Marshall Auerback
What Could Go Wrong In 2005?
January 11, 2005
DeTocqueville once wrote, “The more things change, the more they stay the same.” In the case of the United States in 2005, the opposite might be true: the more things stay the same, the more they are likely to change…for the worse. In that regard, compiling a list of potential threats to the US as we come into the New Year represents nothing more than a longstanding catalogue of economic policy making run amok. The same list could have been drawn up in 2004, 2003, and even the years before that. They include: the persistent and increasing resort to debt-financed growth, a concomitant and growing external imbalance in the current account (leading to an ever greater reliance on “the kindness of strangers” who keep the US economy afloat by enormous foreign lending so that consumers can keep buying more imports, thus further increasing an already bloated external trade imbalance).
All of which is occurring against an increasingly problematic Vietnam-style quagmire in Iraq, and the ongoing (and related) problem of high energy prices, which are themselves spurring an ever more frantic competition for energy security, thereby intensifying existing global and regional rivalries.
Just as a haystack soaked in kerosene will appear relatively benign until somebody strikes a match, so too it is worth noting that although America’s longstanding economic problems have not yet engendered financial Armageddon does not invalidate the threat they ultimately pose. But the key is finding out which event (or combination of them) represents the match that could set this “haystack” alight, if there is indeed one “event” which precipitates the bursting of a historically unprecedented credit bubble.
The odd thing about credit bubbles is that they have no determinate resolution. There is nothing about a self fulfilling prophecy dynamic that generates a specific level of financial excess or an eventual end to it. It can happen at any level or at any time. There is also nothing about such a dynamic that specifies the path of its reversal. True, the Federal Reserve’s move to raise rates suggests the start of a process to rebuild national savings and rid America of the debt disease, but the underlying reality is that the Greenspan Fed has shown itself ready to turn on a dime at the first sign of market stress. The moral hazard dialectic of remedying successive crises in an ever more fragile financial structure with bailout measures had fostered a dynamic in which the economy’s lead actors assume greater and greater risk because they expect current credit conditions to persist (or at the very least, to be bailed out when they do not).
Mr Greenspan, therefore, has to walk a tightrope. Once economic agents recognize that government will intervene to avert instability, they adjust their behavior and take on more risky financial positions. In time such increased financial fragility leads to outbreaks of financial instability despite prior stabilizing policies. If people genuinely believe that the Fed chairman today is serious about curbing today’s rampant financial excess, the behavior which led to the bubble in the first place could unwind rapidly. This implies a potential for a crash pattern.
Of course, this is not the conventional view. In the eyes of Britain’s Financial Times, “Global economic growth is expected to slow, but only back towards a trend increase of about 3.5 per cent. Inflation and interest rates remain low, while liquidity is high, supporting investor risk appetite.”
What the FT analysis overlooks is the source of much of that global growth: debt. This debt is a form of policy steroids, but unlike major league baseball,America’s monetary and financial officials still refuse to deal with its persistent abuse. Rather, policy has been almost designed to encourage even larger doses: the Penn Central crisis, the Franklin National bank, the Chrysler and Lockheed bailouts, the Continental Illinois crisis, and eventually the bailout of much of the savings and loan and commercial banking system in the early 1990’s.
Throughout his tenure as chairman of the Federal Reserve, Mr Greenspan has taken this moral hazard to an altogether new level. The widely publicized talk of a Greenspan “put” and a Bernanke put has reached households by way of the “new” financial media (e.g. CNBC and Bloomberg TV) has made the American public ever more certain that government intervention would prevent financial crisis and reduce the risks of taking on what would have been considered dangerous levels of debt in prior eras.
The Fed Chairman himself declared the advent of a high-tech new era that justified internet stock speculation and refused to consider the late 1990’s stock speculation as a bubble. Most recently, Fed officials have begun to talk about electronic printing presses and helicopter money to lift asset prices and the inflation rate to avert debt deflation. Awareness of such government support measures on the part of US households is fostered by the financial media, the internet, and other information channels. Convinced of such support, financial intermediaries respond to debt defaults by households by Ponzi financing them with yet larger loans.
It is generally assumed that increases in credit stimulate aggregate demand. In the short run that is always true. But in the long run it need not be true. The expansion of credit is an increase in debt. When debt levels are low a credit expansion which increases debt does not leave a legacy which later suffocates demand, since the resulting still low level of debt is not yet a problem. But when debt levels are very high the increases in debt created by credit expansion soon act as a burden on demand.
It follows from the above that, as the level of debt relative to income rises, it should take larger expansions of credit to achieve any given percentage increase in demand, since the now high and climbing debt burden acts as a countervailing force to depress demand. Which is essentially what has been occurring for the past several years in the US: America’s federal debt is now $7.5 trillion, of which all but $1 trillion was built up over the past three decades, the last $2 trillion in the past eight years, and the last $1 trillion in the past two years. According to economist Andre Gunder Frank, “All Uncle Sam's debt, including private household consumer credit-card, mortgage etc debt of about $10 trillion, plus corporate and financial, with options, derivatives and the like, and state and local government debt comes to an unvisualizable, indeed unimaginable, $37 trillion, which is nearly four times Uncle Sam's GDP.” This rising level of indebtedness becomes a huge deflationary weight on economic activity once debt growth seriously slows.
