World Economy: 'Correction' or crash?
IN THE second week of May there was a convulsion in
the world financial system. Shortly after rising to
near-peak levels, shares fell sharply on world stock
exchanges, especially in so-called 'emerging markets'
like India and Turkey. Prices of commodities, such as
copper, which had soared over recent months, also
plummeted. There was a general flight of fluid,
speculative capital from risky (if potentially highly
profitable) investments to safer assets, especially
cash and government bonds.
Lynn Walsh examines these events and exposes the
instability of the global capitalist system.
WAS THIS merely a timely 'correction' of speculative
bubbles or a preliminary tremor marking the onset of a
deeper crisis? This was the question being asked by
jittery capitalist leaders and commentators.
Initially, financiers feared a crash, dumped risky
assets (collecting the profits from their recently
inflated prices) and took refuge in safer investments.
After a few days, however, share prices in the
advanced capitalist countries bounced back. In New
York, London and other advanced capitalist countries,
shares fell about 4-5% overall. Shares in 'emerging
markets', such as Russia, Turkey, India, Mexico, etc,
fell by 10-25%. Many commodities and shares in mining
companies, which had recently soared, fell by 10% or
more (though some later recovered).
The partial sell-off appeared to be triggered by fears
of rising inflation in the USA, where 'core' inflation
(excluding food and fuel) rose to an annualised rate
of 3.2% compared to 2.3% in 2005. Behind this was the
deeper fear that the US Federal Reserve will respond
by raising interest rates even further, threatening to
bring to an end the era of ultra-cheap credit.
Speculators soon resumed their frenzied search for
profits. Capitalists everywhere breathed a huge sigh
of relief. Most of them complacently believe that new
technology and globalisation guarantee uninterrupted
growth and profitability, relegating financial crashes
and economic slumps to the dustbin of history.
In reality, the May turbulence reveals the fragility
of the global capitalist economy, which works in an
anarchic way. So far, it appears to have been mostly a
correction of feverish investment in some of the most
speculative markets: inflated shares in 'emerging
markets', 'junk' bonds in dodgy companies, industrial
commodities (like copper), oil and gas and foreign
currency trading. In the last year or so, bubbles have
developed in all these market sectors, with finance
houses and hedge funds at the forefront of the
But the May episode highlights the dominant, parasitic
role of finance capital, which is by its very nature
volatile and destabilising. Moreover, the rebound of
financial markets since mid-May in no way helps
overcome the unsustainable trade and currency
imbalances in the world economy.
THE GROWTH of speculative finance capital reflects the
intensification of the exploitation of the working
class, in the advanced capitalist countries and
especially in the under-developed countries.
The neo-liberal (ultra-free market) policies adopted
by governments since the early 1980s have enormously
boosted the profits of corporations and finance
houses, at the same time increasing the share of the
wealth going to the capitalist class. Twenty years ago
there were 140 billionaires according to Forbes
magazine. Today there are 793 billionaires (102
joining their ranks in the last year alone).
While there has been increased investment in China and
a handful of other cheap-labour, low-cost countries,
there has been no general increase in capital
investment in new plant, machinery, factories, etc.
Since 2000, the capital stock in OECD countries has
been growing at only 2% per year, less than half the
rate of the 1960s (during the post-war upswing).
In the USA, financial companies take 30-40% of total
US corporate profits (over 50% if the financial
activities of industrial and commercial companies are
included), compared to 10-15% in the 1950-1960s.
Instead of extensive investment in new means of
production, the super-rich and big corporations have
intensified the search for profits from speculative
investment. The deregulation and globalisation of
international financial markets has provided endless
opportunities for profits. The super-profits of
corporations and the colossal personal wealth of
capitalists have provided a deep pool of liquidity.
Speculators, moreover, have been able to take
advantage of abundant, cheap credit - they don't even
have to speculate with their own money. Major
capitalist governments, like Japan from the 1980s and
the USA after 2000, cut interest rates to zero or
near-zero levels in an effort to avert financial
crises and stimulate growth.
Huge profits and virtually unlimited cheap credit
produced the multiple bubbles of recent years. The
stock exchange bubble of the 1990s in the US and
elsewhere was fuelled by cheap credit, as is the more
recent housing bubble. Both in turn played a vital
role in sustaining consumer demand through the 'wealth
effect', the conversion - on the basis of more loans -
of capital gains into consumer spending.
In the last few years, capitalist investors, flush
with liquid cash, have been desperately searching for
new sources of extra profit - investments reaping
profits above the average return of 'safe', 'blue
chip' shares and bonds. Thus the surge of investment
in currency trading, junk bonds, commodities, and
shares in 'emerging markets'.
