Are we headed for another crash?

September 28, 2015

The recent swings in world financial markets and the growing international effects of an economic slowdown in China have raised fears in the U.S. that the economic recovery could be on its last legs--even before working people felt like they had escaped the last crisis. And what will come next? In the first installment of a three-part series, Lee Sustar answers questions about the underlying causes of the instability in the markets--and explains how the troubles in the world economy today are tied the same problems that led to the Great Recession of 2007-09.

THE STOCK markets in China and much of the rest of the world seemed to calm down in September after the chaos of August. Does this mean the financial instability was a passing thing, and the prospects for the economy are looking up again?

NOT IF you go by the decision of the Federal Reserve's Open Market Committee to keep its basic interest rate at just 0.25 percent.

The Fed bowed to pressure from those who argued that a rate hike would further destabilize the world economy. According to the chief economist at the World Bank, a rise in U.S. interest rates would risk panic and turmoil."

Nevertheless, some members of the Federal Reserve Board's Open Market Committee argued for a rate increase, contending that the U.S. economic recovery is strong enough to trigger inflation--and that if the economy does go into slump, it will be impossible to stimulate growth without an interest rate cut.

In the end, the Fed put off an increase in interest rates for at least a few months. That means more than six years will have gone by with the lowest interests rates in history. If there's any one indicator that something is deeply wrong with the U.S. economy, that's it.

Are we headed for another crash?

The economic statistics show that the U.S. economy has been doing better this year--the increase in gross domestic product is estimated at 3.9 percent for April through June. But there are all kinds of indications--the stock market chaos being one--that the recovery, weak as it has been until recently, has already reached its peak. We are now entering a new phase of this economic period, which needs to be analyzed and understood.

WHY HAVEN'T low interest rates been able to spur faster economic growth? That's how it's supposed to work, right?

TO BETTER understand the financial instability and weaknesses of the world economy today, it's useful to look back at the last crisis and the weak economic recovery since then.

The wild ups and downs in the markets over the last month revived memories of the crash of 2008, when the entire global financial system was on the brink of collapse. Since Wall Street and Washington have been trying to make us forget all that, it's worth recalling just how severe that crisis got.

It started with a recession that is usually dated to December 2007, but the big downswing came months later with the stock market crash of October 2008, after the housing bubble burst and the Wall Street investment bank Lehman Brothers went under. As the economy contracted, wage growth fell, unemployment rose and mortgage debt went bad. As a result, the complicated financial investments tied to mortgages--such as credit default swaps, valued at $62 trillion, about five times the size of the U.S. economy--also plunged in value.

That blasted huge holes in the balance sheets of Wall Street banks and other financial institutions worldwide. The global economy as a whole contracted by 2.9 percent in 2009, with world trade shrinking by 12 percent. Nothing remotely like that had been seen since the end of the Second World War.

The U.S. economy itself was on the brink of a meltdown that could have sent unemployment far beyond the 10 percent level it would reach in the depths of the recession. Banks refused to lend to one another, and industrial production fell at an annualized rate of 18 percent in the last four months of 2008.

Remember how then-President George W. Bush elegantly put it: "[T]his sucker could go down."

The financial free fall ended when Timothy Geithner, then president of the New York Federal Reserve Bank and later Barack Obama's first Treasury Secretary, successfully argued to Bush that the U.S. had to guarantee all financial transactions, following the example of Britain. The Bush administration and a Democratic-controlled Congress rushed through the $700 billion Troubled Asset Relief Program (TARP) to fund the bank bailouts.

Several of biggest banks in the U.S. were effectively insolvent. They were unofficially nationalized by the U.S. government, which forced several big banks to merge.

The U.S. also took over the insurance giant AIG with a $182 bailout, while taking direct control over the quasi-governmental Fannie Mae and Freddie Mac mortgage giants with another $187.5 billion "investment." Washington also stepped in with a bailout of GM and Chrysler.

It's worth recalling that even those uncompromising defenders of free-market capitalism, the Wall Street Journal's editorial board, had previously advocated the government takeover of Fannie Mae as an "honest form of socialism."

But the Obama administration's version of "socialism" was one that only a boss could love. The AIG bigwigs who had helped to create the financial catastrophe got their bonuses on the way out the door, and the banks to which AIG owed money--like Wall Street powerhouse Goldman Sachs--got repaid in full. Meanwhile, autoworkers at all of the U.S. car companies took massive concessions as a condition of the government bailout.

