The sluggish world economy is being dragged along by two coupled locomotives, with US capitalism at the head of the train and with China as a key auxiliary.
During the presidential election Bush diverted attention away from the US economy. Yet the richest, most powerful country in the world is also its biggest debtor, with its economy slowing down. Lynn Walsh takes an in-depth look at the processes taking place and the latest developments in the US and world economies.
This article was reproduced as background material for the 2004 cwi international conference. socialistworld.net
The US economy ‘running on fumes’
The US provides massive consumer demand, while China provides a growing share of the manufactured goods. US growth, however, is being fuelled by huge flows of capital from the rest of the world. In recent years, US capitalism has been absorbing 80% of the world’s surplus savings, funds that could be used to develop the economy in the countries of origin. US consumption depends on phenomenal levels of debt, external and internal, which (for the US) are historically unprecedented. These debts have surged on the basis of low interest rates, made possible by the tidal inflow of capital. Between 1995 and 2003, growth of US consumption averaged 3.9% pa in real terms, almost double the 2.2% pa growth typical for the advanced capitalist countries in the same period.
The ever-rising level of US debt, expressed in the ‘twin deficits’ (balance of payments and Federal budget), is becoming unsustainable. At the same time, the runaway investment boom and property bubble in China, which have driven China’s rapid growth rate, have reached their limits.
A crunch is undoubtedly approaching, hastened by soaring oil prices over recent months. (See: A New Oil Crisis, www.socialismtoday.org). A slowdown in the US will unavoidably mean a slowdown in China. As the US-China nexus has been the only dynamic element in the world economy since the 2001 recession, a US-China downturn will spell recession for the world economy. A sharp fall in the value of the dollar would cause a convulsion in the world currency and trading system. Moreover, the resurgence of large-scale speculative activity, encouraged by the sharp fall in interest rates after 2001, simultaneously poses the threat of financial crisis. The frenzied intervention by banks and hedge funds in foreign exchange markets and, more recently, in oil and other commodities, demonstrates the potential for the destabilisation of world financial markets.
US capitalism managed to avoid a major downturn after the financial bubble burst in 2001 through drastic reductions in interest rates and the rapid running up of a huge Federal budget deficit. This dual policy by the Bush regime and Alan Greenspan’s Federal Reserve was massively reinforced after the 9/11 2001 attacks, when the US ruling class feared an imminent slump. Apart from massive tax concessions to the rich and super-rich to which Bush was already committed, low interest rates and increased military spending have been the key planks of the Bush regime’s economic strategy. This approach inevitably implied an increasing dependence on the inflow of capital from abroad.
From January 2001 to June 2003, the Federal Reserve reduced its base rate from 6.5% to 1%, the lowest in 40 years. (Greenspan is now easing rates up again – to 1.75% on 22 September – and the increases are likely to accelerate now the election is over.)
Growth, however, has not been very impressive, except in contrast to the eurozone and Japan. The much-trumpeted surge to a 7.4% (annualised) growth of real GDP in the third quarter of 2003 (mainly reflecting Bush’s tax rebates) has not been sustained. Third-quarter 2003 growth was 3.7%. In 2004, the (annualised) quarterly growth has been 4.5%, 3.3%, and 3.7%. Over Bush’s first term, GDP growth has averaged 2.7%, better than his father’s record (2.1%) but trailing behind Clinton (3.7%), Carter (3.3%) and Reagan (3.4%). The present recovery from the 2001 recession is weaker than the six previous business cycles. The job growth is weaker than any time since the Great Depression in the 1930s.
Total investment in the business sector (especially equipment) recovered during 2000-04, but still remains below the 2000 level. Net investment (capital investment over and above the replacement of worn out equipment), however, is a massive 60% below 2000. And manufacturing continues to shed jobs: over 2.7 million (15% of the 2000 level) have disappeared since January 2001. The information sector, hit by the bursting of the dot.com bubble, has also lost over 500,000 jobs (15% of sector employment). Under Bush, most new jobs have come in the government, health-care and restaurant sectors.
