forumpurpsm.GIF (8368 bytes)

Risky Business

With so much at stake, we must prepare for the worst and hope for the best.

BY EDWARD YARDENI

Our global and domestic markets for financial securities, commodities, products, and services depend on the smooth functioning of the vast information technology structure. Because information is the life blood of our domestic and global markets, the Y2K computer problem poses risks to economies around the world. If the information flow is severely disrupted by Y2K, then markets will allocate and use resources inefficiently. Market participants will be forced to spend more time and money obtaining the information that was instantly available at almost no cost before the market was disrupted.

The division of labor could also be radically upset by Y2K. This process is the very foundation of economic prosperity and progress based on the exchange of goods and services produced as the result of our competitive advantage. We all either thrive, or have the potential to do so, by producing the goods and services that we are especially endowed, qualified, or trained to produce. We exchange the fruit of our labor for the goods and services that are better made by others.

Information technology systems have expanded the size of markets and the opportunities for an even greater division of labor. Just-in-time manufacturing, outsourcing, and globalization are the most obvious modern extensions of the division of labor. Now imagine a world in which those information technology systems are either impaired or completely fail. Suddenly we might all be forced to do without goods and services that can no longer be produced for us by others. We could attempt to make them ourselves, but in most cases that would be impossible. If it is possible, the cost and time of doing so will be enormous. There are no low-tech alternatives if our high-tech information systems fail in 2000. We simply cannot manually collect, sort, store, process, and analyze all the data we must have to support, let alone grow, our global economy.

Numerous experts, testifying at recent congressional hearings, have warned that serious computer malfunctions could play havoc with our military defense systems, electric power grid, telecommunications network, health care providers, and government tax collection and support payments. The economic and geopolitical upheaval caused by Y2K could be significant.

Indeed, I believe there is a 70 percent probability of a global recession in 2000. It could be as severe as the 1973-74 global downturn, which was caused by a disruption in the supply of oil. In a similar way, Y2K disruptions in the flow of information could cause a significant global recession. Blackouts and frequent brownouts are possible, especially overseas. In the United States, the phones might work, but the network could be saturated with callers attempting to deal with various Y2K problems, including buggy personal computers, erroneous bills, and undelivered tax refund checks. Overseas calls to important countries may be impossible to place for some time. This would be disruptive to world trade and to the just-in-time manufacturing system in the global economy.

In a plausible worst-case scenario, the global recession could last 12 months. Business failures would rise, as would jobless rates. The resulting political upheaval would be unpredictable. Protectionist backlashes could further depress world trade and cause deflation.

SERIOUS OPTIMISTS

There are, however, some smart, very important people who don’t agree with my predictions. Cathy Minehan, president of the Federal Reserve Bank in Boston, told the Boston Globe (January 20, 1999), "It just doesn’t seem realistic to say [Y2K] would produce, all by itself, a recession." A more realistic forecast, she believes, is provided by Standard and Poor’s DRI, which predicts that Y2K might reduce gross domestic product by just 0.2 percent. The article did not explain why Minehan believes this is a more realistic forecast. However, she did conclude that "it’s not realistic to think there will be no glitches either."

Another heavyweight optimist is Federal Reserve Board Governor Edward W. Kelley Jr. In an October 29, 1998, speech, Kelley said:

A few economists already are suggesting that Y2K disruptions will induce a deep recession in 2000. That probably is a stretch, but I do not think we will escape unaffected. I anticipate there will be isolated production problems and disruptions to commerce, and perhaps some public services that will reduce the rate of gross domestic product growth early in 2000. Certainly a mild inventory cycle seems very likely to develop. But, just like the shocks to our nation’s physical infrastructure that occur periodically, I would expect the Y2K shock to our information and electronic control infrastructure is most likely to be short-lived and fully reversed.

