Photograph: Tony Gentile/Reuters.
By Jack Rasmus
Originally published in Kyklos Publications.
Much like a perfect storm at sea is the consequence of three converging bad weather fronts, three significant global economic trends have begun to intensify and converge in recent months: (1) a slowing of the China economy and a parallel growing financial instability in its shadow banking system; (2) a collapse in emerging markets currencies (India, Brazil, Turkey, South Africa, Indonesia, etc.) and their economic slowdown; (3) a continued drift toward deflation in the Eurozone economies, led by growing problems in Italy and economic stagnation now spreading to France, the Eurozone’s second largest economy.
The problems in these three critical areas of the global economy, moreover, have begun to feed off of each other. As of early February 2014, U.S. stock markets have begun a major correction and decline. Effects on the U.S. real economy and policy in the short to medium term are also emerging—as the latest data for weakening U.S. construction, manufacturing, job creation, and slowing auto sales for January have begun to reveal.
Three Phases of the Global Economic Crisis
The first phase of today’s continuing global economic crisis was centered in the U.S. economy during the 2007-2010 period. An already slowing real economy by 2007 was hammered by the overlay of a severe financial crash in 2008 that shut down U.S. credit markets in general and precipitated an especially severe epic recession.
U.S. economic policies of 2008-09 in response to the crisis served to bail out financial institutions, corporations, and wealthy investors, but did little to jumpstart the rest of the economy. The theory was that by bailing out the banks, corporations and investors they would respond, in turn, by investing and creating jobs in the U.S. But they didn’t. Much of the $3 trillion fiscal stimulus from 2008-10 (tax cuts and government spending) rescued non-bank corporate America, which then largely hoarded the money or invested offshore. Meanwhile, more than $15 trillion in monetary stimulus—in the form of five years of near zero Federal Reserve interest loans issued to financial institutions plus more than $4 trillion of Fed QE purchases of securities held by the wealthy and shadow banks—bailed out financial America.
Together the fiscal and monetary stimulus programs set off record booms in U.S. and global stock, bond, derivatives, and other financial asset markets that benefitted the wealthiest households—but left the remaining 80 percent households, more than 100 million in the U.S., behind. Not surprising, wealthy investors and their institutions accrued 95 percent of all the income gains after 2009 through 2013 as a result. Those gains flowed not to the U.S. economy, but to offshore emerging markets, to financial securities speculation, or were otherwise simply hoarded as cash on balance sheets and in offshore tax haven accounts.
The second phase of the global crisis centered on Europe. Accompanying the U.S. sharp decline in 2008-09, the Euro economies experienced an even briefer, weaker recovery than the U.S. in 2009-10. The Euro economies thereafter slipped into a second recession by 2011-12, as financial instability and financial crisis shifted from the U.S. to the Euro area in the second phase of the global crisis.
The Euro financial crisis has assumed the appearance of a sovereign (government) debt crisis, but in its essence that crisis has always been a Euro banking-financial system crisis. Having no true central bank like the Federal Reserve, the Euro governments attempted instead to bail out their banks after 2008 by loans to governments which in order to bailout their respective banks. But insufficient bailout funds and problems of distributing bail outs through governments to the banks failed to resolve the crisis. Meanwhile, governments in the most seriously affected economies in the Euro periphery went even deeper in debt. Those governments then attempted to offset rising government deficits by means of austerity policies, designed to make average citizens pay for the rising government debt and the bank bailouts. The Euro strategy of bank bailout by sovereign debt expansion—instead of central bank liquidity injection as in the U.S.—was not successful. Sovereign debt continued to rise, the Euro banks grew weaker, and austerity policies caused a further economic deterioration which exacerbated deficits and the sovereign debt situation even further.
The global shadow bank system (read: professional speculators) made the situation in the Eurozone even worse. They further exacerbated the sovereign debt crisis by speculating in, and driving down, the value of government bonds, especially in the southern Euro periphery, thus raising bailout costs even further.