Excess investment in these assets has over-inflated
their value. A flood of foreign investment into shares
on Indian stock exchanges, for instance, also
encouraged local capitalists to join the speculative
binge. As a result, share prices were pushed up far
beyond any rational estimate of what returns they
would produce from company profits.
The sharp drop of prices in May, therefore, was an
inevitable correction. It remains to be seen whether
shares in countries such as India (which fell 25%)
will recover, and how many speculators and traders
will go bust as a result of their losses.
The May correction has made the major international
speculators and finance houses more cautious - for the
time being. But the underlying conditions which
produced the bubble economy still exist, and new
bubbles will appear - until there is a much more
drastic correction, a real crash.
How it will develop is unpredictable. At the moment,
the 'real' economy - production measured by gross
domestic product (GDP) - is still growing. The IMF
predicts global growth of 4.9% this year. But apart
from the adverse effect of higher energy and commodity
prices (which are beginning to have more of an effect
on growth), current growth could quickly be cut across
by renewed financial crisis.
This could be precipitated by a convulsive realignment
of major trading currencies (US dollar, euro and yen),
unavoidable at some point in the not very distant
A financial crisis could also be triggered by the
collapse of a major finance house, or several big
Given the huge amounts of debt on which the system
runs and the complexity of financial instruments such
as derivatives - described by the famous investor
Warren Buffett as 'weapons of mass destruction' -
major bankruptcies are inevitable.
In 1998, following the collapse of the Russian rouble,
the hedge fund Long Term Capital Management (LTCM)
went bust. The knock-on effects could have been
catastrophic. A systemic meltdown of world financial
markets was prevented only by a $3.6 billion rescue
operation by a consortium of banks organised by the
Federal Reserve Bank. Even now, there is likely to be
more than one new time bomb like LTCM being prepared,
waiting to be detonated. Trade and currency imbalances
THE CHIEF economist of the OECD, Jean-Philippe Cotis,
welcomed the May turmoil as a necessary correction of
over-priced, risky investment assets. But he warned
that, in spite of this, the risks to world economic
growth have increased.
The main threat being the 'unprecedented' imbalances
between (heavily indebted) deficit economies like the
US and (cash-rich) surplus economies like China.
Against all the normal rules of capitalist economics,
the US dollar has been an overvalued, strong currency
(because of capital flows into the US), while the
Chinese yuan (or RMB) has been seriously undervalued
(because the yuan has been pegged to the dollar at an
unrealistically low rate of exchange).
"A brutal unfolding of such imbalances," warns Cotis,
" would hurt the world economy ..." (Financial Times,
24 May 2006)
The relationship between the US and China is the
central pivot of the world economy. US consumers
provide an indispensable market for goods exported
from China, as well as from Japan, SE Asia and other
areas. But US consumption depends heavily on debt.
Internally, as workers' incomes have been squeezed,
many consumers have kept up their living standards by
taking out mortgages on their homes. This was made
possible by the boom in house prices and cheap
House prices, however, are now slowing and the steady
increase of interest rates by the Federal Reserve is
reducing the 'wealth effect' of the housing bubble. If
house prices stagnate or fall, and interest rates rise
even higher, consumer demand will be severely curbed.
Moreover, higher interest rates, combined with a rise
in unemployment, will mean that current levels of
consumer and credit card debt will become
Cheap credit was a key factor in the sustained
strength of US consumer demand, which is why
capitalists are now so fearful of rising interest
rates in response to rising inflation (or the Central
Banks' fear of rising inflation).
Externally, US capitalism also depends on high levels
of debt. The US consumes more than it produces,
importing huge quantities of cheap goods from China
and other developing countries. The strength of the
dollar in recent years made imports even cheaper to US
The investment bank Morgan Stanley estimates that US
consumers saved $600 billion over the past decade by
buying cheaper goods made in China.
Consistently importing more than it exports, the USA
has had a remorselessly rising balance of payments
deficit. In 2005 it was $725 billion or 7% of GDP.
This recurring deficit has to be financed by an inflow
of capital into the USA. Part of the inflow has been
capital invested by overseas capitalists in US
companies, shares, etc. But covering the US deficit
has more and more relied on the purchase of US
government bonds by the central banks of China, Japan,
South Korea and a few other countries (including oil
producers) that have big trade surpluses with the USA.
In 2005 China had a trade surplus with the USA of $201
billion and has now accumulated nearly $1,000 billion
in foreign currency reserves (three-quarters in dollar
assets), more even than Japan, which has $847 billion
foreign currency reserves.
In effect, they have been recycling the dollars earned
by their exports back into the US economy. Their
motive is clear. They want to sustain the US market
for their exports.
A collapse of US demand would have disastrous effect
on export-orientated economies, especially on China
which, because of the poverty of most of its
population, has only very limited domestic demand.
