After two days of trouble and strife in global stock markets, the Federal Reserve’s New York President William Dudley said in remarks to reporters that a September interest rate hike seemed “less compelling” now than in recent weeks. These two words alone calmed global financial markets, and pushed up the price of oil.
So everything’s going to be all right then? That is what some would have you believe. “Relax. Its just a correction” say the analysts. “The stock market always goes up and up and up. Hang on in there.”
However, I do worry. Where there’s volatility and instability, the causes are ultimately fundamental. Given this week’s events what can they be? Is it all to do with China?
I doubt it. When the governors of the People’s Bank of China announced a cut in interest rates – stock markets continued to fall. When a Fed governor uttered two words off the cuff – markets rallied. So when looking for a cause we need to look west, not east.
Most agree that the panic was sparked by a slowdown in China. The question then becomes: why is China slowing down? Some put it down to China’s credit binge, and the rise in debt hobbling local governments and property developers. Demographic change is another. Others believe that China’s extraordinary investment levels will now dive lower.
I don’t buy these analyses as causal. Instead I see them as consequential, and would point the finger at the following: first an overhang of global debt, largely in Anglo-American economies ($57trillion has been added since 2009). Second, the deficiency in global demand for goods and services caused by austerity, low levels of investment and wage repression. Third, the glut of unsold Chinese goods (e.g. cars and rubber tyres) caused by falling demand for these goods, and resulting in falls in prices (disinflation or deflation).
The deficiency of demand and resulting disinflation or deflation originates, I would argue, in the United States, the world’s biggest consumer but also one in which private debt levels remain high, and wages remain repressed.
In the first week of August, I was privileged to be a guest of David Kotok, chief executive of Cumberland advisors at a gathering of economists and analysts at what has come to be called Camp Kotok on Grand Lake Stream, Maine, USA. As the Wall St. Journal reported, the chatter was about “a Fed Rate Rise, China and how the fish are biting.” Most of those present were Wall St. analysts and economists, and the almost unanimous view was that the Fed would go for ‘liftoff’ at its forthcoming meeting on September 17. A journalist from The Street – a Wall Street circular – pointed out that in her survey of Camp Kotok participants, mine was the lone voice forecasting no rate rise in September. At the time I felt a little embarrassed – being a very small fish at this gathering of Wall Street hotshots. But right now I feel vindicated in questioning this consensus.
Let me explain why. Since the 2007-9 global financial crisis very little has been done to reform or transform the existing economic order of financial liberalisation – widely defined as ‘globalisation’. Liberal finance prior to the crisis led to unfettered credit (debt) creation, high real rates of interest on debt for those active in the real economy; volatility in capital flows across borders causing international imbalances and fluctuations in exchange rates. These financial imbalances were accompanied by policies for the privatisation of state assets (often acquired through the creation of debt, and at a loss to taxpayers) and wage repression. The result? The build-up of vast mountains of private debt and the repression of the income needed to repay those debts.
This financial house of cards began to collapse as early as 2007.
How did the public authorities react? At first there was stunned incoherent silence, and even signs of contrition from the architects of the crisis, including Alan Greenspan, governor of the Federal Reserve. But quickly the finance sector, helped by the economics profession, regained its confidence and dominance over governments and society. Liberal finance, they argued, was the only possible basis for the global economic order. In order to reinstate its dominance, western taxpayers would have to cough up and bail out the finance sector, and China would have to move to full adoption of the model that had just brought down the western banking system.
China obliged. The authorities launched a massive, credit-fuelled investment programme which peaked at 49% of GDP – a level of investment that far outstrips that of any western economy. Growth galloped ahead at 10 per cent per annum. Total debt was allowed to rise to 250 per cent of GDP – up 100 points since 2008, according to the IMF. China's corporate debt-to-GDP rose to 160 per cent to $16.1 trillion in 2014, twice that of the United States, from about 120 per cent in 2013.
The result is a full-scale replica of pre-crisis Anglo-American economies: property and other asset markets boom while credit creation balloons and the Peoples Bank of China eases monetary policy. Foreign investors and companies have piled in, and expanded the production of consumer goods churned out by Chinese workers on low wages. Falling Chinese costs contributed to falling wages elsewhere.
Western economists and investors cheered on the Chinese Communist Party which won accolades for their “Goldilocks economy”. Western politicians flocked to Beijing with trade delegations in their wake.
But while China’s stimulus helped keep the global economy afloat, there are limits – economic, ecological, social and political – to its relentless expansion of economic activity.