Real wages and salaries have been rising at only 1% a year on average, compared with an average 4% a year in previous recoveries. The typical working-class family has suffered a $1,500 cut in real income under Bush. Wages account for the lowest share of GDP since 1929.
According to the US Census Bureau, the number of Americans living in poverty or lacking health insurance rose for the third year running in 2003. (Washington Post, 27 August) In 2003, an additional 1.3 million fell below the poverty line, bringing the total to 35.9 million (12.5%), including 12.9 million children. Forty-five million people have no health insurance. At the same time, Bush’s tax cuts, peanuts for the poor and billions for the billionaires, have helped widen inequality, which is now more extreme than any time since the Great Depression.
The only thriving industrial sector under Bush has been the defence and aircraft industry. This reflects the huge increase in military spending. The Pentagon budget for fiscal year 2004 is $400bn, with an additional $40bn a year to be spent on Homeland Security. The Bush administration plans to spend $2.7 trillion on the military over the next six years, despite the huge budget deficit. These budget allocations do not include the cost of the wars in Afghanistan and Iraq, around "200 billion so far, which have been financed from supplementary appropriations by Congress. This military expenditure, while good for the arms manufacturers and dealers, will act as a massive burden on US capitalism over coming years.
Corporate profits rose to record levels in 2003. After-tax profits and interest income rose to 14.8%, higher than the previous peak in 1965 (though 1965 pre-tax profits were higher, corporate taxes were higher then). This rise was mainly the result of ruthless corporate ‘cost cutting’, retrenching workers, cutting working hours and wages. However, this appears to have reached its limits this year, and profits have fallen back.
The rebound in profits, together with low interest rates, helped a recovery in shares, causing stock-exchange indexes to climb again. In early March 2004, for instance, New York’s S&P 500 index recovered about half its precipitate decline from the all-time high of March 2000 – the height of the bubble – to the trough of October 2002. Since March, shares have fallen back to some extent, reflecting the slowing of corporate profits. "The pattern of decline", comments Vince Hastings, "remains consistent with a bearish view. Each successive short-term trough and peak in the index has been lower than the last, one of the hallmarks of a bear market". (Cycles and their Patterns, Financial Times Money Guide, 30 October) Despite the sharp fall 2000-02, shares remain substantially over-valued in relation to corporate profits, making a further fall likely in the coming months.
ON THE BASIS of the actual growth in US incomes, whether private wages and salaries or government tax revenues, there would have been, at best, very feeble growth between the onset of recession in 2000 and today. The US savings rate (which determines the pool of domestic funds available for investment), which was 10% at the end of the 1980s, fell to 5% in the mid-1990s, and has averaged around only 2% during the last five years (falling virtually to zero in some recent quarters). Apart from some improvement between 1996 and 2001, the real wages of the majority of workers stagnated for over two decades, and have declined since 2001. That is why consumer demand, which accounts for about 90% of US growth, has grown on the basis of mountains of debt.
The ratio of household debt to disposable income rose to a record 108% of disposable income at the end of 2003 (16 percentage points above the 2000 level). This was mainly due to mortgage debt, but consumer credit (car loans, credit card debt) was also at record levels. If household debt continued to grow at the 2000-03 rate, the ratio would rise to 152% of disposable income by the end of Bush’s second term. However, further rises in interest rates will make the existing burden of debt unsustainable for many households.
During the last eight years, average house price have risen 35% above the level of inflation (historically, they rose in line with inflation) – driven by the availability of cheap mortgages. In major bubble areas, like San Francisco and Boston, they have risen by 60% above inflation. Homeowners have on a huge scale translated their increased equity into additional consumer spending power through new mortgages. Mortgage debt rose by a staggering $2.3 trillion between 2000 and 2003 (with $750bn borrowed in 2003 alone). In fact, the housing bubble, because it has involved a wider section of people, created more of a ‘wealth effect’ (the debt-financed transfer of capital gains into consumer spending) than the stock exchange bubble of the late 1990s. In September, the IMF warned that a likely ‘correction’ in housing markets (which it says is likely to be synchronised internationally because of the parallel upward trend of interest rates) could have "severe consequences for real economic activity".