Kelley went on to compare Y2K to a disaster like the major snowstorm of 1996 or the United Parcel Service delivery-service strike in 1997. Both events had a transitory and negligible adverse impact on business activity. Kelly did concede, though, that "if the disruptions that occur are not isolated events....but spread across key sectors of the economy by interacting with each other, then an outright decline in real GDP in the first quarter of 2000 could be a plausible outcome." He added:

The more dire of the Y2K scenarios would involve, among other things, a perpetuation and intensification of these feedback effects. In such an event, production disruption could turn out to be a national or international phenomenon and could spread from one industry to another. Under these circumstances, the decline in economic activity would prove to be longer lasting, and a recession—typically defined as a decline in real gross domestic product—could ensue. But let me quickly stress that I do not think this recession scenario has a very high probability. It is possible, but a lot of things have to go wrong for it to occur, and much is being done to prevent its occurrence.

I would rate the scenario Kelley describes as highly probable. The disaster analogies he uses are not good ones because events like snowstorms and strikes tend to be localized. Y2K, in contrast, is potentially a series of disasters and multiple failures that will occur all around the world at more or less the same time. Disaster areas usually recover quickly because outside help from numerous unaffected communities is immediately available. In 2000, there could be many more communities that need help than can provide it.

RAISING THE ODDS

When I first started to study and write about Y2K during the summer of 1997, there wasn’t much information available. I found enough, though, to worry me. Given the dearth of data, I estimated the chances of a global recession at 30 percent. Back then, most of the available credible information was limited to the U.S. federal government’s quarterly progress reports. As a result, most of my concerns during the last few months of 1997 and the first half of 1998 focused on the possibility that vital government services might be seriously impaired. The most vulnerable agencies seemed to be the Internal Revenue Service, the Health Care Finance Administration (Medicare), the Federal Aviation Administration, and the Defense Department.

I gradually raised the odds of a major recession up to 70 percent. I did so even though I have become a bit less alarmed about the readiness of the federal agencies, the banking and finance industry, the national electric power grid, and air traffic control. More alarming now is the increasing evidence of slow progress overseas. At the same time, the Y2K disclosure statements filed by America’s largest companies with the Securities and Exchange Commission during the third quarter of 1998 were disquieting. Other vulnerable sectors include just-in-time manufacturing, global maritime shipping, state and local governments, embedded microprocessors, gas transmission and distribution, world oil production, and local utilities.

I think I now know enough about Y2K to provide a more detailed assessment of my subjective probabilities of five alternate scenarios. I assign 10 percent and 5 percent probabilities to the most optimistic and the most pessimistic scenarios, respectively. Unfortunately, most discussions and debates of the subject tend to focus on these two extremes, namely, that Y2K is either a hoax or doomsday (see Table 1).

TABLE 1
PROBABLE Y2K Economic Scenerios
Y2K Economic Scenarios Probability
Minor disruptions.   Business as usual.  Only a few problems that will be fixed rapidly.   Stock Market unafffected. 10%
Same impact as a natural disaster.  Business as usual within a few weeks.  Stock market unaffected. 20%
Multiple problems that cause a modest 6-month recession.  Real GDP down 1-2%.  Stock market down 10-15% then soars. 25%
Major global recession lasting 12-24 months.  Real GDP down 2-5%.  Stock market down 30-40%.   Deflation. 40%
Depression lasting 2-3 years.  Blackouts.  Social and political upheavel.  Stock market...you don't want to know. 5%

UNNATURAL DISASTER

Like Federal Reserve Board Governor Kelley, many economists liken Y2K to a major natural disaster. They correctly observe that these calamities usually boost economic activity as money is spent to clear the damage and rebuild.  They observe that unlike natural disasters, we know exacly when this one will start, so we will be much more prepared.  I disagree.

If Y2K is a disaster, it will be a global one, not a local one. If there are many failures at the same time, then it will be very difficult to get help, which would delay the recovery effort and deepen the recession. Efforts to recover from natural disasters are usually expedited by assistance from outside the disaster zone. Such help might not be so easily obtained in 2000. Still, I’m a reasonable man, so I’ll weight the second scenario at 20 percent.

The last three recession scenarios still have a joint probability of 70 percent in my opinion: the mild recession at 25 percent, the severe recession at 40 percent, and the depression at 5 percent. Much of our global computer network was created in the last 20 years, and was largely motivated by the proliferation of just-in-time manufacturing. The system requires that all components must arrive exactly at the time scheduled to assemble them into the finished product. To perform this feat, most companies have reduced the number of vendors they rely on. Some of those vendors are likely to be foreign ones.