The Obama administration also moved to halt the downward economic spiral with a $787 billion stimulus bill passed in the first month of Obama's presidency.

But the really big stimulus came through the Federal Reserve, which slashed interest rates to practically nothing. Since 2009, banks have been able to borrow money from the Fed at 0.25 percent interest, then turn around and loan money back to the government by purchasing Treasury bills that paid around 2.5 percent. This was a backdoor bailout that restored a restructured banking sector to profitability.

The Fed itself also bought up U.S. Treasury bonds, along with all kinds of junk mortgage-backed securities that no private investor would touch with a 10-foot pole. In the jargon of central bankers, this was known as quantitative easing, or QE. It's the modern equivalent of simply printing money and flooding the economy with cash.

The result, as the St. Louis Fed noted, was a dizzying $3 trillion expansion in the Fed's balance sheet. That amounts to a vast economic boost, even though it usually isn't discussed in the mainstream media. But the movers and shakers of financial markets pay close attention.

That's why there's so much angst over whether or not the Fed will raise interest rates now. Inflation hawks have predicted that so much money injected into the system will inevitably lead to rising prices, and that has to be stopped. But U.S. banks are addicted to cheap money from the Fed. And beyond them, many big-money investors are worried that higher interest rates will choke off weak U.S. economic growth--at a moment when the biggest threat in the world today is deflation.

PROBABLY THE biggest factor behind the deflation threat is China, which is why bad news about the Chinese economy drove so much of the stock market panic over the past month. But why is China at the center of this new crisis? It's been the big success story of the last few years.

THE IMMEDIATE cause is a bubble on the Chinese stock market. But even if Chinese stock markets stabilize for some time to come, the underlying problems of the Chinese economy are likely to get worse. As a recent editorial explained, the roots of the current crisis lie in the way China responded to the financial crash of 2008 and the Great Recession.

As the U.S. Fed was pumping money into the system through quantitative easing in late 2008 and early 2009, China launched a $635 billion stimulus plan of its own--bigger, proportionate to the size of the Chinese economy, than that of the U.S.

Alongside this stimulus came a vast expansion of credit. China's total private and public debt is now 282 percent of its gross domestic product--a lower percentage than the U.S., but unprecedented for a newly industrialized country. The unregulated $2 trillion Chinese shadow banking system is bigger than the entire Russian economy. One consequence was that the money supply in China expanded faster between 2007 and 2013 than the rest of the world combined.

The new flood of money expanded China's already fast-growing industrial base, including new steel mills, chemical plants and heavy equipment manufacturing facilities. China used more cement between 2011 and 2013 than the U.S. did in the entire 20th century as the country continued to go through an astonishing rate of urbanization.

The Chinese authorities recognized that this economic program of boosting basic industry would create problems of overproduction and eventually lead to lower prices for manufactured goods because of a glut on the world market--too many products and too few companies with the money to buy them.

So the government also set out to raise the consumption of the Chinese middle class and even workers, who were able to win pay increases through protests and strikes, despite the lack of independent trade unions. Meanwhile, upscale Chinese consumers among an expanding professional and managerial middle class could use their own pay increases to buy property or invest in the stock market.

This led to what an analyst at Credit Suisse bank calls a "triple bubble" centered on real estate, credit and investment.

Essentially, the Chinese economy is stuck between two economic models. There is the old strategy of constantly expanding basic industry to fuel manufacturing exports, which can't deliver the 14 percent annual growth rates of a decade ago because there simply isn't enough demand around the globe--and a new economic model of consumer-driven growth that is still too small to "rebalance" the economy, as economists put it.

What's more, the Chinese economy is increasingly difficult for authorities to control. When the Stalinist state-capitalist economy opened up to the West 30 years ago, the Chinese state had direct or indirect control of most big investment, and foreign capital was a tiny proportion. Today, China is intertwined with the world economy at every level. Plus, decisions that were once made by Communist Party officials in the state bureaucracy have devolved to regional local officials who can tap into credit from a shadow banking system outside the big state banks.