In the latest strategic shift, Eurozone governments are now moving toward policies to stimulate their economies at the direct expense of workers’ wages and benefits. What’s euphemistically called ‘labor market reform’ means to reduce wages in order to make Eurozone exports more competitive globally. Instead of formally devaluing the Euro and other European currencies, the strategy is to ‘devalue by wage reduction’.
But neither an increase in bank lending nor reduction of business costs has generated investment and recovery—in the U.S. or Europe. Real, job creating investment is slowing everywhere globally. In both the U.S. and Europe, wealthy investors, their corporations, and their financial institutions have instead hoarded the cash, invested it in global financial markets, or invested it in emerging markets (China, Brazil, etc.) real economies. That is, until now.
As of 2014, the 3rd phase of the global economic crisis has now begun. The massive capital diversion from the U.S. and Europe to China and the emerging market, that occurred from 2009 through 2013, made possible by the bailout policies introduced in the U.S. and Europe during those years, is now beginning to flow back from the emerging markets.
Thus the locus of the global crisis that first erupted in 2008 in the U.S., then shifted to Europe between 2010 2013 has now shifted again to the emerging market economies. Financial and economic instability is now emerging and deepening in offshore markets as well—including China.
China’s Slowdown & Growing Fragility
Prior to the 2008 global financial crisis and recession, China’s economy was growing at an annual rate of 14 percent. Today that rate is 7.5 percent, with the strong possibility of a still much slower rate of growth in 2014.
China initially slowed economically in 2008 but quickly recovered and grew more rapidly by 2009—unlike the U.S. and Europe. A massive fiscal stimulus of about 15 percent of its GDP, or 3 times the size of the comparable U.S. stimulus of 2009, was responsible for China’s quick recovery. That fiscal stimulus focused on government-direct investment in infrastructure, unlike the U.S. 2009 stimulus that largely focused on subsidies to states and tax cuts for business and investors. In 2007-08 China also had no shadow banking problem to speak of. So the expansionary monetary policies it introduced, along with its stimulus, further aided its rapid recovery by 2010. Since 2012, however, China has been encountering a growing problem with global shadow banks that have been destabilizing its housing and local government debt markets. At the same time, beginning in 2012, the China non-financial economy, including its manufacturing and export sectors, has been showing distinct signs of slowing as well.
On the financial side, total debt (government and private) in China has risen from 130 percent of GDP in 2008 to 230 percent of GDP, with shadow banks share rising from 25 percent in 2008 to 90 percent of the totals by 2013. So shadow banks share of total debt has almost quadrupled and represents nearly all the debt as share of GDP increase since 2008. Shadow banks have thus been the driving force behind China’s growing local debt problem and emerging financial fragility.
Much of that debt increase has been directed into a local housing bubble and an accompanying local government debt bubble, as local governments have pushed housing, new enterprise lending, and local infrastructure projects to the limit. Local government debt was estimated in 2011 by China central government at $1.7 trillion. It has grown in just 2 years to more than $5 trillion by some estimates. Much of that debt is also short term. It is thus highly unstable, subject to unpredictable defaults, and could spread and destabilize a broader segment of the financial system in China—much like subprime mortgages did in the U.S. before.
A run-up in private sector debt is now approaching critical proportions in China. A major global instability event could easily erupt there, in the event of a default of a bank or a financial product. In some ways, China’s situation today increasingly appears like the U.S. housing and U.S. state and local government debt markets circa 2006. China may, in other words, be approaching its own Lehman Moment. That, in fact, almost occurred a few months ago with financial trusts in China. Fearing a potential default by the China Credit Trust, and its spread, investors were bailed out at the last moment by China central government. According to the Wall St. Journal, the event “exposes the weakness of the shadow banking system that has sprung up since 2009.
Growing financial instability in China in its local markets is thus a major potential problem for China, and for the global economy as well, as both China and the world economy begin to slow in 2014.
