Worries about home loans in Detroit and Houston make French banks close their funds and push Germans toward bankruptcy, in a global market that is now so complex that mere humans can barely work out who owes what to whom. And the computers take over, deciding on the basis of algorithms that were concocted in calmer and happier times that stock X should be sold and stock Y should be bought, sending bizarre signals to the rest of the market that few know how to interpret.
There are three real oddities about the storms that have swept the world’s markets in recent days. The first is that the fundamentals of the global economy are very promising. For once, every major economy is growing at once.
With China and India and the Gulf markets booming, Japan and Europe in recovery, Latin America growing at a healthy 5 percent and even sub-Saharan Africa growing at 6 percent, every single cylinder in the world’s economic engine is firing at once. And after the last six years of bearing the lonely burden of being the world’s market of last resort, and its only major growth locomotive, the United States is still growing at something close to 3 percent.
The second oddity is the Bank of England, which has decided against following the lead of the U.S. Federal Reserve, the European Central Bank and the Central Bank of Japan and joining the effort to pump some $300 billion of liquidity into the financial system to loosen the liquidity block.
In Washington, Frankfurt and Tokyo, the central bankers put aside their concerns about moral hazard and made funds available to bankers and investors who make over-risky bets, judging that the real priority was to keep the wheels of credit turning. In London, the central bank decided to stick with its traditional policy, that it would lend its banks as much money as they wanted, as long as they were prepared to pay an extra 1 percent above the formal interest rate. Bad decisions thus got punished, while the wheels of credit still turned. This old-fashioned remedy, which at the Bank of England dates from at least the 1850s, seems to be working as well as the blank checks being written by other central bankers.
The third oddity is that there is an exception to the gloom and chaos on the global markets -- China, where the Shanghai index has blithely grown by another 25 percent. Perhaps, observers should not be surprised when the last trade figures show the U.S. trade deficit with China jumping another 6 percent in the last month, and now running at close to $250 billion a year. At this rate, the China deficit ($21.2 billion) will soon overtake the petroleum deficit ($23.4 billion in June).
But at some point, Chinese investors are going to have to start pricing in the risk that the U.S. goose may have to stop laying golden eggs. First, there is the serious threat of the bill from Sen. Charles Schumer, D-N.Y., to require Beijing to revalue its currency or face massive tariffs across the board. Second, there is the prospect of a U.S. downturn cutting the appetite for imports from China. And third, there is the fear of what is called the nuclear option.
In its fullest sense, this would mean the Chinese deciding to overturn the U.S. economy by dumping its $1.3 trillion holdings onto world markets; this is most unlikely to happen in any event short of all-out war. But what we might call the tactical nuclear option, of the Chinese steadily cutting back on their dollar holdings and their purchases of T-bonds, is very much more likely. And since the decline of the dollar means the Chinese are watching their dollar pile sink in value, the temptation to diversify their holdings is very strong.
The conventional wisdom says that if that happens, and other foreign banks and countries then also decide to shun the dollar, the Fed would have to raise interest rates to prevent a free-fall, but probably plunging the country into a recession. But the Fed does not have to do that. So long as some political deal can be reached on oil imports, the United States can probably live with a tumbling dollar, as it did in the mid-1980s when the Louvre and Plaza agreements arranged an orderly halving of the dollar’s value against the Deutsche mark.
By making U.S. exports cheaper and imports more costly, such a devalued dollar would sharply reduce the trade deficit and get the U.S. economy back on the road to recovery. In short, if the Chinese can play at the economic version of tactical nuclear warfare, so can the United States. As an earlier U.S. treasury secretary, John Connally, told the European central bankers in 1971 at a time of another financial crisis, the dollar “is our currency, but it’s your problem.”
The lesson of the past two weeks in the markets has been the deepening interdependence of the global economy and its financial system, and everybody has an interest in keeping it going. The grim news is that these days, that means everybody has an interest is nursing the United States back to health. And as David Walker, comptroller general of the United States, reported this week, the current state of play of the U.S. economy with its crumbling infrastructure, its over-extended military, its astronomical levels of debt and deficit is in such trouble that it shows some "striking similarities" with the fall of the Roman Empire.
"With the looming retirement of baby boomers, spiraling healthcare costs, plummeting savings rates and increasing reliance on foreign lenders, we face unprecedented fiscal risks," Walker, a former top executive at the PricewaterhouseCoopers accountancy group, told the Financial Times. The United States is "on a path toward an explosion of debt," and U.S. policies on education, energy, the environment, immigration and Iraq were all on an "unsustainable path," said Walker, who runs the powerful Government Accountability Office.
The Chinese, of course, can retort that by buying more than $600 billion in U.S. government debt they are doing their bit to fend off the fall of Rome. In fact, they are buying T-bonds mainly to finance future U.S. purchases and to protect their own economy from inflation. The contribution that they will eventually have to make will be to let their currency rise by some 25 percent or more. If they do not, it is simply a matter of time before the custodians of the dollar let it fall anyway, on the rule that it may be "our" currency, but it will be China’s problem to manage its own recession if the United States stops buying Chinese goods.
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