If the US were a self contained economy, the problem of debt and its deflationary implications would already be manifest. But in an open globalised world, there is always the potential to resort to borrowing from abroad. This is in fact what has occurred in the past few years. As domestic savings have been drawn down to virtually nothing, the US has looked abroad for capital. The US has continued to grow rapidly because its government and consumers have been spending more and more relative to their incomes. Other countries have been growing more slowly because their governments are fiscally constrained and their consumers are cautious and are trying to save more. Viewed from this perspective the U.S. current account imbalance exists because it is the profligate in the world, with virtually no net national savings, in effect financed by the surplus savings bloc of Asia. Despite ebbs and surges, the gap between US exports and imports has been steadily widening steadily across three decades, but the sheer magnitude today is the external counterpoint to what is occurring domestically.
No other major economy in the world accepts perennial trade deficits to the degree that they have been accepted in America; some, notably those in Asia, maintain huge surpluses. But American leaders and policy-makers have hitherto been uniquely dedicated to a faith in “free market” globalization, and they have regularly promised Americans that despite the disruptions, this policy guarantees their long-term prosperity. In reality, the true guarantors of America’s “prosperity” are the country’s foreign creditors--major trading partners like Japan,China and Europe, who can decide at any time to stop the lending or simply reduce it substantially.
Although China, Japan and other major foreign creditors are thought willing to sustain the status quo because they calculate that sustaining their own industrial output and employment is worth more than seeking risking the implosion of their largest and most important consumer market, it is still possible that things could spin out of control, if for no other reason than China and Japan face their own internal domestic economic challenges, which ultimately will be given primacy over sustaining the US consumer. Already China has given indications of its long term intentions: roughly half of China's growth in foreign exchange since 2001 was placed into dollars. However, last year China saw its reserves grow by $112 billion, but the dollar portion was only $25 billion.
(Source: Bank Credit Analyst)
China has made it clear they are spreading out their reserves and putting less emphasis on the dollar. It is reasonable to suspect that this move to diversify out of the dollar has also putting upward pressure on the euro and other “floating currencies”, creating yet another potential strain on the global economy this year.
But it is also possible that a major economic adjustment in the US is triggered simply by the sheer financial exhaustion of America's overextended consumers. Already, America has a recession-sized fiscal deficit and zero household savings. That never happened before. In the early 1980’s the household saving rate was 9% when the fiscal deficit was this size. This base of savings enabled the US to finance its vast deficits for a time as a consequence of a huge one-off fall in net saving, the scale of which is historically unprecedented and unable to be repeated in the absence of a restoration in the savings of households and government. The alternative is drawing down more credit from overseas at a time when the dollar’s decline suggests a reluctance to underwrite indefinitely the country’s economic adventurism and the concomitant desire for higher yields to compensate for correspondingly higher risk premiums.
On the other hand, a restoration of national savings is fundamentally incompatible with continued economic growth, all other things being equal. And the absence of continued economic growth is something the country can ill-afford, given the magnitude of its growing overseas military commitments, especially in Iraq, which each day looking less like a campaign for democracy and freedom, and more a case of Vietnam redux. In arguing for “staying the course” Mr. Bush has argued for a vision that United States could make Iraq into a beacon of democracy that transform the politics of the Middle East, thereby insinuating it would put in place conditions that would enable a resolution to Israel's Palestinian Question.
The bulk of these goals are now forgotten. Instead, the Bush Administration’s overarching vision has mutated into a military strategy aimed at a single unambiguous objective: exiting as quickly as possible via the Iraqization of the American War.
It is the same objective the US conspicuously failed to achieve in Viet Nam -- namely Vietnamization -- which evolved, much like today’s Iraq war – once the political elite understood victory as originally conceived was an elusive dream.
The Vietnam parallel is also germane in relation to a discussion of the USeconomy. Mr Bush likes to compare his combination of economic, defence and diplomatic strategies with President Reagan’s blend of tax cuts, military assertiveness and massive borrowing in the 1980s. His economic advisers (and especially Vice President Dick “deficits don’t matter” Cheney) appear to believe that America’s huge trade and fiscal deficits will be no more disruptive in the next decade than they were in the Reagan years.
But if we turn again to Vietnam, we find a less comforting historical precedent: the decision, first by President Johnson and then by President Nixon, to finance that unpopular conflict through borrowing and inflation, rather than higher taxes. The ultimate result of that decision was not just America’s military humiliation but also the series of economic crises that began in the late 1960s and continued until 1982.