It wouldn’t take much to disrupt the global just-in-time system. Indeed, during the summer of 1998, General Motors was shut down for several weeks because just two of the company’s plants experienced a strike. Even if most domestic supply chains are fixed, it is very likely that breaks in the global supply chain will occur. This is bound to disrupt production by just-in-time manufacturers everywhere, unless they quickly implement contingency plans.

WHITE HOUSE SPIN

The President’s Council on Year 2000 Conversion, established on February 4, 1998, by Executive Order 13073, coordinates the U.S. federal government’s efforts to address the year 2000 problem. Y2K czar John Koskinen chairs the council, which includes representatives from more than 30 major federal executive and regulatory agencies. The council’s mission is to work with the agencies to prepare critical federal systems for the year 2000 and to prod others outside the federal government to fix the problem.

Council members exchange information on Y2K progress and shared challenges. They also coordinate interagency testing efforts for programs that rely upon multiple agency systems and assist each other with contingency planning efforts for potential Y2K-related failures. To reach beyond the federal government, council members have formed working groups to focus on Y2K issues in over 25 sector areas, including finance, communications, transportation, electric power, health care, water supply, and building operations. The working groups have formed cooperative working relationships with major trade associations and other umbrella organizations representing the individual entities operating in each sector.

On January 7, 1999, the council issued its first Quarterly Summary of Assessment Information. Overall, the report is positive—especially, the council’s claim that it is "increasingly confident that there will not be large-scale disruptions among banks and in the power and telecommunications industries. Disruptions that do occur will most likely be of a more localized nature." I hope they are right. However, a close reading of the report suggests that the positive spin is not fully justified by the available information. Indeed, the report admits that "in every area, the Council is relying partially or entirely on industry trade associations to provide assessment information on Y2K progress within their sectors." In other words, most of the information is not independently verified or audited. The report also notes that "many trade associations are still working to gather initial or more comprehensive survey data on the status of their members’ year 2000 efforts."

THE REST OF THE STORY

While I don’t enjoy looking for bad news, in the interest of providing some balance, here is a list of disturbing items I found in the Council’s happy first assessment:

n Domestic telecommunications. The telephone wireline industry was only 69 percent complete at the end of last year and has an average target completion date of June 30, 1999. This doesn’t leave much room for setbacks and time for everyone who depends on the industry to test their telecommunications systems.

n Foreign telecommunications. Many nations around the world have not prepared for Y2K problems. The countries with the least prepared telecommunications systems were predominantly developing countries from the African continents, South Asia, Southeast
Asia, China, and Russia.

Eastern Europe, the Middle East, and Central and South American countries ranked themselves somewhat prepared for Y2K, while Western Europe, the United States, the Caribbean, and Pacific Rim countries ranked themselves the most prepared. Of course, this is not a race that we want to win by ourselves. We all have to cross the finish line at the same time, or else disruptions around the world will cause a global recession.

n Satellites. Although satellites are mostly compliant, ground equipment and antenna controls are date and time dependent and ground stations contain complex electronics and larger computers. The Council says that "companies are confident that they will complete conversion by January 1, 2000, but cite interoperability testing as difficult."

n Electric power grid. The reliability of the electricity grid is of paramount importance. If it is seriously disrupted, responding to all the other Y2K-related failures will be that much harder. The council’s report mentioned that "particular concerns within the industry include the reliability of voice and data communications needed for monitoring and control of power systems and embedded chips. Embedded chips are used in communications and numerous power system device controllers. While it is estimated that only 1 to 2 percent of these devices use a time/date function in a manner that could result in a Y2K malfunction, the interconnected nature of electric systems make them sensitive to the failure of any equipment."