In response to this, President Xi Jinping launched a reform campaign to take control of local government finances and recentralize authority in the hands of the party apparatus and big state agencies and enterprises. This has taken the form of an aggressive anti-corruption campaign that has targeted key party functionaries and government officials to send a message about who's boss--with a bit of neo-Maoist rhetoric thrown in for populist appeal.

But none of these moves will be able to address the contradictions of the Chinese economy. China has the tremendous benefit of holding $4 trillion in foreign currency reserves--$1.25 trillion of it in dollars. That's enough to pay for nearly two years of imports.

But even as China tried to engineer a modest devaluation of its currency--far less of a decline against the dollar than other currencies have fallen--it was forced to sell $93 billion of its holdings in August alone in order to keep the value of the yuan from crashing, which would create even bigger problems.

According to one estimate, China burned through $300 billion in three months to try and keep its currency stable. What seemed like an almost limitless reserve of cash suddenly doesn't look so big. And no one--not even the Chinese government--really knows just how a crisis in the shadow banking system might affect China and the world financial system.

WHY HAVE China's troubles hit the rest of the world so hard?

CHINA'S EXPANSION since the 1990s has rewired the world economy in many critical respects. Newly industrializing countries--once seen as poor Third World nations unable to develop--have emerged as new centers of capital accumulation. This development was captured with the acronym BRIC--standing for Brazil, Russia, India and China, sometimes expanded to include South Africa.

In those countries, already substantial manufacturing sectors got a boost from Chinese demand for both raw materials and finished goods. There was a renewed raw materials export boom in Latin America, Africa and Asia, with Chinese companies boosting demand for commodities and making big investments in agriculture and mining.

This had far-reaching political impacts. In Latin America, the raw materials boom based on Chinese demand gave left-wing and center-left governments in Venezuela, Bolivia, Ecuador, Chile and Argentina the economic leverage to carry out reforms--the so-called "Pink Tide."

Oil-producing countries, too, benefited from Chinese demand through higher prices for their exports. According to the French bank Société Générale, Chinese demand boosted world oil prices from $20 a barrel to $100 barrel over the 2000s.

By 2014, China was responsible for 12 percent of world GDP at market exchange rates, up from 2 percent in 1995. According to the International Monetary Fund, China led the way as the so-called emerging market economies accounted for three-quarters of world economic growth in 2014.

Now China's slowdown has destabilized all this. The most spectacular collapse is in Brazil, where a combination of the Chinese slowdown, falling oil prices and a corruption scandal in the huge state-owned oil company has led to a budget deficit and a 25 percent plunge in the value of the country's currency, the real. An economy that just a few years ago seemed set to emerge as a global powerhouse is now in its worst recession since the Great Depression of the 1930s.

The drop in the value of the Brazilian real is likely to accelerate a pattern of what's called "competitive devaluations." That's economist-speak for a currency war--the effort by countries to lower the value of their domestic currency in order to make exports and labor costs cheaper in comparison to rivals. It's known as a "beggar thy neighbor" policy, and for good reason: in a slowing world economy, such measures allow the lower-cost producers to steal growth from their rivals.

That's why China's recent move to modestly lower the value of its currency relative to the dollar set off the stock market tumble and raised fears of a currency war. China's devaluation effectively cuts the price of that country's manufactured goods on the world market.

The currency war could well spur a trade war, too. The head of the American Alliance for Manufacturing recently blamed 5,000 U.S. steel industry layoffs on China's dumping of steel at below-market prices, and called for protective measures.

Chinese officials freely acknowledge the problem of overcapacity, citing problems in 18 industries. A few months ago, the government announced measures that would eliminate 80 million tons of steel production annually. But excess steel capacity in China is estimated at 300 million tons per year. By comparison, total U.S. steel output in 2014 was 80 million tons.

Bloomberg News reported earlier this year that in China, the problem of overcapacity "extends far beyond steel, afflicting aluminum, cement, coal, solar panels, and ship-building. According to a recent survey of 3,545 enterprises by the State Council's Development Research Center, 71 percent of respondents called overcapacity 'relatively serious' or 'very serious.'"

The result has been a big downturn in profits for Chinese industry this year. That will tempt Chinese businesses to cut prices on the global market to try to grab more market share and stay afloat--and add to the escalating tensions over trade.

It's a classic crisis of overproduction--one that Karl Marx would recognize from a vantage point of a century and a half ago. What's new is that it is taking shape after a huge shift in the world economy led by China's rise.

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