Battered by two economic storms

July 3, 2008

Lee Sustar reports on the overlapping effects of skyrocketing oil prices and the ongoing credit crunch caused by the housing crisis.

DAMNED IF they do, damned if they don't. That's the reality for working people in the U.S. as the Federal Reserve Bank decides whether or not to raise interest rates to try to curtail inflation in fuel and food prices.

At its June 25 meeting, the Fed's policy committee voted to stand pat and not raise interest rates. With the U.S. economy already staggering under an enormous load of mortgage-related bad debt, the Fed apparently feared that an interest-rate hike would only worsen the credit crunch and possibly trigger a wave of corporate bankruptcies.

But by failing to raise rates, the Fed is abandoning its attempt to curb growing inflation. Instead of raising rates to try to head off speculation in oil, food and other commodities, the Fed issued a statement stating it would raise rates in the future.

In effect, the Fed is trying to bluff speculators in oil futures--that is, everyone from hedge fund bosses to Wall Street investment banks--into pulling back from their headlong rush into the oil markets.

The headlong rush of speculators into the oil markets has driven prices above $140 a barrel, a doubling in less than a year.
The headlong rush of speculators into the oil markets has driven prices above $140 a barrel

By the end of June, prices jumped above $140 per barrel, double that of last September. The reason? The declining value of the dollar on international currency markets has made it much more sensible for big financial capitalists to hold futures in crude oil and other commodities rather than U.S. dollars.

"Crude is now moving almost reflexively as a sort of 'anti-dollar,'" Ambrose Evans-Pritchard of Britain's Daily Telegraph wrote June 10. "No matter that the global economy is slowing hard. Bad is good for oil in the topsy-turvy world of commodity funds."

In other words, oil has partially replaced gold as the commodity that investors turn to when currencies are unstable--which is the case now, with banks and investors increasingly reluctant to hold on to devalued U.S. dollars.

The rapid rise of oil prices, in turn, has helped spur a big increase in the price of food worldwide, triggering food riots in more than 30 countries. The U.S., having invaded Iraq in part to put pressure on the OPEC oil cartel and drive down prices, has instead pushed oil prices to unprecedented highs.

The interest rate cuts by the Fed--from 5 percent in September to 2 percent today--have only aggravated the problem. The lower rates injected new liquidity into the system, providing investment banks, hedge funds and other investors with the credit they're using to bid up the price of oil futures.

The oil bubble will eventually burst as a slowing world economy curtails demand. But in the meantime, the damage to the U.S. and global system may be enormous. The former CEO of American Airlines warned recently that the entire U.S. airline industry could soon end up in bankruptcy.

Workers, meanwhile, are enduring sharp and sudden cuts in their living standards as more and more of their paychecks go into the gas tank or a cartload of groceries.

THIS OIL-and-food price surge, moreover, comes amid the worldwide credit crunch caused by the housing crisis. The big European and U.S. banks have already written off hundreds of billions of dollars in bad mortgage-backed securities. Yet a steady leak of information about banks' dismal balance sheets points to more huge losses to come.

The Fed has responded by both lowering interest rates and accepting mortgage-backed securities as collateral for loans to commercial and investment banks. Still, the banks remain reluctant to lend to one another, not to mention to businesses and consumers. "Two storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one," wrote Martin Wolf, the economics columnist for the Financial Times.

These aren't two separate crises, however. They're two aspects of the same underlying problem: repeated efforts over the last decade by the Fed and U.S. economic policymakers to prevent a deep recession by using the same tools of monetary policy.

During the 1997-1998 financial crisis that began in East Asia and spread to Russia, Brazil and beyond, Alan Greenspan, then Federal Reserve chair, lowered U.S. interest rates at the height of an economic expansion. This stimulated the economy and allowed the U.S. to play the role of importer of last resort.

Austerity policies pushed by the U.S. Treasury and International Monetary Fund (IMF) forced through a "restructuring" in East Asia that led to factory closures and a spike in unemployment and poverty. Yet the crisis, though agonizing for workers and peasants, was relatively brief.