The Federal deficit, largely funded by foreign capital, is a key factor in allowing US capitalism to consume more than it produces. This year’s deficit is expected to be $422 billion, or 3.7% of GDP. This represents a 4.9% deterioration from the 2000 budget surplus of 2.4% of GDP. This is even sharper than the previous worst, the 4.4% deterioration during the 1979-83 slump.
"According to the administration’s ‘Mid-Session Review’, the 2001-2003 tax cuts account for over half of the 2004 budget deficit and have contributed more to increasing the deficit than the costs of homeland security, the war on terrorism, Iraq and Afghanistan, and the growth in domestic spending programmes combined". (Laura D’Andrea Tyson, There’s Nothing Macho About Soaring Deficits, Business Week 27 September)
The world’s biggest debtor
AT THE END of 2003, the current account deficit was 4.5% of GDP, by mid-2004 it had risen to 5.7%, around $600 billion. Financing this requires the US to sell off assets (stocks, corporate bonds, Treasury bonds) at the rate of $600 billion a year. Even an economy as rich and powerful as the US cannot sustain this indefinitely. Vice-president Cheney notoriously proclaimed "deficits don’t matter". However, repeated current account deficits, year after year, lead to an accumulated deficit with the rest of the world. This is expressed in the US’s international investment position, the balance between US-owed assets abroad and foreign-owned assets in the US. This is the broadest measure of the US’s indebtedness to the rest of the world.
In 1980, the US was still a creditor internationally, with a positive investment balance of $360 billion (the world owed $360bn more to the US than the US owed to the world). At the end of the 1980s, however, the balance turned negative. Now the US has a net indebtedness of $2.4 trillion or 24% of GDP, and it is likely to be 28% by the end of this year. This is around 300% of US exports (not far from the 400% ratio of Brazil and Argentina, ‘basket cases’ according to Wall Street investors). If the current trend continues during Bush’s second term, the accumulated external debt will soar to 40% or 50% of GDP by 2008. This is clearly an unsustainable process. Something has to give.
Commenting on this situation, Lawrence Summers, formerly Treasury Secretary under Clinton, writes: "Much has been made of US dependence on foreign energy, but the country’s dependence on foreign cash is even more distressing. In a real sense, the countries that hold US currency and security in their banks also hold US prosperity in their hands…"
Moreover, "the character of the investors in US debt is also changing – for the worse. Short-term investors, who are less predictable and have more uncertain motives, finance an increasing share of the US current account deficit. These changes are warning signs that US spending is approaching a critical stage".
"There is something odd", Summers goes on, "about the world’s greatest power being the world’s greatest debtor". If foreign governments and investors were to dump their dollar reserves and bankrupt the US economy, the ensuing crisis would severely damage their own economies as well. "But having finally emerged from the cold war’s military balance of terror, the US should not lightly accept a new version of mutually assured destruction if it can be avoided". (America Overdrawn, Foreign Policy, July-August 2004)
The US economy, according to Summers, is "running on fumes", but he offers no solutions apart from "recognising the US savings crisis". The reality is, however, that the US is already locked into a symbiotic relationship with China and Japan (and other South-East Asian exporters), from which neither side can easily extract themselves.
DURING THE WEAK recovery since 2001, the flow of private capital investment into the US has been drying up. Until recently, inflows of portfolio investment (in shares, company bonds, government bonds, etc) provided a cushion, a surplus of portfolio investment over the trade deficit. But this is declining. In the first quarter of 2004 the monthly average was $36 billion, in the third quarter only $8.7bn a month.
Wealthy overseas investors are no longer buying shares as they did in the 1990s, when they were attracted by the prospect of super-profits in the US. At the peak, foreigners were buying $14.6 billion shares a month. During 2001-03, they were buying only $5.7 billion a month, while the average for 2004 (first seven months) is a mere $0.6 billion.
