imposed by the International Monetary Fund on countries that run into trouble must be reinvented. "This has to be reversed," he said. "They are applying a model that works well with one country in distress but not with multiple countries or regions in distress."
Typically, the IMF arranges bridge financing for nations in economic distress, provided they raise interest rates, cut government spending, and raise taxes so that the country can run a trade surplus and repay the bridge financing.
But when the problems reflect excess capacity rather than simply bad financial management or overborrowing, the IMF bridge financing program worsens the downward spiral in economic activity, he said.
"The big banks and bondholders don't want to hear this," he said, "but we need something closer to Chapter 11 (the reorganization section of U.S. bankruptcy law) in which failed borrowers transfer ownership of assets to the lender. Then the central banks can get on with the business of stimulating economic growth."
Philip Braverman, chief economist at DKB Securities USA, suggested the economic distress of New York City in the mid-1970s offers a possible model, an international version of the Municipal Assistance Corp. created by New York State to restore the city's financial health.
Such an entity, perhaps under the aegis of the IMF, World Bank, or Group of Seven industrial nations, would guarantee repayment to bondholders and have first claim on the most important source of revenue for nations getting the credit. The IMF could thus deploy its reserves to guarantee borrowings rather than expending them in new credits.
"Of course, a first claim would be seen as a threat to national sovereignty, and many nations might not be willing to take that step," Mr. Braverman said, "but without it they should not be getting the credit."