Bubble Economics: When the ship hits the fan


Roshan Madawela – Research Intelligence Unit – www.riunit.com

The most recent wave of stock market slumps all round the globe can be attributed to speculative forces and panic selling rather than any fundamental collapses. However, there is a school of thought that says that the unsustainable structure of the US economy is now taking its toll on its trade partners.

Currency markets

End of February witnessed a new two month low in the US dollar against the Euro as analysts speculated on the dawning of a state-wide housing slump. Further, the greenback weakened against 13 of the world’s 16 most active currencies amidst speculation of a lower growth forecast for the fourth quarter. The U.S. currency has dropped six percent against the euro in the past year.

In London the dollar traded at $1.3184 per Euro and is expected to fall to $1.36 per Euro by mid-2007 due to key financial parameters. For instance, the Federal Reserve’s target overnight lending rate between banks of 5.25 per cent is 1.75 per cent higher than the European Central Bank’s rate whilst the yield premium that investors earn on ten year US Treasuries compared with similar maturity German bonds reached 0.613 per cent, chipping-away at the comparative lure of the US as a choice destination. Real Estate, also a driving force of the US economy is weakening with sales of new homes declining 3.6 per cent in January according to sources.

The slip in the dollar also came in the wake of a Royal Bank of Scotland survey showing that 19 of 47 Central Banks surveyed cut their share of dollar reserves and 21 have raised their holdings of euro according to Bloomberg sources.

However, some traders believe that the dollar is not likely to free-fall due to vested interests that will intervene in order to protect options. It is expected that buying will be triggered at around $1.32 per euro thereby serving to stem the decline. Options give holders the right to buy or sell a currency at a set price at a fixed future date. Furthermore, the dollar is likely to strengthen by up to four per cent against the Japanese yen by mid-year due to the expectation that Japan’s Central Bank will not raise rates before the fourth quarter, according to sources at the world’s largest currency trader, Deutsch Bank AG.

Bubble economics

Commentators have argued that the recent US equity bubble that spurred the continuation of artificially low interest rates and a reckless expansion of the money supply has served to further deteriorate the income and wealth disparities in the US. The recent phenomenon has effectively shifted billions of dollars from the poor to the rich and if it continues unabated, may even threaten democracy in the long run.

Internationally, each and every time the dollar is traded, a check is drawn against an account that is overdrawn by $8.6 trillion, the estimated size of the US national debt. Mike Whiteny describes it as the biggest swindle in history. He argues that the only reason why the world continues to engage in dollar denominated trade is due to the glutinous US consumerism that is commonly referred to as the engine of global growth, sucking in exports from all corners of the globe. Monopoly status of the dollar in global trade is also supported by the functioning of the petro-dollar which is underpinned with unsubtle the threat of force.

The US love for consumer spending is unparalleled and the world marvels at its obsession with electronic gadgetry and craving for the latest fashions and other consumer goods. The shopping mall is at the center of the US consumer culture that drives the economy. Consumer spending is estimated to account for 70 per cent of GDP. However, recent data indicates that the US consumer is staring to come apart at the seams under the strain of personal debt. The AP reported that US saving are at the lowest rate since the Great Depression. The Commerce Department has confirmed this, reporting that the nation’s personal savings rate for 2006 was a negative one per cent, the worst in 73 years.

Skyrocketing credit card debt is also another feature of the phenomenon that analysts say is an indication that home owners are no longer able to leverage easy money from their home equity. Moreover, rumblings of a real estate crash in parts of the continent have served to reduce the mortgage value of many properties. Last year an estimated $825 billion worth of loans were extracted from real estate equity. The signs are that the housing bubble is on a downward roll.

The other cornerstone of the dollar supremacy its inseparable link to the worlds’ oil trade. Following Washington’s decision to default on payment of gold in kind for foreign dollar holdings in August 1971, the US entered into an ironclad agreement with Saudi Arabia to support the House of Saud in return for accepting only US dollars for its oil. Subsequently, other Gulf States and the rest of OPEC followed to secure the dollar with a monopoly position in any oil transaction. With the spread of these interlocking agreements and the world’s growing thirst for more and more oil, the global demand for dollars only rose.

