The financial world is locked into a circle of imbalance. It is imbalanced because the US is booming while running a huge external deficit. Meanwhile, Europe and Japan struggle and run external surpluses; Asia and the Opec members boom by selling to the US. It’s a circle because Japan and Asia and Opec recycle their surpluses back into dollars. And thus the financial world goes round – after a fashion.
So, despite relatively modest growth in the OECD, the share of profits is at or near its historical peak and the cost of capital is near historical lows.
All this is made possible because China and other emerging markets hold down global labour rates as effectively as their own through the threat and reality of job losses in areas where labour costs are high.
World inflation
China is keeping world inflation down because it is not a profit maximizer – the result of its long history as a centrally planned economy. Its economic model is characterized by maximizing volume and size at low margins. China is also able to underpay its workers because its labour supply is so large. And capital is underpriced in China because it is still directed by the state towards huge investment projects of doubtful economic viability.
With global inflation held down, low wage increases enable OECD corporations to make big profits even at expensive facilities that have not been moved to China or elsewhere in Asia.
To complete the circle, Asia’s huge export earnings are recycled back into the US by their central bankers and governments, which are dollar junkies by tradition. So the US current account deficit is financed.
How much longer can the circle of imbalance last? Not for much longer, I would argue.
First, China is undoubtedly a bubble of underpriced labour and capital, and has inadequate policy tools to control the economy. Anybody who goes there can see the evidence of wasted capital. China’s demand for resources from oil to aluminium is hugely excessive when compared with the size and growth rate of its economy. China has a GDP the size of Italy’s but is the world’s second-largest oil consumer.
Wasteful use of resources washes up as inadequate return on capital and as unpaid loans. So far, this has been contained by the state-owned productive sector and the fiscalized bad debts of the state-owned banks. China’s massive household savings, whose owners seem inured to earning lousy returns, fund these bad debts and worthless mountains of capital.
What could bring all this into jeopardy? It would take a lot, because nations that owe their bad debts to themselves can weasel their way out of the crisis for a lot longer than those that are indebted to foreigners.
The most likely cause of a crisis would be a sharp increase in the cost of capital. This might be prompted by the privatization of China’s banks, which could lead to a rise in the cost of credit and a more rational allocation of capital. China’s recent slowing in credit growth might be an indication that this is already happening. This in turn might herald a sharp decline in China’s growth rate, coupled with massive overcapacity in many sectors.
Bonds tank
Nevertheless, a more likely cause of the end of the circle of imbalance could come from outside China. My favourite candidate remains rising US inflation that causes bond markets to tank, whatever the reaction of the US Federal Reserve. My second favourite is a precipitous decline in the dollar caused partly by a sharp fall in the dollar-holding propensity of corporations and, less important, in the holdings of Asian central banks.
Other storm clouds blowing into a sky of complacency include the impact on the US consumer of a housing bust or an energy price shock that pushes the economy into recession. And keep an eye on the balance sheets of US quasi-government agencies – such as Fannie Mae and Freddie Mac – that are heavily exposed to the US mortgage market and financial derivatives. Any crisis there would ripple through the financial sector.
It would take only a couple of these events to occur simultaneously to shatter the current benign global set-up. This might take some time, and meanwhile markets will remain optimistic.
US: corporate profits and German capital income*
% of GDP |
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* Gross entrepreneurial and property income
Source: Datastream |
