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Turmoil's Effect: Key Questions and Answers

September 17, 1992|TOM PETRUNO | TIMES STAFF WRITER

The turmoil that has gripped financial markets in recent days has raised serious questions about the health of the global economy and the faltering U.S. recovery. Here are answers to some pressing questions Americans may have about the crisis.

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Question: Will the chaos in Europe's financial markets mean a fresh blow to the world economy?

Answer: If it persists, the crisis over currency exchange rates and interest rates could indeed harm the global economy by increasing uncertainty, thus sapping already weak confidence levels of businesses and consumers, experts say.

But if the crisis is resolved in a matter of weeks--as expected--the impact could be relatively minor.

And the ultimate result could be favorable to the United States: Europeans are being forced to revalue their currencies in relation to each other. That will most likely result in lower interest rates there, which could mean lower rates here--good for everyone.

But the financial tumult almost certainly sets back the goal of a unified Europe. Whether that will be good or bad for U.S. businesses in the longer run isn't clear.

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Q: Are American businesses, consumers and investors immediately affected by current high European interest rates?

A: The stunning numbers Americans have read about--such as 500% interest rates in Sweden--don't affect American rates. The rates in question are on overnight bank loans in Europe and don't apply to business loans or individual investments.

The key is that these rates are not expected to last. So most global investors who might be tempted to take advantage of the high rates are virtually ignoring them.

In fact, money is flowing into U.S. dollar investments as investors seek a haven from Europe's troubles. The value of the dollar rose to 1.514 German marks Wednesday from 1.491 marks Tuesday, even though U.S. interest rates are far below European rates.

So for now, America is merely a bystander to the crisis. Federal Reserve Vice Chairman David Mullins on Wednesday said he saw "no compelling reason to believe that the situation (in Europe) will have any effect on us."

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Q: What ultimately sparked this crisis?

A: High interest rates are just symptoms of the real problem: The Europeans themselves, and investors worldwide, have lost faith that Europe can figure out how to create a unified economy among its diverse nations. So chaos has replaced order, at least temporarily.

In the unification process, Europe was to have a single currency by 1997 that would in theory have replaced the various national currencies. In the interim, the Europeans had agreed among themselves to a monetary system that regulated the value of their individual currencies--for example, how many Italian lira it would take to buy a British pound.

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Q: Why would the Europeans want a single currency in the first place?

A: Imagine if, in the United States, all 50 states had separate currencies, and prices for goods and services were set differently in each state. It would be extraordinarily complicated to do business among the states, to say the least. There would be constant uncertainty about what each state's currency was truly worth.

With a single currency, Europe could achieve the dream of easy commerce among nations, which in theory would mean that each country would realize the "highest and best use" of its resources. In a word, Europe would become more efficient, and thus more a powerful economic force on the globe.

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Q: Then what got in the way?

A: The reality that the differences among the nations of Europe are still huge--different inflation rates, different price structures, different living standards. While most Europeans seemed to agree that the idea of a single currency made sense, "people couldn't see how they were going to get from here to there," said William Dudley, economist at Goldman Sachs & Co. in New York.

Many minds began to change after the Danes in June rejected the Maastricht Treaty of European unity. Europeans began to question the supposed inevitability of economic union.

With unity no longer assured, investors increasingly began to pull their money from Britain, Italy and other high-inflation, economically weak nations--which by definition have weak currencies--and instead took their money to Germany, which is the biggest European economy and by most accounts the strongest.

Leaving one's money in Germany seemed to be a good way to preserve your purchasing power in the long run--especially since the Germans offered high interest rates to boot.

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Q: What was the effect of the shift of investment capital to Germany?

A: Germany's currency, the mark, rose sharply in value, while other European currencies and the dollar lost value. The reason for that is simple: To buy a German bond, you first had to buy German marks. So investors were increasingly trading other currencies for marks.

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