As traders brace for fresh turmoil, soothing words may simply be hiding reality
Larry Elliott, economics editorMonday March 5, 2007
The Guardian
Little wonder, then, that Washington did its best to rubbish any suggestion that last week's turbulence on the financial markets amounted to anything more than a little temporary difficulty. In this, the Bush administration was ably supported by the great and good of New York - or at least that part of the financial elite that wasn't banged up for alleged insider trading last week by the securities and exchange commission. As ever, the same reassuring story was spun. Like a hypnotist faced with a sceptical member of the audience, the words were repeated over and over again. Listen, this is a correction not a crash. Relax, the fundamentals of the global economy are strong. Are you listening to me? There will be no recession in the US. Did you hear what I said? There will be no recession in the US.
By the end of the week, the trick seemed to have paid off. Ben Bernanke, the chairman of the Fed, had downplayed the risks of recession brought to the public's attention by his predecessor, Alan Greenspan. And the markets were gagging for reassurance. After all, if you've spent the past couple of years persuading yourself and clients that investing in the current climate is risk-free, the last thing you want to hear is that the glittering edifice of the global economy is a Potemkin village - the fake Crimean settlements set up to impress Catherine II. The dozen charged by the SEC are not the only ones guilty of rigging markets; they were just a bit more self-serving about it, that's all.
Naturally, the consensus may be right. The consensus tends to be right more often than it is wrong, which is why real crashes of the sort seen in October 1929 and October 1987 tend to be a rarity. Indeed, the big sell-off of 20 years ago did prove to be far less of a threat than was initially feared.
Even so, there are reasons for concern. One is that the soothing words were at odds with what happened in the markets. Wall Street suffered its biggest weekly fall in four years with the Dow Jones industrial average down 4.2%.
Banks raised the cost of the dodgy loans in the sub-prime market, and the contagion affected other markets. The cost of insurance against credit defaults rose sharply and there was a flight to quality assets. This may prove temporary; if the self-hypnotism works the financial markets may soon again be seeking out all sorts of rococo investments, amplified by derivatives, in the belief that they are risk-free.
This, in some ways, would be more worrying than a flight to quality or rising spreads on junk bonds, because the riskiest of all markets is the one where the players can see no risk.
A second concern is that the US may be in a lot worse shape than Wall Street - cocooned by its sky-high salaries and lucrative bonuses - realises. One view of the US economy since the early 1990s is a glorious renaissance built on the coming industries of the hi-tech revolution; another is that an unsustainable stock market was followed by a bust, and that in turn was followed by an unsustainable boom in the housing market that has also now gone bust. Sure, the Fed could respond to the threat of recession by cutting interest rates, but the traction gained by cheap money is going to be a lot less this time. Why? For one thing, the two debt-driven bubbles have left consumers enormously over-extended. For another, inflation in the asset markets has spilled over into general inflation. Cutting the cost of borrowing might have more of an impact on prices than it would on activity.
As Stephen Lewis of Insinger de Beaufort puts it, the real surprise, given what has been happening in the US housing market, is that consumer spending has held up so well. But there is a sense that the consumer is starting to run out of road, with spending propped up by the one-off impact of lower energy prices.
Charles Dumas at Lombard Street Research agrees, and says the increase in borrowing on credit cards rather than the rising value of real estate, is a sign that US consumers are drinking in the last-chance saloon. The vast majority of Americans don't have a yacht and a summer home in the Hamptons; they don't have stock options and they have not seen their salaries rise at 10, 50 or 100 times the current inflation rate.
Given Asia's export-dominated growth is heavily weighted towards the US, investors should be prepared for the 9% fall in Shanghai last Tuesday to be the first of many bad days.
"Household borrowing is the centre of the storm," says Dumas. "When economies fluctuate, services fluctuate gently, construction and manufacturing more violently. Construction we know about: the housing slump is now beginning to be reinforced by a business construction collapse. The US manufacturing sector is now called China, or Pacific-developing Asia more generally. The current US downswing must take the gloss off growth in that region, where asset markets are priced for perfection." A different perspective comes from Stephen King at HSBC. His view is that the global economy is now more than the United States and its satellites. Even if America does slide into recession, there is no reason to assume the rest of the world will follow.
This requires a radical re-think, since we have become accustomed, particularly since the collapse of the Soviet Union to assume the world is unipolar with the US the hegemonic power. King says the weaker domestic demand growth in the US last year did not seem to have knock-on effects elsewhere. Far from catching a cold when the US sneezed, the rest of the world went shopping. "Relative to our own forecasts, the big surprise last year was the strength of domestic demand growth, notably in Canada, Mexico, China, the Middle East, Germany and the UK."
On the face of it, this is a relatively reassuring interpretation of events. If there really has been a de-coupling going on under our noses, it is possible that a US recession could be isolated. Scratch beneath the surface, though, and King's thesis has some potentially serious long-term geo-political - and hence economic - consequences. What could be happening is that we are seeing the very gradual waning of US economic supremacy, with years of budget and trade deficits and two decades of excessive consumption chipping away at what is still a phenomenally powerful economy. Britain suffered from just this process in the final quarter of the 19th century; other nations were growing in strength and Britain was in the early stages of relative decline.
Paul Kennedy argued in the late 1980s that political power derives from economic power. The first doubts crept in for Britain when winning the Boer War in the face of determined resistance and guerrilla attacks proved a lot more difficult than London had blithely imagined. History may show that South Africa between 1899 and 1902 is a better parallel for America under Bush than is Vietnam.
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