At the same time, foreign direct investment (FDI), largely linked to the establishment or acquisition of companies, has been declining since the end of the 1990s takeover (merger and acquisition) boom. In fact, more FDI has left the US than entered (reflecting investment in China and elsewhere), giving rise to a negative balance of $134 billion in 2003 (in contrast to a positive balance of $160bn in 2000). Between late 2003 and early 2004, the FDI deficit (which appears on the US capital account) more than wiped out the small surplus of portfolio investment, with the result that the current account deficit was not covered by capital inflows. Moreover, combining the capital and current accounts, the US was basically failing to pay its way. It seems that this balance of payments gap was covered by ‘reserve assets’, banking transfers and creative accounting (so-called ‘balancing items’). If this situation arose in any other country, the IMF and Wall Street would be screaming about insolvency and the danger of the debtor nation defaulting on its international debts. But even in the case of the US, protected by its power and a conspiracy of silence, something has to give soon.
The capital inflow into the US has shifted from wealthy private/corporate investors to the central banks of China, Japan and other SE Asian economies, which have been buying US government bonds on a massive scale. Between September 2003 and July 2004, central bank purchases of US treasury bonds accounted for 35% of the net inflow into dollars. This was double the long-term trend, and four-and-a-half times their 7.5% share of 2000-03. The last time there was a comparable surge in central bank purchases of US government bonds was in the months leading up to the October 1987 stock exchange crash.
As a result of their purchases of dollar assets (US government bonds) the Asian central banks currently hold about $2.2 trillion (80%) of the world’s foreign exchange reserves (70% of world reserves are dollar-denominated, although the US accounts for 30% of the world economy). Japan now has foreign currency reserves of $825 billion, China has $480 billion.
Why have the governments of Japan and China been buying dollar bonds on such a huge scale? In both cases, their economic growth depends decisively on exports, above all to the huge US market. Domestic demand in Japan has been virtually stagnant for well over a decade, while in China huge inequalities of wealth, widespread poverty, and low wages are a massive barrier to the growth of its home market. The US trade deficit, reflecting US dependency on imported goods, is indispensable for China’s exports. The same applies to other industrial or semi-industrial South-East Asian countries.
The falling dollar
THE US DOLLAR, still the world’s main trading currency, plays a crucial role in the relationship between the US market and the South-East Asian producers. The strong dollar of the 1990s effectively allowed US consumers to buy imported goods relatively cheaply, and gave South-East Asian producers a competitive advantage in the US market. This situation gave rise to the US trade deficit, as US imports grew much faster than US exports. Normally, a prolonged deficit on the current account (trade in goods and services plus flow of profits, interest, etc) would lead to a country’s currency falling to correct the imbalance. The dollar, however, was pushed up, in spite of the deficit, by the huge inflow of capital from abroad. Wealthy investors internationally were eager to grab a share of the profits available in the US during the late 1990s boom. Despite falling since 2001 (25% against a broad basket of currencies), the dollar remains over-valued, as the continuing current account deficit testifies. The dollar is still being supported by an inflow of capital, but the flow increasingly comes from Asian central banks rather than private investors. At a certain point, slowing US growth and fear of an accelerated fall in the dollar, will lead to a flight from dollar assets by private investors and, at the very least, a reduction of inflows from the Asian central banks.
A fall in the dollar (making Asian goods more expensive in the US) would be accompanied (as funds flowed from dollar assets to Asian assets) by a rise in the Asian currencies (making their goods more expensive everywhere). Moreover, if the US trade deficit was drastically reduced or wiped out, the market for Asia’s exports would be disastrously curtailed. So it is in the economic interest of Japan, China, etc, to support the dollar (by buying dollar assets) and prevent the upward revaluation of their own currencies. Their trade surpluses with the US over a lengthy period allowed them to accumulate the resources to purchase huge dollar reserves. In effect, their purchases of US government bonds is a recycling of their trade surpluses to allow the US demand/Asian supply relationship to carry on.