The council prepared its report prior to the release of the second survey of the electric power industry by the North American Reliability Council. This second survey report notes that embedded chips are not as much of a problem as feared, but there are concerns about the effect of possible telecommunications failures on power plants1

n Oil and gas. According to the council, "The U.S. oil and gas industry is concerned about international oil production and shipping, especially in light of the lack of information available." It should be; the Kuwaiti government sponsored a conference in early December 1998, titled "Kuwaiti Conference on the Year 2000 Problem...Is It Too Late to Start?"

n Emergency Services. State emergency management directors expressed several areas of concern, especially "the limited nature of financial resources to assess, fix, test, and validate systems at the state level." Other concerns included the impact of possible power failures and the lack of contingency planning at state and local levels.

n Water. Approximately 4,000 water supply systems in the United States provide for 80 percent of the U.S. population. A survey of 600 of them during the summer of 1998 found that 36 percent had no Y2K plan. In addition, the data also suggest that few system operators have assessed possible exposure to Y2K problems from failures in systems of outside service providers (e.g. telecommunications, power, and chemical suppliers).

n State governments. The progress that state governments have made in addressing the Y2K problem varies. The council reports that "according to a National Association of State Information Resource Executives survey of state Y2K remediation efforts, several states report that they have completed Y2K work on more than 70 percent of their systems. But a handful of states still have much work left to do, reporting that they haven’t yet completed work on any of their critical systems."

n Small businesses. Small businesses appear to be at high risk for Y2K failures. The council reported that "a recent National Federation of Independent Business survey released in January 1999 indicates that as many as a third of small businesses using computers or other at-risk devices have no plans to assess their exposure to the Y2K problem." The survey also indicates that more than half of small firms have not yet taken any defensive steps.

The reasons for this inactivity vary. Many of these business owners believe that unless they operate large, mainframe computers, the Y2K problem poses no threat to their operations. Others have stated that they will fix the systems when and if they fail, and that taking preemptive action to assess and fix potential Y2K problems is a waste of time and money.

MIRCLES IN WASHINGTON

Since late 1996, federal agencies have been required to report quarterly to the Office of Management and Budget (OMB) and Congress on their progress to assess, remediate, test, and implement mission-critical systems toward a governmentwide goal of having all critical systems Y2K compliant by March 31, 1999.

On that date, only 13 of the 24 federal agencies had repaired and tested 100 percent of the their computer systems. Of the 11 other agencies, 10 claimed to have repaired and tested at least 85 percent of their systems.

Interestingly, 14 of the 24 agencies reported declines in their number of mission-critical systems. The number of mission-critical systems is down a whopping 25 percent from 8,589 in November 1997 to 6,399 in February 1999. This raises the suspicion that federal Y2K managers might have reclassified systems to meet the March deadline. Especially troublesome are the big declines in numbers of critical systems at key agencies such as the departments of Agriculture (down 74 percent), Health and Human Services (down 41 percent) and Defense (down 27 percent). It isn’t clear who made the decisions to drop systems and why, or whether the agencies received independent authorization to do so.

Partly as a result of these puzzling redefinitions, government officials were able to claim that 92 percent of the government’s mission-critical systems have been fixed, undergone an initial round of Y2K tests, and been put back on line.

Now comes the tough part. The next phase, called end-to-end testing, will be difficult, consume huge amounts of time, and add to agency costs. In such tests, agencies must determine if their systems can reliably exchange data with other systems after Y2K changes have been made to hardware or lines of code. Programmers know from past experience that when systems undergo multiple changes, errors are often introduced inadvertently and thus require further debugging.

The Clinton administration recently touted the success of the Social Security Administration in completely fixing its computer systems. The administration failed to emphasize, however, that this agency has been aware of the problem and has been working on it for 10 years. About a year ago, the OMB’s progress reports suggested that the Defense Department, the Internal Revenue Service, the Health Care Finance Administration (Medicare), and the Federal Aviation Administration were almost hopelessly behind in their Y2K projects. Now these same agencies all claim that they will be ready on time. That’s quite a miracle, when you consider how long it took the Social Security Administration to do the job.

