The buck pops here
The crisis may have to visit America before there is any reform to financial system
By Larry Elliott
Monday December 7, 1998
If the 1970s were the decade of stagflation and the 1980s the decade of debt, the 1990s have been the decade of currency crises. Starting with the pound's ejection from the European exchange rate mechanism in September 1992, there have been regular and increasingly virulent bouts of currency turbulence.
The presumption is that Brazil will be next on the list, and with the Cardoso government gripped in the pincers of economic contraction and an over-valued exchange rate, only the foolish would bet against it. Even now, the predators are gathering.
Important though it is, Brazil may prove to be something of a sideshow, because there is an even bigger danger lurking out there - the risk of a collapse in the US dollar. As yet, this possibility has yet to embed itself in the psyche of the global markets, and indeed may sound a bit counter-intuitive given that American unemployment is still falling.
This complacency may soon be punctured, and indeed there were the first signs last week that the suckers' rally of the past two months has come to an end. The lay-offs at Boeing brought home an uncomfortable truth, namely that the earnings growth which the stock market bulls use to justify rocketing share prices simply are not coming through. In the end, of course, what's happening to earnings and profits cannot be divorced from stock market performance. Profits drive investment and employment, and as such are the key component of growth.
So what is happening to profits in America's 'miracle economy'? Far from rising exponentially, they have been dropping for the past year and are now declining at an annual rate of 6 per cent. Margins are being squeezed by over-capacity, rising employment costs and a deceleration in productivity growth.
As Ian Harwood of Dresdner Kleinwort Benson put it at his firm's seminar last week: 'The Q3 year-on-year profits decline is the first since the early 1990s recession and - if history is any guide - will produce a sharp economic slowdown, especially with the record corporate financing gap. Already capital expenditure plans are being cut, lay-offs are rising and new hiring slowing.' Mr Harwood's colleague, Albert Edwards, expanded on this theme. His view is that, price stability having been attained, global markets will have to get used to an 'Ice Age' in which equity prices will be driven entirely by earnings.
"In the US, analysts have become seriously deluded and need help. In the Ice Age, double-digit earnings expansion will be rare at the market level - an occasional early-cycle phenomenon. Double digit earnings growth will become like Yeti. They will be occasionally glimpsed and then vanish." The absurd euphoria surrounding US technology stocks is a classic example of Wall Street's advanced state of denial. According to the analysts who continually badger American citizens to invest in mutual funds, the sky's the limit for these go-go stocks. When these so-called experts sat down to compile their forecasts for 1998 in October 1997 they were in no doubt. Earnings per share would rise by a whopping 32.2 per cent, fully justifying booming share prices.
By February, they were a bit more cautious, but not much. EPS growth was put at 23.2 per cent, a more than respectable performance, particularly in a time of low and falling inflation. In October, reality had intruded on this escapist fantasy. Earnings per share in the technology sector would not actually rise at all in 1998. In fact, EPS would drop by 2.4 per cent.
Any sane person might learn something from this and use the experience of what happened this year as a guide to what might be in store for the technology sector in 1999. Did this happen? Hardly. Whereas this February, analysts saw EPS growth of 26.6 per cent in 1999, by October they has pushed this up to 40 per cent. Such forecasts not only beggar belief, they verge on the criminally negligent.
"We believe the US economic and market conjuncture closely resembles the Asia economic catastrophe (formally known as miracle) back in 1996," said Mr Edwards. "Excesses in the US have built up which inevitably will be corrected. The cycle has yet to be abolished. When adjustment does occur, the dollar should be watched closely." Far from being a 'new paradigm,' the US bears all the hallmarks of a Mexico or a Thailand, only on a frighteningly colossal scale. For a start, it is running a vast and expanding current account deficit, which is being funded by flows of foreign capital. This hot money is attracted by the rise in US asset prices, which in turn are helping to fund excessive consumption by both businesses and individuals.
At some point, this tail-chasing will stop. For the entire post-war period, America has had the benefit of sitting on the world's only reserve currency. In less than a month's time that will change with the birth of the euro, and it is a stone-cold certainty that there will be a rebalancing of portfolios by global investors. This is not especially good news for Europe, which has no need of an appreciating currency, but it could prove to be the trigger for a run on the dollar.
From the market's point of view, it could become a one-way bet. A cheaper dollar would make New York an even less attractive place to park hot money. With the American economy dependent on the stock market, there would be pressure on the Federal Reserve to cut rates. All the recent evidence is that its chairman, Alan Greenspan, would be rather quicker to slash rates than the European Central Bank chiefs.
What would be the policy implications of this? Obviously, in the short run, a dollar currency crisis would be utterly disastrous, since it would choke off European exports and do immeasurable damage to the prospects of a Japanese recovery. But in the longer term, the global crisis may have to arrive in America's backyard before anything serious is done to reform the world's financial system.
Britain is eager that the Group of Seven industrialised countries and the International Monetary Fund speed up efforts to push through changes to regulate better the activities of hedge funds, improve global regulation and make policies more accountable and transparent. But the stock market rally since the end of September has wrongly fostered the impression that the system is essentially sound.
Robert Skidelsky, the biographer of Keynes, said at a Social Market Foundation seminar recently that in the first era of globalisation, between 1880 and 1914, there were plenty of financial crises, but these were confined to the periphery of the world economy, principally Latin America. The mood changed when the developed world became gripped by economic collapse between the wars.
"Clearly it was the spread of financial instability from the second class to the first class powers which spurred the demand for capital controls. For the first time unlimited capital mobility posed a serious threat to the core countries of the world economy.
"The interesting question is whether our world resembles more closely the world of the 1920s and early 1930s which shaped Keynes's views, or the pre-1914 world when international capital mobility did not give rise to much trouble." An interesting question indeed. If it really is a pre-1914 world out there, there are enough worrying signs to suggest it may be one last glorious Edwardian summer.
reports.guardian.co.uk |