Early in 2013, China policymakers recognized the growing problem of shadow banks and bubbles in its local housing and investment markets. Speculators had driven housing prices up by more than 20 percent in its major cities by 2013, from a more or less stable 3-5 percent annual housing market inflation rate in 2010. China leaders therefore attempted to rein in the shadow banks in May-June 2013 by reducing credit throughout the economy. But that provoked a serious slowdown of the rest of the economy in the spring of 2013. Politicians then returned on the money spigot quickly again by summer 2013 and added another mini-fiscal stimulus package to boost the faltering economy. That stimulus targeted government spending on transport infrastructure, on reducing costs of exports for businesses, and reducing taxes for smaller businesses. The economy recovered in the second half of 2013.
By early 2014, the housing bubble has again appeared to gather steam, while the real economy shows signs once again of slowing as well. In early 2014 it appears once again that China policymakers intend to go after its shadow bank-housing bubble this spring 2014. That will most likely mean another policy-initiated slowing of the China economy, as occurred in the spring of 2013 a year earlier. But that’s not all. Overlaid on the financial instability, and the economic slowdown that confronting that instability will provoke, are a number of other factors contributing to still further slowing of the China economy in 2014.
Apart from the economy’s recent fiscal stimulus and its overheated housing markets, China’s other major source of economic growth is its manufacturing sector, and manufacturing exports in particular. And that, too, is slowing. The reasons for the slowing in manufacturing and exports lie in both internal developments within the Chinese economy as well as problems growing in the Euro and Emerging market economies.
China is experiencing rising wages and a worsening exchange rate for its currency, the Yuan. Both are raising its manufacturing costs of production and in turn making its exports less competitive. Rising costs of production are even leading to an exodus of global multinational corporations from China, headed for even cheaper cost economies like Vietnam, Thailand, and elsewhere.
The majority of China’s exports go to Europe and to emerging markets, not just to the U.S. And as emerging market economies slow, their demand for China manufactured goods and exports declines. Conversely, as China itself slows economically, it reduces its imports of commodities, semi-finished goods, and raw materials from the emerging market world (as well as from key markets like Australia and Korea).
Similar trade-related effects exist between China and the Eurozone. China in fact is Germany’s largest source for its exports, larger even than German exports to the rest of Europe. So if China slows, it will require fewer exports from Europe, which will slow the already stagnant Eurozone economies even further. Similarly, as Europe stagnates, it means less demand for China goods—and thus a further slowing of China’s manufacturing. In other words, China’s internal slowdown will exacerbate stagnation and deflation in Europe, as well as contribute to an even faster economic slowing now underway in the emerging market world.
Slowing will result as well from government policies designed to structurally shift the economy to a more consumption driven focus. That shift to consumption will begin in earnest following the Community Party’s March 2014 meeting. But consumption in China represents only 35% percent of the economy (unlike 70 percent) in the U.S., while China government investment is well over 40 percent of GDP. And it is not likely that consumption can grow faster enough to offset the reduction in investment, at least not initially.
So a long list of imminent major developments and trends in China point to a slowing of growth in that key global economy of almost $10 trillion a year. What happens in China, the second largest economy in the world, has and will continue to have a major negative impact on an already slowing Emerging Markets and a chronically stagnant Eurozone.
The Eurozone Drift Toward Deflation
After experiencing an even weaker and briefer recovery from the 2008-09 U.S. financial crash and recession, compared to the U.S. and China recoveries, Europe entered a bona fide double dip recession again relatively quickly in 2011-2012. In the second quarter of 2013, the Eurozone emerged from that official double dip, but only barely—growing at a meager 0.4 percent GDP rate. The Eurozone’s overall growth rate for all of 2013 is not expected to exceed 0.8 percent at best. Meanwhile, forecasts for 2014 growth have been repeatedly revised downward by the IMF and other research sources.
The strongest Eurozone economy, Germany, grew only 1.3 percent in 2013. Other major economies like Italy and France have fared worse. Both Italy and France appear to have returned to slightly negative growth rates in the second half of 2013, and throughout the southern periphery of the Eurozone stagnation at depression levels remains the case.