Today some 70 per cent of the world’s oil is denominated in dollars with even Russia using the greenback for oil transactions until last year. This is the status quo that the Whitehouse is fighting to maintain as it allows the leadership a free hand in expanding the public budget. It is the most significant factor as to why the Fed was able to raise money supply last year by a massive 15 per cent. Conversely, a massive current account deficit of some $800 billion per annum has prevented hyperinflation as the Asian giants together with the oil exporters soak up the US debt.

Bush’s plans for 2007-2008 include an unprecedented $700 billion for foreign wars. The fact that he can raise such funds sans the conventional means of doing so via export growth, tax increases and / or economic expansion is a testament to the power of the petro-dollar. By forcing foreign central banks to hold increasing reserves of the dollar, he can shift the US debt on to trading partners in foreign lands. According to sources at The International Forecaster, US debt was up 10.1 per cent to 4.085 trillion last year and now accounts for over 58.8 per cent of total 2006 globally issued credit.

Any attempts to move away from trading oil in dollars on the part of foreign governments has been met with negative propaganda – Russia, outright threats of military action – Iran, Venezuela or outright military attack - Iraq.

Gradual change

However, if rebellion is out of the question, quite transition is taking place as more and more central banks start to diversify into the euro or a mixed basket at the expense of the greenback. Analysts note that the central banks around the world are now watching for any sign of cracks like in American consumer confidence. As soon as that happens, bank managers everywhere will swing into action, ditch their U.S. dollars and head for the exits. When the “global engine” sputters to a halt; it could be curtains for the greenback.

During the recent Davos World Economic Forum meeting in Switzerland, Malaysian Prime Minister Ahmad Badawi said in an interview that his country had shifted $82 billion of currency reserves away from the dollar as measure to protect Malaysian exporters. He also admitted that they have cut their dollar holding and will watch the situation in order to take further measures as required.

He is not alone. Kuwait’s Finance Minister has also said this year that the Arab state, the world’s third largest oil producer, may abandon the dinar’s peg against the dollar in favor of a basket of currencies.

Malaysia unpegged from the dollar in July 2005 and switched to an undisclosed basket of currencies. The ringgit has gained 0.7 per cent on the dollar this year and is the world second best performing currency next to Iceland. The Malaysian Central Bank has on occasion declined to comment on the issue of diversification of currencies and foreign exchange policy.


Chinese arithmetic

The dangers of a sliding dollar were enunciated by China’s Central Bank in December last year. The statement said;

“If external capital stops flowing into the US, a significant drop in the dollar may occur with consumption and investment shrinking, interest rates rising, and financial markets experiencing turbulence, endangering global financial and economic stability. There could be adjustments to how European private capital, Asian foreign exchange reserves and oil export proceeds are invested.”

Adding that;

“If the US current account deficit continues to grow faster than GDP, then the investment value of US assets may be subject to doubts and challenges and the willingness of investors to continue holding and buying US financial products may weaken. This could cause changes in capital flows, the exchange rates of major currencies, and the value of foreign exchange assets.”

The Chinese message is clear - “If you keep spending more than you are taking in; the stock market will fall, the dollar will plummet, and the US economy will tank”.

Within the US, pressure is set to mount this year for a devaluation of the dollar. Democrats now controlling Congress have long called for the revaluation of the Chinese and Japanese currencies, which in effect will devalue the dollar. However, the calls have fallen on deaf ears and consequently cheaper imports, particularly from China have flooded the US thereby further straining the current account balance. A case in point, the record breaking loss announced last year by Ford of $13 billion is at least in part due to Tokyo’s weak yen policy. The loss surpassed the previous record of $11 billion by General Motors according to The Asia Times.

Analysts also expect inflation to rise over the course of this year and this will knock on to the dollar-denominated agricultural produce. In reaction, many Central Banks around the world might start to switch their reserves out of dollars in order to avoid imported inflation, some thing that is already now in motion.

Main source: Information Clearing House, Asia Times, Lanka Business Online, Associated Press, Bloomberg, BBC.

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