This relationship, however, is now approaching breaking point. The US cannot sustain the growth of its current account deficit, and has been hoping for a slow, controlled decline of the dollar. Under Bush, the US administration has conducted a policy of ‘benign neglect’, tacit support for a gradual decline of the dollar. If they openly declared support for a weaker dollar, that could in itself precipitate a major fall. Despite the 25% fall of the dollar (against a broad basket of currencies) over the last two-and-a half years, however, the US balance of payments deficit has risen by 50%. This is because there has been no significant devaluation of the dollar against the currencies of the countries that have the biggest trade surpluses with the US. The US’s top ten bilateral trade deficits are with countries that are operating a de facto peg against the US dollar (together they account for 40% of the US’s total current account deficit). Most of these trading partners generate more than half their GDP growth from exports, mostly to the US.
In effect, South-East Asia forms a dollar zone, which together with the US now accounts for over half the world’s GDP. China is the dominant economy in this zone, and has long pegged its currency, the renminbi (RMB or yuan), to the dollar. So when the dollar falls, the RMB falls – so there is no correction to the US trade deficit. Hong Kong and Malaysia also operate an official peg, while Japan, India, South Korea, Taiwan, Thailand, Indonesia, Singapore and Russia all follow a policy of closely shadowing the dollar.
China has long resisted pressure to revalue the RMB, which would undermine some of its exports’ competitive edge. More recently, the Chinese government has promised to consider revaluation when the time is ripe. However, they fear that a revaluation would reduce the growth of China’s exports, which would mean a reduction of the growth rate. At the same time, other Asian exporters are very reluctant to revalue their currencies unilaterally, because they would lose out even more to cheap Chinese exports.
One of the side effects of the formation of this new dollar zone is that ‘hot money’ leaving dollar assets (because of the downward movement of the dollar) has flowed into the euro, the only major currency big enough to absorb large capital flows. This has pushed up the euro against the dollar and other currencies, making the eurozone’s exports more expensive on world markets. This is a major factor in the low levels of economic growth in the eurozone economies.
Some commentators, eternally optimistic, have hailed the new dollar zone as a ‘Bretton Woods II’, a replacement for the relatively stable world money system that prevailed during the post-war upswing. As always, some have discovered a ‘new paradigm’ in this purely conjunctural relationship. The idea that it can provide a permanent, stable framework for a major share of world trade is absurd. More realistic commentators recognise that this dollar zone will be blown apart by contradictory forces. Brian Redding, of Lombard Street Research, comments: "The new dollar area, like Bretton Woods, must end in tears. The synchronised boom it has created cannot continue. There can be no soft landing for the US or China. Quite simply, Americans save too little and must save more, meaning demand and incomes must shrink. The Chinese invest too much and must invest less, meaning demand and incomes will contract. This is the recipe for synchronised sinking". (Quoted in Larry Elliot, There Can Be No Soft Landing, Guardian, 20 September 2004)
Pressures on US-Asian nexus
THE SHOCKS THAT will trigger a breakdown of the US-Asian nexus can come from several directions. A rise in US interest rates (possibly a quite rapid rise to a Federal base rate of around 5% or 6%) would deflate the US housing bubble and consumer boom, reducing US demand for imports. It would also cut off the US as a cheap source of international credit, reducing US and international investment in China and elsewhere. Higher interest rates would also make the existing levels of Federal government debt unsustainable, raising the spectre of a turn to an inflationary trend in order to devalue the US’s burden of debt (throwing the adjustment onto the creditors). International fears of a precipitate fall of the dollar and an acceleration of inflation in the US would, at some point, provoke a massive flight from the dollar. This has already begun, to some extent, among private capitalist investors, finance houses, and institutions, etc. But the Asian central banks, which have recently been accumulating massive dollar reserves, would be faced with a stark choice: sell their dollar assets or suffer a huge devaluation of those assets as the dollar sinks. Moreover, faced with economic crisis at home, they would need to draw on their foreign currency reserves to attempt to stabilise their own economies. Large-scale withdrawal of funds from the US by central banks would make the twin deficits (balance of payments and Federal budget) absolutely unsustainable. The US would either have to slash public spending, raise taxes, and cut consumer spending (through further interest rate rises) or print money to cover expenditure, which would lead to accelerated inflation.
