[Partridge: I usually find it very hard to understand the minutae of economics in the mainstream press, and even in the alt. press. This article was a refreshing, easy to understand, look at the recent semi-crisis in the world economy]

World Economy: 'Correction' or crash?
Lynn Walsh - The Socilaist (UK)

In the second week of May there was a convulsion in the world financial system. Shortly after rising to near-peak levels, shares fell sharply on world stock exchanges, especially in so-called ‘emerging markets’ like India and Turkey. Prices of commodities, such as copper, which had soared over recent months, also plummeted. There was a general flight of fluid, speculative capital from risky (if potentially highly profitable) investments to safer assets, especially cash and government bonds. Lynn Walsh examines these events and exposes the instability of the global capitalist system.


Was this merely a timely ‘correction’ of speculative bubbles or a preliminary tremor marking the onset of a deeper crisis?

This was the question being asked by jittery capitalist leaders and commentators. Initially, financiers feared a crash, dumped risky assets (collecting the profits from their recently inflated prices) and took refuge in safer investments.

After a few days, however, share prices in the advanced capitalist countries bounced back. In New York, London and other advanced capitalist countries, shares fell about 4-5% overall. Shares in ‘emerging markets’, such as Russia, Turkey, India, Mexico, etc, fell by 10-25%. Many commodities and shares in mining companies, which had recently soared, fell by 10% or more (though some later recovered).

The partial sell-off appeared to be triggered by fears of rising inflation in the USA, where ‘core’ inflation (excluding food and fuel) rose to an annualised rate of 3.2% compared to 2.3% in 2005. Behind this was the deeper fear that the US Federal Reserve will respond by raising interest rates even further, threatening to bring to an end the era of ultra-cheap credit.

Speculators soon resumed their frenzied search for profits. Capitalists everywhere breathed a huge sigh of relief. Most of them complacently believe that new technology and globalisation guarantee uninterrupted growth and profitability, relegating financial crashes and economic slumps to the dustbin of history.

In reality, the May turbulence reveals the fragility of the global capitalist economy, which works in an anarchic way. So far, it appears to have been mostly a correction of feverish investment in some of the most speculative markets: inflated shares in ‘emerging markets’, ‘junk’ bonds in dodgy companies, industrial commodities (like copper), oil and gas and foreign currency trading. In the last year or so, bubbles have developed in all these market sectors, with finance houses and hedge funds at the forefront of the activity.

But the May episode highlights the dominant, parasitic role of finance capital, which is by its very nature volatile and destabilising. Moreover, the rebound of financial markets since mid-May in no way helps overcome the unsustainable trade and currency imbalances in the world economy.

Speculative capital

The growth of speculative finance capital reflects the intensification of the exploitation of the working class, in the advanced capitalist countries and especially in the under-developed countries.

The neo-liberal (ultra-free market) policies adopted by governments since the early 1980s have enormously boosted the profits of corporations and finance houses, at the same time increasing the share of the wealth going to the capitalist class. Twenty years ago there were 140 billionaires according to Forbes magazine. Today there are 793 billionaires (102 joining their ranks in the last year alone).

While there has been increased investment in China and a handful of other cheap-labour, low-cost countries, there has been no general increase in capital investment in new plant, machinery, factories, etc.

Since 2000, the capital stock in OECD countries has been growing at only 2% per year, less than half the rate of the 1960s (during the post-war upswing).

In the USA, financial companies take 30-40% of total US corporate profits (over 50% if the financial activities of industrial and commercial companies are included), compared to 10-15% in the 1950-1960s.

Instead of extensive investment in new means of production, the super-rich and big corporations have intensified the search for profits from speculative investment. The deregulation and globalisation of international financial markets has provided endless opportunities for profits. The super-profits of corporations and the colossal personal wealth of capitalists have provided a deep pool of liquidity.

Speculators, moreover, have been able to take advantage of abundant, cheap credit - they don’t even have to speculate with their own money. Major capitalist governments, like Japan from the 1980s and the USA after 2000, cut interest rates to zero or near-zero levels in an effort to avert financial crises and stimulate growth.

Huge profits and virtually unlimited cheap credit produced the multiple bubbles of recent years. The stock exchange bubble of the 1990s in the US and elsewhere was fuelled by cheap credit, as is the more recent housing bubble. Both in turn played a vital role in sustaining consumer demand through the ‘wealth effect’, the conversion - on the basis of more loans - of capital gains into consumer spending.

In the last few years, capitalist investors, flush with liquid cash, have been desperately searching for new sources of extra profit - investments reaping profits above the average return of ‘safe’, ‘blue chip’ shares and bonds. Thus the surge of investment in currency trading, junk bonds, commodities, and shares in ‘emerging markets’.

