Dick Nichols
The previous article in this series (GLW #674) discussed the debate among mainstream economists about the seriousness of "global economic imbalances", in particular the US current account deficit (CAD). This reached 6.4% of US GDP by the end of 2005, stirring fears that the US economy might be heading for a violent "adjustment".
What would such an event look like? A sudden drop in the US$8 billion inflow needed every working day both to finance the US CAD and counterbalance US investment flows abroad would sharply depreciate the dollar, lift import prices and force the US Federal Reserve Board to increase interest rates to contain inflation.
Asset values (and the credit and consumption growth they increasingly underpin) would stagnate or collapse. The US CAD — that is, the gap between US domestic savings and investment — would eventually shrink, but only after an initial increase due to increased interest payments on US foreign debt. The price of the smaller CAD would be slower growth or even recession— as in the Asian 1997-98 crisis. Any further increase in energy prices would intensify the blow and with it the prospect of a global economic slump.
It is impossible to predict which economic bloc would bear the greatest part of the US-initiated global slump. However, if the east Asian economies sought to defend their export share by defending their currency pegs with the dollar, almost the entire initial shrinkage in growth would be channelled into the underdeveloped economies and — via an overvalued euro — into "Euroland".
Would the Australian economy once again be able to duck and weave its way through such a slump? It's very hard to imagine the Reserve Bank, repeating the manoeuvre that got Australia through the 1997-98 Asian economic crisis and the 2001 global slowdown — by allowing interest rates to fall and the Australian dollar to depreciate. That's because the epicentre of the global slump would be in the world's leading nation economy — accounting for 25% of world economic activity.
The Reserve Bank's room to manoeuvre would be even less if energy prices and inflation held up as growth slowed, in a revisiting of the "stagflation" of the 1970s.
All very scary. But the US currency has gone through waves of appreciation and depreciation, depending mainly on relative growth rates of the main economic blocs and the interest rate differentials among them without touching off a global slump.
Nonetheless, as sober an authority as the Bank for International Settlements (BIS, the central banks' central bank) can't rule out a "banana republic" episode for the dollar. In its latest annual report, it argues that the potential for a run on the greenback lies in global financial market instability combined with the existence of the euro.
The BIS writes: "Given the relationships among all markets, both domestic and international, there is reasonable likelihood that if one market were to come under significant stress, it would spill over to others ... Both private and public sector purchasers of US dollar liabilities might, at some point, lose patience in such a situation."
A possible straw in the wind was the February 18-22, 2005 fall of the dollar against the yen (1.2%) and the euro (1%), the result of rumours that South Korea's central bank was about to shift some of its $200 billion in foreign exchange reserves out of dollar holdings. This event confirmed that even small shifts in official foreign exchange reserve weightings could have large "multiplier" effects in today's markets.
Corporate investment
Moreover, financial market instability, while still low at this point in the business cycle, is beginning to rise and is bound to increase. This is the result of the intersection between two recent powerful economic trends.
One is the easy money policy of the central banks of the imperialist centres carried out to prevent the 2001 downturn from becoming a serious recession (a policy applied in Japan since the 1990 collapse of the property and stock markets). This poured massive liquidity into the banks and corporate treasuries, especially in the US where it was combined with tax breaks to business.
The second is that — despite the large corporate profits, which hardly dipped during 2001 — in the US, Japan and Europe the rate of new investment remains historically low. In the words of the International Monetary Fund's Raghuram Rajan, "corporations don't seem to be investing serious amounts at this point in the cycle. They are below where they should be in their investment patterns ... as they are flush with cash".
Three-quarters of this ocean of undistributed corporate profits is due to the fall in investment in production within the developed capitalist economies (Australia remains an exception), as the corporations invest a smaller share of their takings in upgrading and expanding their capital stock. Also, with the important exception of China, rates of investment in east Asian economies remain below those prevailing before the 1997-98 crisis.
This trend is partly due to the declining price of capital goods relative to all other goods (especially in the information and communications sector), partly to the decision to reduce overall indebtedness by paying back the debts accumulated in the 1990s "new economy" boom out of retained earnings, partly to nervousness about exposure to volatile financial markets and partly to an increase in "just-in-case" cash holdings (especially when faced with unfunded liabilities like company pension schemes).
However, the most important factor has been the accelerating drive towards the global rationalisation of production coming out of the 2000-01 recession. The corporations have been engaged in both massive share buybacks (greater than new issues in some countries) as well as in pursuing a strategy of expansion through acquiring assets abroad, especially but not only in the "emerging economies" of Asia.