The flow of funds into the USA has turned US
capitalism into the world's biggest debtor. It now has
a capital account deficit with the rest of the world
of over $2.5 trillion. This, combined with the rising
current account (balance of payments) deficit, is
unsustainable. Something will have to give.
So far, US capitalism has been able to get away with
this unprecedented position because of its size and
power. The dollar was strengthened, despite recurring
current account deficits, by the inflow of funds
(which made foreign goods even cheaper).
The flood of capital into the USA allowed interest
rates to stay very low, providing cheap credit for the
housing boom and other bubbles, in the USA and
It has also allowed Bush to finance the federal budget
deficit very cheaply (without needing to raise
interest rates). Cheap credit, contrary to past
experience, did not produce accelerating inflation,
mainly because cheap manufactures from China and
elsewhere have kept prices low.
Even Greenspan at the Federal Reserve realised that
this cheap credit paradise could not last forever.
After the collapse of the dot.com bubble in 2000, the
Fed attempted a 'managed decline' of the dollar. This
was resisted by China, Japan, etc, because a weaker
dollar means a stronger yuan, yen, euro, etc, which
would cut across their exports to the US. However,
after a pause during 2005, the dollar has begun to
This poses an acute dilemma for states that hold huge
dollar assets (mainly in the form of US government
bonds). If they hold on to them, their reserves will
fall in value as the dollar declines.
If, on the other hand, they start selling their US
dollar assets, they are likely to accelerate the
decline of the dollar - and suffer even bigger losses
as a consequence.
There are already widespread fears that the 'managed
decline' of the dollar will, at a certain point,
become a rout. The value of the foreign currency
reserves of China, Japan, etc, would be sharply
reduced if they continue to hold mostly dollars.
Recently, a number of states, including China and a
number of oil producers, have begun to shift the
balance of their new foreign currency reserve
purchases away from the dollar and into the euro.
They are moving cautiously and largely secretly.
Sooner or later, however, dollar holders will begin to
sell dollar reserves on a significant scale and switch
to other, stronger currencies.
This shift, already beginning, will have serious
knock-on effects. First, a reduction of the capital
flow into the USA will force the US government and Fed
to take steps to reduce the balance of payments
deficit and cut the federal government deficit.
This will mean reduced consumption in the US, less
demand for exports from China and the rest of the
In order to attract the funds it needs to finance the
twin deficits, the Fed will have to raise US interest
rates even higher. This will spell the end of the
cheap credit regime, the foundation of recent world
The decline of the dollar will mean a strengthening of
the euro (as hot money, state currency reserves, etc,
flow from one to the other). This will raise the
relative price of euro-zone exports, cutting across
the feeble recovery currently under way in Europe.
If US interest rates rise, it is likely that rates in
Europe, Japan and elsewhere will be forced to follow
(to prevent a flight of capital to higher-interest
assets). That would have a depressing effect on growth
in Europe, Japan, etc.
All these likely trends will have a negative impact on
economic growth and the stability of financial
markets. The idea, raised by optimistic commentators,
that China, Japan, Germany, etc, will take over from
the US as locomotives of growth- on the basis of their
domestic markets - is fanciful.
Since the collapse of the dot.com bubble in 2000-2001,
there has been a period of sustained growth in the
At the same time, underlying contradictions,
especially in relation to trade imbalances and
currency misalignments, have been pushed to
The polarisation between rich and poor, in advanced,
semi-developed and poor countries, has also developed
in a grotesque way, preparing the ground for new
The idea, put forward by many capitalist leaders and
their policy-makers, that there can now be a gradual,
managed rebalancing of an extremely unbalanced world
economy is also a complacent dream.
Capitalism works through the competitive drive for
profit and the anarchy of the market. While a certain
level of co-operation between governments is
achievable at times, it is impossible to co-ordinate
and plan capitalism in order to eliminate the cycle of
boom and slump.
True, there currently appears to be a high level of
co-operation between the major capitalist powers
through the IMF, OECD, etc. They all agree that the
living standards of the working class should be cut,
cut and cut again to enhance capitalist profits.
Nevertheless, they remain national states with their
own interests and they will inevitably come into
conflict as they attempt to protect their own
interests and dump the cost of economic crisis onto
For the moment, the May turbulence may be passed off
as just a 'technical correction' of over-heated
markets. But such events do not happen in isolation.
They cannot be separated from the underlying,
contradictory trends in world capitalism.
At least a few financiers heard 'echoes of 1987' in
the May convulsion, recalling the 20% slump in share
markets which prepared the way for the prolonged
recession that began in 1990.
This may have been a tremor rather than an earthquake.
But tremors often precede events that register much
bigger shocks on the Richter scale.
By Lynn Walsh