Excess investment in these assets has over-inflated their value. A flood of foreign investment into shares on Indian stock exchanges, for instance, also encouraged local capitalists to join the speculative binge. As a result, share prices were pushed up far beyond any rational estimate of what returns they would produce from company profits.

The sharp drop of prices in May, therefore, was an inevitable correction. It remains to be seen whether shares in countries such as India (which fell 25%) will recover, and how many speculators and traders will go bust as a result of their losses.

The May correction has made the major international speculators and finance houses more cautious - for the time being. But the underlying conditions which produced the bubble economy still exist, and new bubbles will appear - until there is a much more drastic correction, a real crash.

How it will develop is unpredictable. At the moment, the ‘real’ economy - production measured by gross domestic product (GDP) - is still growing. The IMF predicts global growth of 4.9% this year. But apart from the adverse effect of higher energy and commodity prices (which are beginning to have more of an effect on growth), current growth could quickly be cut across by renewed financial crisis.

This could be precipitated by a convulsive realignment of major trading currencies (US dollar, euro and yen), unavoidable at some point in the not very distant future.

A financial crisis could also be triggered by the collapse of a major finance house, or several big financial players.

Given the huge amounts of debt on which the system runs and the complexity of financial instruments such as derivatives - described by the famous investor Warren Buffett as ‘weapons of mass destruction’ - major bankruptcies are inevitable.

In 1998, following the collapse of the Russian rouble, the hedge fund Long Term Capital Management (LTCM) went bust. The knock-on effects could have been catastrophic. A systemic meltdown of world financial markets was prevented only by a $3.6 billion rescue operation by a consortium of banks organised by the Federal Reserve Bank. Even now, there is likely to be more than one new time bomb like LTCM being prepared, waiting to be detonated.

Trade and currency imbalances

The chief economist of the OECD, Jean-Philippe Cotis, welcomed the May turmoil as a necessary correction of over-priced, risky investment assets. But he warned that, in spite of this, the risks to world economic growth have increased.

The main threat being the ‘unprecedented’ imbalances between (heavily indebted) deficit economies like the US and (cash-rich) surplus economies like China.

Against all the normal rules of capitalist economics, the US dollar has been an overvalued, strong currency (because of capital flows into the US), while the Chinese yuan (or RMB) has been seriously undervalued (because the yuan has been pegged to the dollar at an unrealistically low rate of exchange).

“A brutal unfolding of such imbalances,” warns Cotis, “ would hurt the world economy ...” (Financial Times, 24 May 2006)

The relationship between the US and China is the central pivot of the world economy. US consumers provide an indispensable market for goods exported from China, as well as from Japan, SE Asia and other areas. But US consumption depends heavily on debt.

Internally, as workers’ incomes have been squeezed, many consumers have kept up their living standards by taking out mortgages on their homes. This was made possible by the boom in house prices and cheap mortgages.

House prices, however, are now slowing and the steady increase of interest rates by the Federal Reserve is reducing the ‘wealth effect’ of the housing bubble. If house prices stagnate or fall, and interest rates rise even higher, consumer demand will be severely curbed.

Moreover, higher interest rates, combined with a rise in unemployment, will mean that current levels of consumer and credit card debt will become unsustainable.

Cheap credit was a key factor in the sustained strength of US consumer demand, which is why capitalists are now so fearful of rising interest rates in response to rising inflation (or the Central Banks’ fear of rising inflation).

Externally, US capitalism also depends on high levels of debt. The US consumes more than it produces, importing huge quantities of cheap goods from China and other developing countries. The strength of the dollar in recent years made imports even cheaper to US consumers.

The investment bank Morgan Stanley estimates that US consumers saved $600 billion over the past decade by buying cheaper goods made in China.

Consistently importing more than it exports, the USA has had a remorselessly rising balance of payments deficit. In 2005 it was $725 billion or 7% of GDP.

This recurring deficit has to be financed by an inflow of capital into the USA. Part of the inflow has been capital invested by overseas capitalists in US companies, shares, etc. But covering the US deficit has more and more relied on the purchase of US government bonds by the central banks of China, Japan, South Korea and a few other countries (including oil producers) that have big trade surpluses with the USA.

In 2005 China had a trade surplus with the USA of $201 billion and has now accumulated nearly $1,000 billion in foreign currency reserves (three-quarters in dollar assets), more even than Japan, which has $847 billion foreign currency reserves.

In effect, they have been recycling the dollars earned by their exports back into the US economy. Their motive is clear. They want to sustain the US market for their exports.