On the other hand, the US-Asian nexus may be broken by a downturn in China and its neighbours. The massive investment bubble, fuelled by the inflow of investment and massive loans from state banks, together with the more recent property bubble in the coastal cities, have clearly reached their limits. For some time, the Chinese government has been trying to slow growth through administrative restriction of credit, but with little success. Now it has tentatively begun to use ‘market based’ means, that is, raising interest rates to restrict credit and cool growth. This may be too little too late, however. To effectively curb growth and inflation, especially of raw material and energy prices, it would have to raise interest rates much more. Of course, the Chinese regime is hoping for a soft landing. After such a frenzied industrial and property boom, however, it will be very difficult to achieve a gentle de-acceleration, especially given the international factors. A severe slowdown in China appears unavoidable, the only question being the timing and the scale.
A downturn in China would cut across Japan’s recent, limited recovery, which has depended mainly on its exports to China. The same applies to other South-East Asian economies.
The recent, rapid rise in the price of oil and other major commodities (for example, steel), in which increased demand from China has been a big factor, will curb growth in China and the world economy, reducing world demand for Asian exports. In a period of robust growth, world capitalism could absorb the current increase in oil prices. As it is, however, a whole series of problems makes the world economy vulnerable to a new oil ‘shock’.
Increased speculation on world financial markets, always a symptom of approaching crisis, is aggravating global volatility. Speculative activity has surged since 2001. As profits from shares and bonds declined, finance houses, with hedge funds to the fore, engaged in high-risk speculative activity on foreign exchanges and derivatives markets. The number of hedge funds has doubled in the last five years (there are now around 8,000) and they control around $1 trillion of funds. These secretive, unregulated clubs of wealthy speculators only account for about 4-6% of investment funds internationally. But because of their active, high-risk strategies they have a disproportionate effect on world financial markets. In 1998, the insolvency of the US hedge fund, Long Term Capital Management (LTCM), threatened to bring down the world financial system. This was prevented only by the US Federal Reserve organising a consortium of banks to bail out LTCM. Hedge fund investment is highly leveraged, that is, based on huge loans (totalling between $1.5-2 trillion). Derivative trading has doubled since 2001 (now around $1.2 trillion a day), whereas world trade grew by about a third in the same time. According to the Bank of International Settlements, trading on the world’s foreign exchange markets has now soared to a record $1.9 trillion a day. This activity is supposed to ‘spread’ risk, but it is one of the biggest sources of volatility in world financial markets. A sharp fall in the dollar or a sudden end to the investment boom in China could bring new LTCM-type crises on an even bigger scale than 1998.
A downturn in the US and China would mean a world downturn. The feeble rate of growth in the eurozone would be wiped out. The majority of underdeveloped countries, which have not benefited from the limited recovery in the US and Asia in the last couple of years, would once again be plunged into horrendous economic, social and political crisis.
During his first term, Bush managed to postpone the impending economic crisis in the US. Greenspan and the Federal Reserve completely colluded with this policy, brushing aside problems like the housing bubble and debt mountain. Greenspan maintained a near zero base interest rate for as long as he dared up until the November election. This allowed the new debt bubble to grow to even bigger proportions, posing the possibility of a massive ‘correction’ in the next few months. Sections of the US ruling class believe that the low tax, cheap credit Nirvana will last forever. Under Bush’s faith-based economics, economic salvation for US capitalism will come through another surge of high growth comparable to 1995-2000, fired by further tax cuts for corporations and the super-rich. But serious bourgeois strategists fear that they will pay a heavy price for Bush’s reckless policies. But it is above all the working class of the US and internationally who will suffer the devastating consequences of a US downturn. Bush managed to beat the oncoming crisis and win a second term. Exploiting fears about security and appealing to ‘moral values’, Bush was able to divert attention from economic and social problems among a layer of the electorate, just big enough to swing the vote in his favour. But the ‘political capital’ Bush claims he won during the election will not prevent the unwinding of the contradictions in US and world capitalism. The exact course of the crisis and its timing cannot be precisely predicted. But Bush and other world capitalist leaders will face an extremely turbulent period. Winning re-election, Bush has reached the top of the roller-coaster. He is about to experience the big dip, the corkscrew and other convulsions.