WONDERS ON WALL STREET

Last summer, Merrill Lynch published an ambitious report that reviewed the Y2K outlook for all the companies this great global brokerage firm follows. The conclusion was reassuring, but it was based on very flimsy analysis, and there has been no follow-up. Morgan Stanley Dean Witter joined the Y2K cheerleader squad in January 1999 with a report titled "Year 2000 Research: Getting over the Bug: An Assessment of the Y2K Preparedness of the Standard and Poors 500 Companies." Here is their major conclusion:

Undoubtedly there will be glitches, temporary stoppages, and sporadic failures of computers and services in the early hours and days of the new millennium. Nevertheless, we believe that most of the people in the United States will get to work on January 3, 2000. When they get there, the lights will go on, the phones will work, and they will have access to and control over bank and other financial assets. We anticipate no recession and no bear market in U.S. financial assets.

This expected happy ending is based on a review by the firm’s analysts of the 10-Q quarterly and 10-K annual disclosure statements filed with the Securities and Exchange Commission from August 4, 1998, through the end of that year. I went through the same exercise myself for the same S&P 500 universe of companies and didn’t get the same warm, fuzzy feeling. I concluded that most of America’s biggest and best companies were not far enough along in fixing their Y2K problems.

I found that 344 of the S&P 500 companies reporting the total estimated cost of their Y2K projects had spent, on average, only 42 percent of their estimated Y2K budgets by the end of September 1998. Only 20 companies claimed to have spent 75 percent or more of their budgets. Reporting the estimated cost of their Y2K projects at both the beginning of 1998 and during the third quarter were 190 companies. On average, their estimated costs increased by 19 percent. The vitally important utility industry is next to last in the spending-to-budget ranking and shows a 36 percent increase in total estimated costs.

JUST-IN-TIME DISRUPTIONS

I recently attended the 1999 World Economic Forum in Davos, Switzerland, as a member of a panel of experts to discuss Y2K problems. The other members of the panel were Frances Cairncross of The Economist, Carlos Prima Braga of the World Bank, Bruno Giussani of the World Economic Forum, and Ulf Dahlsten of Posten AB in Sweden. Prior to the meeting, we agreed to call on the world leaders attending the conference to provide more leadership on Y2K. The group believed that greater progress in fixing the problem and preparing contingency plans required more attention by government and business leaders. In our opinion, it was not too late for them to act. So we jointly wrote a "Call to Leadership," which I was selected to present at the ministers’ session.

I was just one of several speakers on various topics. Prior to my presentation, Bill Gates of Microsoft spoke about the rapid pace of change in technology and the overvaluation of Internet stocks. He was followed by Scott McNealy, the CEO of Sun Microsystems, who said we should wire villages with access to the Internet even before we build roads to them. Then I spoke for five minutes on Y2K and outlined the Call to Leadership.

Although Gates chose not to comment, McNealy responded by saying that everyone in the room should buy the computers they need this year because his company might not be able to produce them in 2000. He estimated that his component suppliers in Asia are "one to three years behind in fixing their year 2000 problem."

I nearly fell off my chair. Many companies have been including boilerplate language about possible adverse impacts of Y2K in their SEC disclosures. Here, for example, is an excerpt of what Sun disclosed to investors in its third quarter 1998 report (10Q) filed with the SEC:

Furthermore, a reasonably likely worst-case scenario would be if one of the Company’s major vendors experienced a material disruption in business, which caused the Company to experience a material disruption in business, such a disruption would have a material adverse effect on the Company’s business, financial condition and operating results. Should either the Company’s internal systems or the internal systems, products or services of one or more of the Company’s major vendors fail to achieve Year 2000 compliance, the Company’s business, financial position or results of operations could be materially adversely affected.

McNealy’s remarks signaled the first time that the CEO of a major corporation had warned that Y2K could be so disruptive. I leaned over and quietly asked McNealy if he was on the record, and he said yes. Indeed, the next day, he repeated his concerns in a press conference: "People are talking about stockpiling cash, water, and canned goods. Given what I and everybody else in the computer industry know about Asia, it might not be a bad idea to stockpile some computers for the next millennium."

McNealy confirmed my number-one concern about Y2K: that it will seriously disrupt the global just-in-time manufacturing system, thus causing a severe worldwide recession.

What if Sun actually won’t be able to produce computers in 2000? If Sun can’t, neither will Dell, Compaq, and IBM. (Of course, lots of other businesses that depend on Asian suppliers could also be severely disrupted.) The stocks for these companies are among the
leaders of the current bull market. They aren’t cheap, and they are likely to plunge if earnings expectations are dashed by Y2K disruptions.

