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WHAT WE THINK
Is the stock market turmoil sign of a recession to come?
Economic storm warnings

March 9, 2007 | Page 3

THE DROP in world stock markets as March began raised the specter of recession in the U.S. and globally.

While attention focused on the 9 percent drop in the Shanghai stock exchange in a single day, the Chinese stock market is too closed and small to cause a similar drop in, say, New York or Tokyo. The nervousness on the international stock markets is really centered on dimming prospects for the U.S. economy, the engine of world economic growth.

If the stock market drop began in China, it's because the seemingly endless demand for Chinese goods from the U.S. could be waning, as a downturn in the housing market sucks the air out of the U.S. economy.

The Commerce Department revised its estimate of growth rates in the fourth quarter of 2006 down from 3.5 percent to 2.2 percent, with rising defaults in mortgages and a decline in new housing construction the main causes.

There's no predicting whether a recession will come next month or next year or somewhat later. But since the boom-bust cycle is endemic to the capitalist system, come it must.

And for workers--facing stagnation or outright declines in their living standards during the years of economic growth--a downturn will be devastating.

Some 3.1 million manufacturing jobs disappeared in the U.S. between 2000 and 2006--an unprecedented loss of jobs while the economy expanded. As the Economic Policy Institute (EPI) reported last year, five years of economic recovery since 2001 has pushed overall payroll employment up just 4.5 percent--half the pace of job growth in the 1990s.

With the lousy job market has come a spike in those without health insurance. As of 2004 (the latest figures available), some 46 million people--many of them working poor--were uninsured, an increase of 6 million since 2000.

"For middle-income households, real incomes were lower in 2005 than in the recession year of 2001, and real wages, after rising through mid-2003, fell consistently until most recently," the EPI's Jared Bernstein and Jason Furman noted last November.

Where did the gains of the economy go? Straight to the top. In the third quarter of 2006, owners of capital received 23 percent of total corporate income, the highest proportion since 1966.

And according to census data, the wealthiest fifth of U.S. households got half of the national income in 2005, tying the record level. The richest 1 percent got a staggering 59.4 percent of all capital income in 2004, up from 37.8 percent in 1979.

By contrast, workers--and sections of the middle class--have had to bolster their incomes through borrowing, from credit card debt to mortgage refinancing. As a result, the domestic savings rate in the U.S. is now negative 1 percent--the lowest since the Great Depression.

Low interest rates, set by the Federal Reserve Bank to lift the U.S. out of the 2001 recession, opened the way for people who in the past wouldn't have qualified for loans to purchase houses. A growing percentage of such "subprime" loans--often at adjustable interest rates, well above market rates--have started to turn bad as the Fed raised interest rates in the past two years.

With subprime loans rising from $150 billion in 2000 to $650 billion in 2005, the economic consequences of the U.S. housing slump are considerable--and international in scope.

That's because these mortgages were packaged into bonds and sold off to banks worldwide, including central banks in China, Japan and elsewhere. No one knows how great the risk is. But when the big Hong Kong bank HSBC recently reported that it was writing off $11 billion in bad loans in the U.S. housing market, it was enough to add to the shakeup in the world stock markets.

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THE SHAKEUP has already highlighted the contradictions of the world economy in the era of globalization--which have only deepened since the 1997-98 East Asian economic crash.

That crisis began with a run on Thailand's currency, and led to a flood of capital out of East Asia as investors realized that the 1990s boom had peaked, and profits would decline as a result of overproduction--not just of autos, steel and computers, but of the plants that produced them.

Washington responded through the International Monetary Fund, offering loans in exchange for savage cuts in social spending and the opening of East Asian economies to benefit the U.S. At the same time, the U.S. stepped in to become the importer of last resort, cutting interest rates to spur demand in the global economy and stave off an even deeper worldwide crisis.

The result in the U.S. was a stock market boom that finally burst in 2000. Recession followed a year later. But a continued policy of low interest rates--along with huge increases in government spending for wars in Iraq and Afghanistan--made the recession relatively mild by historical standards.

When a recovery began after 2001, the hangover of debt made for sluggish growth, as business investment lagged far behind the pace of the 1990s. Thus, the U.S. auto industry--once synonymous with the nation's economic health--entered its worst-ever crisis in the current economic expansion, hammered by competition from imports and production by foreign-owned auto plants in the U.S. Tens of thousands of auto jobs were eliminated.

More generally, U.S. deficit spending and consumer demand has created a current account deficit--the gap between imports and investment in the U.S. and exports and investments abroad--that now totals 7 percent of U.S. gross domestic product. All this means that the U.S. increasingly depends on central banks in China, Japan and other countries to purchase U.S. Treasury bonds to finance America's deficit spending.

The shaky financial markets threaten this setup. And the vast expansion of debt globally and the resurgence of huge unregulated hedge funds--a key factor in the 1997-98 crisis--makes it impossible to predict whether similar turmoil lies ahead now.

Could another cut in interest rates rescue the U.S. economy again? Not without collateral damage.

"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," economist Larry Elliot wrote in Britain's Guardian newspaper. "Why? For one thing, the two debt-driven bubbles have left consumers enormously overextended. 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."

This scenario raises the prospect of "stagflation"--the term used in the 1970s to describe a U.S. economy suffering from lousy growth rates even as prices soared. Since then, U.S. economic policymakers have regarded inflation as anathema. But if the Federal Reserve raises interest rates to prevent inflation, it could push the U.S. into a much deeper recession than in 2001.

The U.S. may not have much choice in the matter. If the declining value of the dollar relative to other currencies prompts China and other foreign holders of U.S. bonds to sell off U.S. assets, the Federal Reserve might have to raise interest rates to attract the investment necessary to finance this country's huge deficits.

In any case, the toll of a recession on workers--already shut out of the gains of the current expansion, enduring huge levels of household debt and faced with the threat of a rotten job market--would be severe. Cuts in social spending at the federal and state level are already taking place during the expansion. They would become much more severe.

For now, the world economy is expanding. China and India have high growth rates, and a number of newly industrializing countries, including several in Latin America, have benefited from China's demand for oil and other raw materials. The U.S. economy, although slowed, continues to grow, as does its counterparts in Germany and Japan.

No can say for sure if the world stock market tremors presage the end of this expansion. But they are a reminder that capitalism today increasingly locks workers out of the booms--only to make them bear the cost of the bust.

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