As a result, the proportion of corporate earnings devoted to dividend payouts, share buybacks, mergers and acquisitions and generally speculative investment has been unprecedented.
During 2001-05, vast tides of funds combed world financial markets looking for profit in everything from Filipino government bonds to nickel futures, seemingly impervious to the riskiness of the "financial instruments" on offer.
Over this period, differences in the rate of return on all forms of debt — government versus commercial, developed capitalist versus "emerging economy", short-term versus long-term, etc — all narrowed to an unprecedented degree. Indeed, such was the demand for longer-term debt (10-year bonds or longer) that for a while long-term interest rates fell below short-term rates in some bond markets.
Financial tremors
The question now is how all this debt (and the institutions obliged to meet payments) will perform in the new cycle of rising interest rates and financial market nervousness. One tremor took place in February this year in that exotic speculative market — the "yen carry trade". Here the punter borrows yen (where the cash rate has been zero) then invests the funds in a high-interest currency (like Icelandic krona assets). The bet is that the yen won't appreciate nor Japanese interest rates rise, so that the speculator will receive the gain from the interest rate differential (plus any capital gains) once the funds invested are converted back into yen.
The only problem is if suspicion grows that krona assets are about to devalue, and/or that the krona is about to depreciate against the yen and/or that interest rates are about to rise in Japan. Then there's a stampede to get out of kronas, bringing about the very depreciation that was feared.
In February, after ratings agency Fitch downgraded Icelandic debt, the krona fell by 7% against the US dollar, producing sympathetic, although temporary, falls in other high-interest, large CAD currencies, including the Australian dollar.
Other recent examples of volatility have been the May-June drop in stock indexes (particularly in Middle Eastern countries like Saudi Arabia, which fell 50% from its peak even though oil profits have been skyrocketing). Speculation has also been furious and nervous in raw materials, stocks and mortgage- and asset-backed securities.
In the vast US mortgage-backed securities (MBS) market growth in recent years has been driven by the bundling into bonds ("securitisation") of mortgages contracted by "non-prime" borrowers: in 2005, 40% of MBSs issued were backed by mortgages, as against 10% in the late 1990s.
Also potentially headed for tricky times is the speculative den of the hedge funds, which punt on movements in publicly traded stocks, debt, foreign exchange and derivatives. Hedge funds are basically like insurance agents writing policies for other market "players" and pocketing the premiums. When markets crash — as with the Asian economic crisis and the 1998 Russian crisis — hedge funds more often than not lose money. Moreover, because they are highly leveraged these losses can be enormous, as with the 1998 near-meltdown of the US fund Long-Term Capital Management (LTCM), bailed out by a consortium of banks brought together by the Federal Reserve.
Despite claims that hedge funds now manage risk and monitor market movements better than before LTCM, they have confronted generally benign markets. However, such has been the tide of money into hedge funds since 2004 that returns are dropping as their hunt for new opportunities intensifies on a global scale.
Crunches will come. Will the funds then be able to prove unfounded the opinion of Jochen Sanjo, the head of the German financial regulator BaFin, that "hedge funds pose a big threat to the stability of the world financial system"?
Around the world, central bank attention is presently fixated on the problem of how to carry out anti-inflationary interest rate rises so as not to unduly exacerbate the interaction between global imbalances and financial market volatility. This effort is also taking place when financial regulators are struggling to keep up with the rapidly multiplying variety of corporate "financial products" and when the impact of global financial market integration on national monetary (interest rate) policy is hard to assess.
But this situation is not something that even the cleverest monetary policy alone can control. On the battlefield of global capitalist competition, both fiscal (budgetary) and "structural reform" (a la Work Choices) are under rising pressure to make their contribution to stabilisation.
Despite the high global growth rates of the last three years and the increased room for economy policy manoeuvre they have allowed, stable capitalist growth is not firmly entrenched. Indeed, in the present phase of rapidly rising global economic integration the fundamental trend is not towards increasingly uniform and stable conditions of profit-making across the main economic blocs, but increasing contradiction and inter-bloc rivalry.
The combined and uneven development of these contradictions and the political impact of attempts to soften them will be the focus of the last article in this series.
[Dick Nichols is the managing editor of Seeing Red. For sources used in this article contact <dicknichols@greenleft.org.au>.]