That's because purchases by U.S. consumers helped alleviate the crisis of overproduction in East Asia--too many factories producing too many goods to maintain profits. At the same time, the Fed's easy money policy gave rise to the technology stock bubble of the late 1990s.

When that bubble burst in 2000 and a recession ensued, Greenspan stepped in again with steep cuts in interest rates. This time, the low rates fueled the boom of borrowing for mortgages and home equity loans, which millions of people used to compensate for stagnant or falling wages.

Again, the U.S. remained the importer of last resort. But today, with record-high household debt and a squeeze on credit, U.S. consumers can no longer play the same role that they did before.

"A snarky but accurate description of monetary policy over the past five years is that the Federal Reserve successfully replaced the technology bubble with a housing bubble," the economist and New York Times columnist Paul Krugman wrote in 2006. "But where will the Fed find another bubble?"

Turns out that the bubble is in oil--but rather than stimulating economic growth, it's choking it off.

WHY OIL, why now? Essentially, we're seeing the beginning of a flight from the dollar, something long anticipated--and feared--in U.S. political and financial circles.

The U.S. depends on foreign investors to finance its trade deficits. But the decline in the value of the dollar is putting pressure on those investors to search for other, more stable alternatives. However, the yen isn't an alterative, given Japan's huge government budget deficits. The euro could potentially displace the dollar, but that's less likely now that the European Central Bank is even more burdened than the Fed in propping up banks reeling from toxic mortgage-backed securities.

The Fed has long gambled that it can let the dollar decline because investors had nowhere else to go. The dollar accounts for some 63 percent of reserves held by central banks worldwide, making it the world's reserve currency. Further, by allowing the dollar to decline relative to other currencies, the U.S. not only effectively cuts the price of its exports, but also reduces the amount in loans and interest that the U.S. must repay to the rest of the world.

Now that's changing. "Foreign investors in U.S. dollar assets have seen big losses measured in dollars, and still bigger ones measured in their own currency," the Bank of International Settlements stated in its newly released annual report. "While unlikely, indeed, highly improbable for public-sector investors, a sudden rush for the exits cannot be ruled out completely."

In addition, the U.S. role in the world economy is very different than it was a decade ago, when it could dictate the harsh terms of the solution to the East Asian financial crisis.

"Since 2001, the U.S. share of world gross domestic product has fallen from 34 percent to 28 percent, while that of the BRICs [Brazil, Russia, India and China] has risen from 8 percent to 16 percent," Robert Hormats and Jim O'Neill of the Wall Street bank Goldman Sachs wrote in the Financial Times.

In that period, China's foreign currency reserves increased from $200 billion to $1.8 trillion, Brazil's from $35 billion to $200 billion, Russia's from $35 billion to $500 billion, and India's from $50 billion to $300 billion.

As a result, the IMF is practically out of the business of making loans to developing countries. In fact, the shoe is on the other foot. "The U.S. has long depended on the kindness of strangers to finance its import bill," the Wall Street Journal reported. "These days, those strangers are likely to be in China, Brazil, Mexico or some other emerging nation.

"The U.S. has to import, on net, almost $2 billion in capital a day to cover its enormous trade gap. Of the $920 billion that foreigners pumped into U.S. stocks, bonds and government securities last year, $361 billion--a stunning 39 percent--came from emerging-market nations, according to calculations by Bank of America, using Treasury Department data." China accounted for 21 percent of the total.

Instead of a sudden shift from the dollar to the euro, we're seeing investors of every sort pile into the market for oil futures and, to a lesser extent, food and other commodities. With interest rates low, the stock market sinking and the dollar's value waning, it makes sense for capitalists to hold commodities rather than cash. But what's logical for individual capitalists is destabilizing for the system as a whole.

The oil bubble will burst, sooner or later. But by then, the damage will be done--and the political impact will far-reaching.

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