In the meantime, back in the US, the UK and Japan, the public authorities’ unwillingness to accept alternative diagnoses of the nature and cause of the global financial crisis led to a firm denial that any shift in the paradigm was necessary. Like the bloodletters of old, they persisted in their own flawed practices. Schooled in the existing order, mainstream economists, central bankers and officials knew no other way except that of ‘free market’ control over reckless, speculative and debt-addicted financial markets.
As a result, and instead of diagnosing and eliminating the disease of liberal finance, central bankers rushed to offer ‘life support’ to private banking systems in the UK, Japan and the US. The treatment took the form of more ‘easy money’ for speculation: quantitative easing (QE), low interest rates and taxpayer-backed guarantees for the finance sector. Very little was done to ease the debt addiction, or to operate on, and remove the growth of private debt that afflicted most capitalist economies.
And instead of generating the income or tax revenues needed to repay private and public debts, the authorities in both the US and Europe reverted to variations on ‘austerity’ and wage repression – which contracted incomes.
Central bankers in Europe too were initially unconcerned. Interest rates were raised in 2011, when elsewhere they were falling. This precipitated a frightening rise in unemployment and decline in activity. It was not until very recently, March, 2015, that the European Central Bank promised to act on its promise to do “whatever it takes” to save the Euro, by launching its ‘life support’ - QE. By then it was too late: deflation had taken hold in some states, demand had collapsed and unemployment had risen to brutally high levels.
In the meantime in October, 2014, the US’s Federal Reserve had withdrawn ‘life support’ by ending its QE programme of bond purchases.
Soon after, the US ‘patient’ began to show signs of weakness. In the first quarter of 2015, the US economy contracted by 0.7%. The first estimate for the second quarter of US GDP was an increase of just 0.6%. This was followed by the OECD’s grim outlook in June, 2015. It noted the “sharp contraction” in the US and slower- than-expected growth in China. And while the OECD believed the weakness in the first quarter to be transitory, the outlook for the world economy, its economists argued, was still grim, due to “a sustained trend of low investment and low demand”.
Then this week came news of the biggest fall in world trade in six years, according to the World Trade Monitor.
Despite this emerging evidence, economists cheered on falling oil and commodity prices as “good deflation”;’ dismissed market turmoil as transitory and ignored the trade numbers.
Nevertheless the weakness of the world’s biggest economy had begun to spread – to China and all emerging markets, where gluts of goods are building up, commodity prices are falling, and currencies and stock markets are in a tailspin. This is having its major impact on so-called ‘emerging’ as well as ‘developing’ economies’ markets. The BRICs, once promoted by Jim O’Neill (ex chief economist at Goldman Sachs) as the drivers of the new economy, are no longer even mentioned, whilst the MINT economies (Mexico, Indonesia, Nigeria, Turkey) – O’Neill’s later acronymic concoction – have bigger holes than a Polo. This will also have a feedback impact on ‘developed’ economies – both through the deflation imported via their lower commodity prices, and through fewer export opportunities for western firms. There is also a vast flight of capital out of emerging markets, back into the perceived safer havens of western economies, but this will only tend to deflate prices further.
Then on Thursday the US’s statistics bureau surprisingly revised second quarter data upward – which only served to confuse markets further, and to reinforce fears of a rate rise by the Federal Reserve. Naturally this expectation will revive panic in the highly synchronized, globalised economy.
It is easy to understand why. Disinflation/deflation is already tightening real rates. (Interest rates cannot fall below zero – the zero-bound rate – but prices and wages can. Price falls relative to static rates or yields imply real rate rises.) If the weakened ‘patient’ that is the US economy is injected with higher rates, then the vast overhang of private debt becomes less payable, demand will fall further; investment will likely stall and consumers may well keep their purses firmly shut. Falling prices, accentuated by China’s recent devaluation, will hurt US profits. Producers, distributors and retailers are likely to lay off more workers.
In the recent panic, the finance sector, represented by Lawrence Summers former US Treasury Secretary and Ray Dalio head of the world’s biggest hedge fund manager - called for more ‘life support’ in the form of QE. Summers explained away the crisis by arguing that its origins were “rooted in technological and demographic change and reinforced by greater regulation of the financial sector”. It was these factors, he wrote, that explained why “the global economy has difficulty generating demand for all that can be produced.”
Once again the jaded but unbowed financial and economic establishment are in stupid denial. Far from acknowledging all the evidence - that it is the very deep flaws in the dominant economic model of liberal, unfettered finance that is the ongoing cause of many crises - they instead resort to appeals for more ‘life support’ to revive a private finance sector addicted to massive capital gains and profits.
So expect more trouble and strife. Without using the growing evidence of the system’s flaws to produce a sound diagnosis of the disease at the heart of the global financial system, it will not be possible to find a cure for periodic and even systemic crises.
This is cross posted from The Sunday Herald, 30 August 2015.