It is clear from events at the end of 1994 that there is too little global saving to go around. We cannot simultaneously have strong and accelerating economic growth in industrial countries, rapid growth in emerging markets fueled by a large flow of savings from the industrial countries, and strong bond and equity markets. The casualties of too much of a good thing are surfacing rapidly after the "aggressive" tightening by the Federal Reserve in November that merely raised short-term interest rates by a quarter of a percentage point more than had been expected.

The corpses that have bobbed to the surface in the swamp of competing demands for global savings include infamous Orange County with its highly leveraged long position in U.S. bonds, more recently Mexico, and, through guilt by association, the rest of the emerging markets, now dubbed submerging markets.

U.S. Growth: Too Much of a Good Thing

The basic problem is that the current global economy cannot survive U.S. growth at 4.0 percent. Although faster U.S. growth encourages exports of more goods to the U.S. economy, it also forces the export of more savings to the United States. The U.S. recovery is unusually far ahead of recoveries elsewhere in the industrial world. Thus, with a national savings shortage of 2 percent of a massive $7 trillion gross domestic product, U.S. economic strength is a major threat to continued recoveries in countries that need to import savings. This will be especially true if the Fed does the "right thing" and pushes up real interest rates to slow U.S. growth.

At the top of the list of vulnerable countries are those with the greatest need to import savings with their currencies pegged to the U.S. dollar. Without the exchange rate to take the pressure, faster U.S. growth and higher U.S. interest rates force politically unsustainable interest rate increases on vulnerable capital importers. The Mexican government attempted to avoid necessary increases in interest rates by using up its international reserves to prop up the peso artificially. The result was an abrupt abandonment of the currency-pegging exercise, followed by a currency collapse and surging interest rates.

It is true that Mexico worsened its problems first by bungling the devaluation and then by failing to articulate an understanding of the adjustments needed to restore the confidence of Mexico's numerous foreign investors. By the time Mexico abandoned its pegged currency on December 20, its need to import savings had risen to 8 percent of GDP, one of the highest shares of requisite capital imports in the world and certainly the highest in Latin America. The Mexicans put forward an unconvincing proposal to reduce their required capital imports to 4 percent of GDP within a year.

The botching of the devaluation by the Zedillo government also raised questions about its ability to perform the difficult economic management required for a devaluation to eliminate a crisis in the balance of payments. A devaluation is an instant tax increase that reduces real wages and real wealth but only if the central bank refuses to print more money and thereby frustrates attempts to pass through to wages and prices the inflationary pressure following a devaluation.

Statements from the Bank of Mexico showed that the bank and the Mexican government did not understand the monetary discipline required for a successful devaluation. That lack led markets, after a brief consideration of Mexico's sales job in New York early in January, to reject it and push the peso more than 60 percent below its predevaluation level.

Simultaneously, global investors dumped investments in Mexico, even those denominated in dollars. The dumping of Brady bonds and other dollar-denominated claims on Mexico displayed concern over a possible default brought on by the political risk of unsuccessful attempts by the Zedillo government to rein in Mexican growth. Lower growth is necessary to reduce inflationary pressure and preserve the downward pressure on Mexican demand growth required for a successful devaluation, one that reduces Mexico's reliance on imports of savings.

From the Mexican Crisis to Global Capital Markets

The Mexican devaluation and the chaos in financial markets that followed killed the favorite notion of 1994 that emerging markets were "the place to be." The large and rising current account deficits in most of Latin America and in other emerging markets in Asia and Europe have been funded by retail U.S. investors. The buzzword "diversification" essentially masked the triumph of greed over fear when U.S. investors--attempting to maintain the high rates of return that they had been accustomed to on U.S. fixed income securities and equities before 1993--were told simply to invest in emerging markets, where returns were higher.

U.S. mutual fund and investment advisers relied on the naive notion that higher returns are always available without risk if only you look in the right place. The obscurity of some emerging market investments, including basket cases such as remnants of the former Soviet Union and Eastern Europe as well as emerging disasters such as Mexico, were turned into a virtue: brochures proclaimed the "discovery" of heretofore unrecognized opportunities in the emerging markets.

Indiscriminate investment in emerging markets and the attendant Mexican collapse present both serious problems and opportunities for global investors. The shortfall in savings to finance a rapidly growing industrial world and emerging markets at the same time has, since the Mexican debacle, turned global capital markets into snakepits. Global investors will now examine statistics to identify emerging market countries with a heavy reliance on external savings and/or a propensity to use inflationary finance to fund a profligate public sector.

The search for weak borrowers will spread from the emerging markets to developed economies, where again a sharp distinction will be made between countries that import savings and have large and seemingly uncontrollable public sector deficits and countries with limited borrowing needs or an excess of domestic saving. The process has already moved quickly. During January 1995, those found wanting were essentially taken out and shot as their currencies weakened and interest rates were pushed higher by the search for 1995's goal, safety.