In a sense, the dollar’s ongoing fall last year in spite of significant Asian central bank intervention reflects a gradual loss of respect in US policy making. In the words of Andre Gunder Frank:
“Uncle Sam's power rests on two pillars only, the paper dollar and the Pentagon. Each supports the other, but the vulnerability of each is also an Achilles' heel that threatens the viability of the other. Since then, Iraq, not to mention Afghanistan, has shown confidence in the Pentagon not to be what it was cracked up to be; and with the in-part-consequent decline in the dollar, so has confidence in it and Uncle Sam's ability to use it to finance his Pentagon's foreign adventures”
– “Why the Emperor has no Clothes” – Asia Times, Jan. 8, 2005
It is also the case that a national economy that cannot produce itself the things that it needs and invests instead in “security” will eventually find itself in a position in which it has to use its military to take from others what it cannot provide for itself, which in turn leads to imperial overstretch. This helps to explain how is it that in the past, an American nation much weaker in absolute terms, fighting more evenly matched opponents, could prevail against its enemies more quickly than a state with an $11-trillion GDP and a defense budget approaching $500 billion (bear in mind, the Bush Administration is preparing a budget supplemental of about $80 billion for the current fiscal year) against 10-20,000 insurgents in a state with a pre-war GDP less than the turnover of a large corporation. It is a nation with a hollowed out industrial base and an increasing incapacity to finance a military adventurism which is propelled by the very forces which created the manufacturing deficiency in the first place.
And then there is the problem of crude: The one thing Mr Bush has never mentioned in Iraq is oil, but as former Secretary of State James Baker presciently indicated years ago in a Council on Foreign Relations study of world energy problems, oil can never lurk far from the forefront of American policy objectives:
“Strong economic growth across the globe and new global demands for more energy, have meant the end of sustained surplus capacity in hydrocarbon fuels and the beginning of capacity limitations. In fact, the world is currently precariously close to utilizing all of its available global oil production capacity, raising the chances of an oil supply crisis with more substantial consequences than seen in three decades. These choices will affect other US policy objectives: US policy toward the Middle East; US policy toward the formerSoviet Union and China; the fight against international terrorism.”
The CFR report made clear another salient point: “Oil price spikes since the 1940s have always been followed by recession.” In its current debt-riddled condition, this could bring on something far worse than a garden-variety economic downturn for the US.
The most recent spike in the price of oil was not simply a reflection of rising political uncertainty in the Middle East. There are reasons to expect higher levels over the next two to three decades than over the past two: strong demand from emerging economies, notably China and India, being the most important.
The parallel drive for energy security on the part of both the US and China has makings of a major war over oil being precipitated at some point in the future. Yukon Huang, a senior advisor at the World Bank recently noted that China'sreliance on oil imports, plus problems with environmental protection, including serious water shortages, pose significant threats to the country's economic development over the next three to five years. The World Bank official said sustainability issues were a much greater threat to China's development than political or economic risks, such as the massive quantity of bad loans held by the nation's state-owned banks or a potential conflict over Taiwan.
China’s response to this challenge is likely to bring them increasingly into conflict with the US. Venezuelan President Hugo Chavez has recently returned from a Christmas trip to China where he apparently sold America's historic oil supply to the Chinese together with prospecting rights. Even Canada (in the words of President Bush, “our most important neighbors to the north”) is negotiating to sell up to 1/3 of its oil reserves to China. CNOOC, China’s third largest oil and gas group, is actually considering a bid of more that $13bn for its American rival, Unocal. The real significance of the deal (which, given the size, could not have been contemplated in the absence of Chinese state support) is that it illustrates an emerging competition between China and the US for global influence – and resources.
The drive for resources is occurring within the context of a world in which alliances are being formed amongst major oil producing and consuming nations (outside the US) as a kind of post-Cold War global lineup against perceived American hegemony: Brazil, China, India, Iran, Russia and Venezuela. Russian President Putin’s riposte to the US strategy of increasing its military presence in some of the nations of the old Soviet Union (and thereby ensure that they cut all links with Moscow) has been to ally the Russian and Iranian oil industries, and open up the shortest, cheapest and most lucrative oil route of all, southwards out of the Caspian to Iran. Russia and China have recently announced large joint military exercises and the EU is negotiating to drop its ban on arms shipments toChina (much to the publicly expressed chagrin of the Pentagon). Russia has also offered a stake in nationalized Yukos to China.
This is pretty brazen behavior by all concerned, but is symptomatic of the growing perception of the US as a declining giant, albeit one with the capacity to strike out lethally when wounded. American military and economic dominance may still be the central fact of world affairs today, but the limits of this primacy (which dates back to the fall of the Berlin Wall) are becoming increasingly evident, just as dollar’s fall reflects this in economic terms. It all makes for a very challenging backdrop in 2005. This could therefore be the year when longstanding problems for the US finally do matter. Do not expect Washingtonto a |