It has been argued that Germany’s export-driven growth is at the expense of slower growth in the rest of the Eurozone, the periphery at least. For example, German exports to Spain and elsewhere, which buys its goods, requires further lending from Germany and other economies to the periphery economies in order for the latter to afford to purchase the German goods. So Germany’s intra-Europe exports are driven by continued rise in deficits and debt in the Eurozone periphery economies, it is argued. The periphery then is forced to engage in deficit cutting (austerity) in order to pay for the credit from Germany. That austerity subsequently slows the periphery economies, requiring more borrowing to buy the exports, and so on.
The U.S. and other economies outside Germany have consequently begun to demand of Germany that it stimulate its own economy internally by increasing government spending and other measures, and not by means of exports. But that means more government spending or fiscal stimulus within Germany itself. So far Germany has resisted such calls and continues to drive its economy via exports, and with that keeps the Eurozone periphery in a kind of economic bondage to it. That will not change. With German exports to China likely to decline, Germany will undoubtedly adhere to its intro-Eurozone export strategy even more, keeping the periphery dependent upon it and forced to continue with austerity policies that will keep the Eurozone locked into a stagnant recovery at best and a possible relapse to a triple dip recession in the not distant future. Meanwhile, Germany will also continue to resist the creation of anything resembling a true Banking Union in the Eurozone, thus ensuring no permanent solution to Europe’s continuing banking fragility.
The Eurozone’s continuing stagnation is reflected more accurately in its current drift toward deflation, than in GDP numbers. Prices decline and turn negative when there is no demand for goods and services by the general population. Demand for goods and services depends on income growth by households and that depends on jobs. The Eurozone economy is stuck almost everywhere in an unemployment rate averaging 12-13 percent for four years now. Unemployment rates in the periphery remain at depression levels of 25 percent or more. Youth unemployment is particularly serious, from 40 to 60 percent in the periphery and more than 20 percent even in economies like France. Moreover, jobs that are created are mostly part time and temp jobs, with low pay—a problem common to capitalist economies in the US and worldwide. Low and declining wages in the Eurozone, chronic high joblessness, and austerity policies cutting government spending and services–and now targeting wages—all translate into a continuing drift toward deflation.
The Eurozone economy’s weakness is reflected not only in general deflation trends, in German insistence on its intra-zone export focus, or on German dependence on slowing China demand for its goods. It is also evident in the spread of the internal Eurozone crisis from the periphery economies to the core economies, like France.
At year end 2013, French manufacturing turned negative and has begun to contract. French export growth is slowing. Business investment fell throughout 2013. And the French economy has stagnated at zero growth, at best. France has become the new sick man of the Eurozone, joining Italy and the southern periphery economies.
Overlay on the above internal forces ensuring a stagnant Euro economy is the rapid decline now underway in currency values in the emerging markets. That means a rising Euro currency. That makes Euro exports to emerging markets more expensive. Less exports means Eurozone manufacturing slows still further and along with it the Eurozone economy. In addition, the currency instability in the emerging markets may likely negatively impact those Euro economies in eastern Europe that are not yet officially part of the Eurozone’s Euro currency, which will have spillover effects on the Eurozone as well. Thirdly, currency instability in the emerging markets means Eurozone companies doing significant business in those economies will now experience major losses of revenue and profits. That could reduce their investment expenditures at home in the Eurozone as they attempt to make up for losses offshore.
In short, the Eurozone is locked into some serious intransigent economic problems. The new emerging slowdown in China and emerging markets will only make them worse.
Emerging Markets Currency Crisis
Thirdly, and not least, barometric pressure is also rising along the emerging market storm front as a result of the U.S. federal reserve now clearly committed to reducing QE monthly spending. At its last January 29, 2014 meeting, another $10 billion a month was reduced from the Fed’s monthly QE purchases of bonds from banks and investors, now at $65 billion a month from an original $85 billion in 2013. A slow, but progressive further retreat by the Fed over the course of the coming year in QE purchases is also likely.