Later, I attended a panel of four top CEOs, including Bill Gates. During the question and answer session, I asked the business leaders to comment on Y2K. All four expected some glitches, but nothing major. Gates said, "We may see 12 months where people are distracted getting their things ready. But I agree with the general sentiment here, that of the range that people have thought about in terms of the problems that will occur, it will be below the middle of the panic that some people have suggested."

Gee, I feel better.

GLOBAL DIMENSIONS

The January 13, 1998, Financial Times reported that 60 senior business executives, in a statement delivered to President Bill Clinton and the prime ministers of Britain and Canada, warned that governments are not moving quickly enough to fix their Y2K problems.

"We fear that governments lag in assessing and addressing the problem," the executives said. They warn that disruptions could delay welfare payments, trigger financial chaos by a breakdown in revenue collection and debt management, and cause malfunctions in the air traffic control and defense system.

Businesses in the rest of the world are even less prepared. In January 1999, the World Bank reported on Y2K preparedness in the developing world.2 Only 54 of 139 developing countries reported that they had initiated national Y2K policies, just 21 were taking concrete remedial steps to safeguard their computing systems, and 33 reported high-to-medium awareness of the problem but were not taking current action. In other words, only 15 percent are taking concrete steps to fix the problem, 24 percent were aware of the problem but were doing nothing, and 38 percent have appointed a Y2K coordinator. The Bank warned that the mere existence of national Y2K action plan and coordinator did not imply that countries would be fully Y2K compliant by the end of 1999. Countries in crisis in East Asia, Latin America, and the former Soviet Union could be especially hard hit. According to the Bank’s January 26, 1999, press release,

The problem has been overlooked because many observers assume developing countries are less dependent on computers on everyday national life. But the majority of developing countries, even the poorest, have computerized essential services, such as power generation, telecommunications, food and fuel distribution, and the provision of medical care. The Bank says that a general failure of such systems could endanger the health, security, and economic well-being of people in the developing world.3

James Bond, director of the World Bank’s Energy, Mining, and Telecommunications Department and coordinator of Y2K compliance in the Bank’s existing loan portfolio and Y2K grants to developing countries, says,

This is a global problem affecting not only industrial countries, which are highly dependent on computers, but developing countries as well. While wealthy countries and large companies have the money and skilled technicians needed to immunize computers and their operating software from the Millennium Bug, many of our developing-country clients cannot muster the resources to tackle a problem that most see as a vague and distant threat.

Actually, the adverse impact of the millennium bug could be greater in developing countries because they are more dependent on fewer and older computing systems and they have more competing national demands for scarce resources.

PREPARE FOR THE WORST

I’m an optimist by nature and not inclined to be an alarmist. Indeed, I have been one of the most vocal stock market bulls on Wall Street for more than 10 years. I remain relatively optimistic that most computer systems will be fixed on time. However, I doubt that all computer systems in the world will be completely fixed. If that’s the case, then some will fail, possibly causing widespread disruptions at critical choke points of vital economic systems and a global recession.

We must give top priority to fixing Y2K around the world. We must assess the impact of Y2K disruptions and prepare contingency plans for plausible worst-case scenarios. It’s conceivable—though highly unlikely—that as the deadline approaches, we may conclude that the economic risks are small and temporary. But with so much at stake, we should prepare for the worst and hope for the best. If we are not all at least a small part of the solution, we will certainly be a big part of the problem.n

Edward Yardeni is the chief economist and global investment strategist of Deutsche Bank Securities in New York.4

1. Read the NERC report at <http://www.nerc.com/y2k/y2k.html>.

2. Press release, January 26, 1999, "Developing Countries Poorly prepared to Combat Millennium Bug in 2000" <http://www.worldbank.org/html/extdr/extme/2078.htm>.

3. Ibid.

4. This article was adapted with permission from the Y2K Reporter, which can be found online at <http://www.yardeni.com>. The author has retained copyright.

forumsquare.GIF (154 bytes)

FORUM Homepage

Table of Contents