Whatever the ultimate resolution, the Mexican crisis will leave emerging market countries with a significantly higher cost of capital. Attractive investment opportunities will still be present in those countries, but the flow of capital into investments will come from highly selective professional investors and not from uncritical retail investors simply looking for a rate of return around 10 percent. Risk will be carefully evaluated and added to the price: the real interest rate at which discerning investors are willing to lend.

Discrimination among emerging market countries will also become far more developed. A good case can be made for some investment in Mexico, where asset prices have been cut in half or even more since Mexico has swallowed the bitter pill of devaluation, the first step toward adjustment. Beyond that, Mexico does have many attractive companies, and some of them may benefit from devaluation. Likewise, Mexican borrowing denominated in dollars may become an attractive investment opportunity provided the Mexican government demonstrates the will to slow the growth of spending in Mexico sharply.

Implications for Capital Markets in Developed Countries

The rush of capital out of emerging markets will provide a temporary and modest boost for capital markets in developed countries. The concept of a kind of rotating core has emerged: funds fleeing emerging markets in the Western Hemisphere will go to the United States, funds fleeing emerging markets in Europe will go to Germany, and funds fleeing emerging markets in Asia will go to Japan. This movement will have a modest impact on the exchange rates between the core countries of the United States, Germany, and Japan, depending on the intensity of flows into those countries out of the emerging markets in their trading blocks. But the capital markets in the developed countries, especially the United States and Japan, are so huge that outflows that seem cataclysmic to emerging market countries produce only a trickle of funds into the huge capital reservoirs of developed economies.

The Mexican crisis and the emerging market crisis have increased the scrutiny of the capital markets in developed countries. Currencies and interest rates are being pressured in economies that need to import a great deal of savings and simultaneously have large public sector deficits and debts.

Canada, which has an open economy with a need to import savings of about 4 percent of GDP, along with a public sector debt equal to its GDP, has become vulnerable. The Canadians have usually demonstrated a willingness to raise interest rates sharply to protect their currency. But a sharp increase in interest rates with a national debt equal to GDP means that the budget deficit worsens and the credibility of interest rate increases lessens. As an open economy with a large export sector, especially to the United States, Canada becomes more and more tempted to allow its currency to depreciate further to absorb some strain associated with a reduced desire to invest in Canada. A weaker currency would encourage exports and, provided inflation pressure does not emerge, might help to reduce the necessary increases in interest rates that Canada is facing.

The emerging markets crisis will also increase pressure on countries running an expensive welfare state that in turn has caused a large accumulation of government debt. Along with Canada, Sweden and Italy come quickly to mind. Global investors are skeptical that such generous welfare states can be supported, especially in a world where global savings are being allocated more and more critically. If the welfare states refuse to raise taxes and reduce their generous welfare benefits, the temptation grows to allow higher inflation as a way to reduce the burden of high levels of debt. The prospect of an inflation tax drives global investors away from those countries and forces further increases in interest rates and currency weakness.

There is an illustrative and interesting exception to the rule that large public sector deficits and debt render a country's currency vulnerable. Belgium's public sector debt is more than 140 percent of its GDP, and it runs an annual deficit of 6 to 7 percent of GDP. Belgium is rescued from this seemingly vulnerable situation by its savers, who save so much that Belgium actually has a savings surplus of more than 2 percent of GDP. In short, the Belgian government could, if it desired, sell most of its bonds to Belgians, and as long as it continues to pursue policies consistent with low inflation, they will contentedly hold the assets.

Belgium has followed the principle of Alexander Hamilton, who made the fundamental point more than 250 years ago that a national debt properly managed can be a blessing. Many investors in the world are looking for bonds to hold. If a country such as Belgium creates a large quantity of such bonds that are viewed as good value because they yield a good rate of return with little prospect of higher inflation or currency devaluation, then it is possible to fund a large deficit without fear even in a world where global saving is in shortage. The key is a high level of domestic saving and credible low-inflation policies.

The Global Saving Shortage, Emerging Market Crisis, and the United States

The problems of emerging markets, together with the unwinding of a leveraged long position in U.S. bonds associated with Orange County's problems, have created a tricky situation for the U.S. Federal Reserve. Forced liquidation of a highly leveraged long position in U.S. government securities, together with forced liquidation of investments in emerging markets, creates a liquidity problem for U.S. financial institutions.

It is the Fed's job to be sure that the liquidity problem does not turn into a solvency problem. The scale of the problem so far encountered with Orange County and emerging markets is easily manageable by the Fed. While some institutions were highly exposed to investments in emerging markets, the impact in the context of the $15 trillion market for financial assets in the United States will not be great. The prudent Fed will make sure that the problems encountered by some imprudent institutions do not produce any systemic risk.

