Double, Bubble, Trouble

ince they reached their nadir of 7500 during the Iraq war US equities have recovered strongly and the Dow Jones Industrial Index (DIJA) now stands at around 10500. This upward surge has also had the effect of pulling up the rest of the equity markets around the world. The FTSE for example has risen from a low of 3,250 to around its present level of around 4,500, still some way off its all time high of nearly 7,000 however, which was recorded on the eve of the millenium. Additionally, US profits have recovered strongly from 0% in 2002, to 17% in 2003, and so far 13% in 2004. Annualised growth rate for the US economy is now roaring ahead at 8.2 percent. So it seems to be business as usual, happy days are here again. Why even internet stocks are picking up. What was that about being once bitten twice shy? Enjoy it while you can guys, because it ain't going to last.

Of course it would be churlish to dispute the figures quoted above: real economic growth has taken place. However the present cyclical upturn should not be seen as a long or even medium term phenomenon. It is little more than a quick fix based upon an injection of liquidity into the US economy brought about by tax cuts and war spending and the decline of the value of the US$ against other currencies. When an economy is running below capacity - as was the US economy during the downturn - any increase in aggregate demand will encourage firms to produce more. Spare capacity will gradually be eliminated and firms will experience falling costs as production moves toward full (i.e., optimum) capacity.

This explains the boom in US profits. This is GCSE Keynesianism. Strange how the Republican Party in opposition is fiscally conservative and how in Office they act like demented Keynesians: Nixon, Reagan, Bush 1 and now Bush 2 have all spent America into deficit. And the Federal deficit (not to mention the various states deficits) is one of the weaknesses of the present recovery. Bush inherited a surplus from Clinton and has managed to turn it into a deficit. In the past two fiscal years the Federal budget has surged by US$296 billion. In percentage terms the growth has risen from 3% in 1999 to 7.5% in 2003.

In addition to the growing budget deficit there is of course the US's massive and growing trade deficit. This now grows at an historically exceptional annualised rate of US$500 billion or US$50 million per hour. This annual figure represents 5% of America's GDP. In cumulative terms America's net liabilities to the rest of the world amount to some 25% of GDP and this figure is growing.

A Government running public spending deficits and economies running trade deficits are not necessarily a disaster; but there must be a limit to this trend however. It can be a cyclical trend but it must never become structural. For it is a mathematical certainty that when borrowing reaches a certain point the servicing of these rising debts becomes impossible. At this point the downturn begins: bad debts, bankruptcies, credit crunch, unemployment and all the other familiar features of economic bust make their appearance. Another negative feature of the present upturn is that it has been - in the economists' vernacular - a jobless recovery. Another interesting aspect of the present economic situation is the continuing bull-market in gold and other precious metals. This started back in 1999 when gold was trading at around US$250 per oz. Currently the price of gold is trading at approximately US$400 per oz. And this is no five minute wonder; it has been an inexorable, long-term trend. Anyone who had bought into this market in the late 90s would be now sitting on cumulative gains of 70% on their investment. Again according to the textbooks this should not be happening during the recovery period of the economic cycle. Investors should be getting out of gold and into booming stocks and other forms of investment. Gold is usually associated with economic crises; held as a commodity of last resort. The Labour theory of value is dead, or so I'm told by these erudite gentlemen from Cambridge. Gold, according to Keynes is a 'barbarous relic.' Well just try telling that to the bullion markets. The truth is surely that investors have little confidence that the present recovery can be sustained and are, quite rightly, hedging their bets by spreading their investment activities.

The current economic revival has been termed the best that money can buy. Its purpose is above all to get Bush re-elected. After that the asperities will have to begin in earnest. The enormous indebtedness of the American economy - government, corporate and private - will have to be addressed. But this will be a painful process fraught with economic and political problems, not just for America but for the world. Even the usually obtuse International Monetary Fund (IMF) can see the difficulties and dangers ahead. Noting the dollar's recent slide against the euro, pound sterling and the yen, and correctly attributing the cause as being the twin deficits on Federal budgets and current account, the IMF warns that 'this trend (of deficits) is likely to continue to put downward pressure on the US$ particularly because the current account deficit increasingly reflects low saving rather than high investment'. At the heart of the problem is the fact that the dollar needs to decline in order that the US corrects its trade deficit. However, the American monetary authorties still need to keep the value of the dollar and other dollar-denominated assets reasonably high in order to induce foreign investors to hold and purchase these assets. For it is precisely in this manner that the US finances its huge trade deficit. Since the 1970s the mighty American economy - the world's biggest debtor - has been underwritten by the willingness of central banks around the world - particularly in East Asia - as well as private investors, to accept eurodollars and other American debt instruments as means of payment. Some two-thirds of the foreign reserves of central banks around the world are held in eurodollars. If the dollar starts to decline holders of this currency will begin to think about diversifying out of dollars. And this is precisely what is happening, and explains the rise in the euro, the pound, and the price of gold.

The only significant players buying the US$ at the moment are the Chinese and Japanese central banks. They have their own reasons for doing this: viz., they do not want to see their own currencies appreciate against the US$ and so become priced out of their chief export market - the US. But significantly even Japan, America's traditional creditor of last resort, is beginning to wonder whether accepting eurodollars as payment is any longer a viable trading strategy given the downward float of the US$.

Asian bullion traders have reacted with cautious optimism to remarks on 28/01/04 by Japan's finance minister on the country's desire to re-examine its foreign exchange reserves including its gold holdings. Sadakazu Tanigaki said his ministry will carefully consider whether to change the composition of its US$673.53 billion in foreign reserves. Which means that Japan will lower its exposure by selling dollars and buying gold.

So here is the predicament: 'It (the Federal Reserve Board) will continue to reduce interest rates to provide liquidity to keep the economy ticking over and defend the value of US assets; but it will, even more, need to raise interest rates so as to attract a continuing inflow of funds from overseas to maintain the dollar, thus making it possible for the US to fund its historically unprecedented current account deficit. Yet how high would interest rates have to go to counteract the enormous downward pressure on the dollar that resulted from foreign investors trying to liquidate their dollar portfolios? Could interest rates be simultaneously kept high enough to allow for the funding of the current account deficit and to prevent a flight of capital, and also low enough to avoid choking off growth?' (Robert Brenner - The Boom and the Bubble) Sounds very tricky. No wonder the IMF is worried.

It looks more and more the case that after the great internet boom-bubble-collapse, the response by the monetary authorities, on both sides of the Atlantic, was to initiate another bubble. This option was preferred to the more austere and painful measures needed to correct the grotesque imbalances which had built up in these economies - principally debt and asset-price inflation. Both the Fed and the UK Monetary Policy Committee (MPC) took one look at the situation, assessed the political and economic risks and 'bottled' it; interest rates were kept low in spite of the fact that both the US and UK economies were overheating. House-price inflation and record levels of consumer debt (debt to disposable household income is now 125% in the UK), illustrates this. Bubble MKII was to be based on property prices, private, corporate indebtedness and government spending. A grotesque gambit of double or quits.

Unfortunately, however, this only prevents the corrective mechanism of capitalism, a good old fashioned slump, from doing its historic work. Economic crises brought about by excess liquidity, may be postponed, but can never be cured by even more liquidity; the situation, though temporarily ameliorated, will be made even worse in the longer run. It's a bit like going to the dentist really, the pain will be all the worse for having been postponed. Where and when this will all end is anybody's guess. An end to boom and bust - don't make me laugh!