As a direct consequence of the Fed’s QE policy shift, emerging markets have begun to destabilize financially and slow economically once again—a development in some ways reminiscent of the 1997-2000 ‘Asian Meltdown’. Already volatile and wobbly from the Fed’s on again-off again QE tapering indecision throughout 2013, now that the Fed has again embarked on, a reduction of QE purchases, emerging markets economies currencies have begun falling again from Asia to Latin America to Turkey and other points east, as it becomes clearer that more tapering is coming. Several attempts thus far by the central banks of those countries to intervene to prop up their currencies and stave off capital flight have proven repeatedly to have failed.
Even though the Fed had given the emerging markets nine months to prepare since last May when the first suggestion of a QE taper policy arose, emerging markets have not done much to prepare. Consequently, the massive flow of cheap capital that rushed into emerging markets after 2008 (made possible by the Fed and central banks worldwide in the form of QE and near zero interest money policies) is now reversing rapidly and flowing back to the U.S., Europe, Japan and the west again.
The currency decline-capital flight-slowing economy scenario promises to become a dangerous, self-amplifying downward spiral. As the capital flows out of the emerging markets, their currencies further collapse. Since late 2013 major emerging market currencies have fallen 10%-20% in a matter of months.
Foreign investors don’t want to hold investments in those countries when their currencies decline, since it means accepting big losses on their investments in those markets. They therefore sell their investments there .They then convert (i.e. sell) the currencies of those countries to safe currencies like the dollar or the Yen. Selling of investments and currencies is quickly reflected in a collapse of stock market values in those countries. Since the beginning of 2014, emerging market stocks have also been in freefall. Stock market declines set off still further selling of the currency by foreign investors. And so on, in a vicious cycle of selling of investments, converting of currencies, stock market collapses, and capital flight, and slowing real investment and economies in the emerging markets.
As emerging market economies slow, they attempt to restore domestic growth by stimulating their exports. That usually means making their exports more competitive by reducing costs of production, which translates into cutting jobs and wages—much as in the Eurozone.
The process has been the most intense in countries like India, Turkey, South Africa, Brazil, Indonesia and Russia. All have raised, or are about to raise, interest rates to slow their currency declines and to reduce capital flight. In the process their domestic economies are shifting to lower growth. Real economic growth in all the aforementioned economies is slowing rapidly. Several economies are likely to enter recession before year end 2014. In turn, their rapid economic slowdown will mean slowing of Eurozone and China economies in turn.
The emerging market economic crisis beginning to unfold is perhaps now the most serious storm front of the three in question: China, Eurozone, and emerging markets. The emerging markets decline has been set in motion by the major policy shift of the Federal Reserve in recent months. But the decline will cause a further deterioration and slowdown in both the Eurozone and China economies—just as those countries economies, as they slow further, will intensify the slowing in the emerging markets.
In other words, a perfect storm may be brewing that will slow global trade in 2014, with consequences for mega-regional domestic economies like the Eurozone, China and the emerging markets. The question is how will the U.S. economy perform in the face of the worst case scenarios, and as the Eurozone-China- emerging markets feed off each other in a negative way?
The global economy is now entering a third phase of the continuing economic crisis. This phase, now emerging in 2014, is characterized by intensifying feedback, or mutually amplifying, effects between the various sectors of the global economy. In the 2010-2013 second phase, the mutual amplifying effects between global sectors dampened. The U.S. economy stabilized at a low-to-stagnant recovery growth rate, China and emerging markets recovered rapidly and robustly, and Europe descended into a muted banking crisis of its own and a moderate double dip recession.
However, 2014 and the 3rd phase may prove different, with similarities more like the first phase, 2007-2009, than the second. The coming year may witness the return to mutually amplifying effects across the global economy. China has begun to slow economically and to experience growing financial instability. That slowing and instability could prove much worse than anticipated. If either occurs, the effect of China on the rest of the global economy could be significant, and especially so for the other two weakest sectors: the Eurozone and the Emerging Market economies. An already very fragile Eurozone economy could easily slip back into recession, with negative feedback effects on both China and emerging markets. But the Emerging market crisis now unfolding could prove the most destabilizing of all, with its feedback effects potentially even greater. All three sectors may provoke through their interactions a qualitatively more severe global result. How the U.S. economy responds to the emerging global perfect storm will prove interesting, to say the least.