The biggest risk of a shortage of global savings is that the Fed will slow down the tightening necessary to bring U.S. growth down to a sustainable level. At the end of 1994, the U.S. economy was growing at about 5 percent, with good momentum carrying over into 1995. Some members of the Federal Open Market Committee, which guides Fed policy, believe that interest rates have already been increased enough to slow the economy. The problems connected with Orange County and Mexico and emerging markets have probably reinforced that belief. But so far, U.S. interest rate increases have produced no slowdown in U.S. growth, while inflation has simultaneously remained moderate.

Higher interest rates alone are seldom sufficient to slow the economy. U.S. spending is not sensitive to interest rates for a number of reasons. First, households are net lenders: when interest rates rise, the disposable income of households as net lenders rises, although some households suffer from higher interest rates.

The higher interest rates also tend to be slow to affect investment spending because most investment projects have required rates of return of 15 to 20 percent. If these projects are financed by borrowing, with a cost of 6 to 8 percent, the effect on spending on attractive projects is small, and investment continues to grow strongly as it has in the U.S. economy.

The sad truth is that to slow the economy, the Fed is usually forced to destroy enough wealth to scare consumers into cutting back on their spending. The process has begun with a sharp drop in the price of U.S. bonds, an end to highly leveraged investing in U.S. bonds signaled by the Orange County debacle, and the emerging markets debt crisis. Unfortunately, the casualty of Fed tightening has not been U.S. spending but rather spending in emerging markets funded by U.S. investors searching for high yields.

The likely path of Fed policy and interest rates in financial markets in 1995 will show some oscillations. Such oscillations are produced by enduring myths that drive financial markets for a time. In 1994, the two big myths were the benefits of diversification, or decoupling, and the idea that the U.S. economy would slow in the second half of 1994. Much to their regret, global investors found that interest rates were highly correlated across different financial markets so that rising U.S. interest rates produced rising interest rates globally. By the spring of 1994, the decoupling hypothesis--whereby U.S. rates were able to rise while foreign rates remained low--had been debunked.

The second half of the 1994 slowdown myth was debunked by the second half of 1994, when growth steadily accelerated. Many investors responded simply by putting off the projected slowdown to the first or second half of 1995. While the U.S. economy will eventually slow, there will be some interesting developments in the interim.

Those developments will probably be related to financial markets myth 3: a period of unexpectedly high U.S. growth, above capacity levels, will not be followed by higher levels of inflation. This "no inflation" myth is sustaining U.S. bond and equity markets early in 1995. The glow surrounding those markets has been enhanced by the newfound unattractiveness of investment in emerging markets and the attendant newfound emphasis on safety over risk.

The complacency of the U.S. financial market over inflation, especially if shared by the Federal Reserve, will end when inflation numbers begin to rise at four-tenths of 1 percent per month, or the equivalent of about 5 percent per year. That will occur sometime during the first half of 1995 and will abruptly put the Fed "behind the curve." At that time, even if the real economy is growing, the Fed will be forced to hike interest rates enough to scare consumers and investors away from additional spending. Normally that scare is accomplished by a 20 percent drop in the price of U.S. equities, and this cycle will probably be no exception.

In short, this U.S. expansion, under way since 1991 and distinguished by a high level of capital expenditure and a relatively low level of inflation, will eventually end as most other expansions, with an abrupt Fed tightening caused by an "unanticipated" jump in inflation. Whether this cycle endgame plays out next winter or in the summer of 1996 will have some implications for the next presidential campaign. It will also set the stage for a major stock market rally that usually follows a late cycle sell-off that in turn produces good value in forward-looking equity markets.

The likelihood of an oscillatory soft landing- hard landing end to this expansion has been increased by the chance of a $40 billion guaranteed line of credit from the United States to Mexico as proposed by the Clinton administration. Such accommodation sharply reduces the chance for curbing the growth of Mexican demand. The Mexican crisis resulted from too much spending financed by foreign lending. Because of a hefty jump in the willingness of U.S. lenders to accommodate Mexican borrowers--courtesy of U.S. government loan guarantees for Mexico--in six months Mexican inflation will be "stubbornly high" while speculators will continue to make "unwarranted" attacks on the peso. The American line of credit to Mexico is an answer to the question, How much will it cost the United States to keep Mexicans from migrating to California and Texas?

Maybe we are just seeing some key steps on the way to higher inflation. Market "crises" that erupt around Orange County or Mexico force the Fed to delay the tightening process to avoid systemic risk. The pause in tightening allows the U.S. economy to build more momentum, which in turn puts more pressure on leveraged investments searching for higher yields. Eventually, the Fed must call an abrupt halt, the yield curve inverts as U.S. short-term interest rates rise above long-term yield, and the hard landing is upon us.

With all this in mind, the Fed's New Year's resolution is, ironically, the same as that of finance ministers in emerging markets countries: pray for slower U.S. growth.

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