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5 Liquidity boom and looming
crisis By Henry C K Liu
Economic growth in the US slowed to 1.3%
in the first quarter (Q1) of 2007, the worst
performance in four years of an overextended debt
bubble. Yet the Dow Jones Industrial Average
(DJIA) rose to an all-time intra-day high of
13,284.53 to close at 13,264.62 last Friday,
rising more than 1,000 points or 9% in the same
period.
The DJIA is now 82% higher than
its low of 7,286.27 on October
9,
2002, during which US gross domestic product (GDP)
grew only 38%.
The 10-year cycle of
financial crises The historical pattern of
a 10-year rhythm of cyclical financial crises
looms as a menacing storm cloud over the financial
markets.
The 30% US market crash of 1987,
in which investors lost 10% of 1987 GDP, was set
off by the 1985 Plaza Accord to push down the
Japanese yen with an aim of reducing the growing
US trade deficit with Japan. The 1987 crash was
followed 10 years later by the Asian financial
crisis of July 2, 1997, with all Asian economies
going broke, and some stock markets such as
Thailand's losing 75% of their value, and Hong
Kong having to raise its overnight deposit rate to
500%, trying to defend the fixed exchange rates of
their currencies.
In South Korea, Daewoo
Motors, facing bankruptcy, was forced to be taken
over on the cheap by General Motors. In Indonesia,
the Suharto government fell because of social
instability arising from the financial crisis. A
wave of deflation spread over all of Asia from
which Japan, already in recession since 1987, has
yet to fully recover two decades later. In the
United States, the DJIA dropped 7.2% on October
27, 1997, and the New York Stock Exchange had to
suspend trading briefly to break the free fall.
Now in 2007, a looming debt-driven
financial crisis threatens to put an end to the
decade-long liquidity boom that has been generated
by the circular flow of trade deficits back into
capital-account surpluses through the conduit of
US dollar hegemony.
While the specific
details of these recurring financial crises are
not congruent, the fundamental causality is
similar. Highly leveraged short-term borrowing of
low-interest currencies was used to finance
high-return long-term investments in high-interest
currencies through "carry trade" and currency
arbitrage, with projected future cash flow booked
as current profit to push up share prices.
In all these cases, a point was reached
where the scale tipped to reverse the irrational
rise in asset prices beyond market fundamentals.
Market analysts call such reversals "paradigm
shifts". One such shift was a steady fall in the
exchange value of the US dollar, the main reserve
currency in international trade and finance, to
cause a sudden market meltdown that quickly spread
across national borders through contagion with
selling in strong markets to try to save hopeless
positions in distressed markets.
There are
ominous signs that such a point is now again
imminent, in fact overdue, in globalized markets
around the world.
Weak economic
data US GDP growth of 1.3% for Q1 2007
announced by the Commerce Department on April 27
was weaker by almost half than the 2.5% growth
rate logged in the fourth quarter (Q4) of 2006.
The main culprit was a housing slump caused by a
meltdown in the subprime mortgage sector.
US home-building dropped by 17% on an
annualized basis and is expected to worsen. That
happened after investment in home-building was
slashed at an even deeper 19.8% pace in Q4 2006.
There are no signs that the housing slump has hit
bottom, or that its adverse impact on the economy
and the financial market has been fully felt
globally.
Deprived of expanding wealth
effect by falling home prices, US consumer
spending was up only 0.3% in April on a 0.7% rise
in personal income, while core inflation was
muted. Consensus estimates had been for a 0.5%
rise in spending on a 0.6% gain in income.
Adjusted for inflation, consumer spending was
actually 0.2% lower month on month, its biggest
drop since September 2005, suggesting that without
additional cash-out refinancing on rising home
values, high energy prices might have finally
dampened consumer willingness and ability to spend
on non-energy purchases.
GDP measures the
value of all goods and services produced in a
domestic economy. It is considered by economists
and policymakers to be the best overall barometer
of economic health. US economic performance in Q1
2007 was weaker by 0.5 percentage point than even
the forecast low expectation of 1.8%.
US
Federal Reserve chairman Ben Bernanke and Treasury
Secretary Henry Paulson both made obligatorily
optimistic statements denying the likelihood of a
recession this year, even though former Fed chief
Alan Greenspan has openly put the odds at one in
three.
Even though the US economy slowed
in Q1 2007, inflation pressure continues to
complicate Fed policy deliberation. Core prices,
excluding food and energy, rose at a rate of 2.2%
in Q1 2007, up from a 1.8% pace in Q4 2006.
Overall prices jumped by 3.4% in Q1 2007, compared
with a 1.0% decline on an annualized basis in Q4
2006.
The Fed's dilemma While
Federal Reserve policymakers traditionally view
inflation as the main danger to the economy, they
optimistically predict that inflation will
moderate as the US central bank stays with a tight
monetary policy.
Since last June 29, the
Federal Reserve has not moved the Fed Funds Rate
target, the interest rate at which depository
institutions lend balances to each other
overnight. Before that, it had lifted rates 17
times at a "measured pace" of 25 basis points over
a 36-month period, for a total 425 basis points to
ward off inflation. The current Fed Funds Rate
target is 5.25%, from a low of 1% set on June 25,
2003. Many economists and money-market
participants predict that the Fed will continue to
leave rates unchanged at its next meeting this
Wednesday.
The Fed's stated goal is to
cool an overheated economy sufficiently to keep
inflation in check by raising short-term interest
rates, but not so much as to provoke a recession.
Yet in this age of finance and credit derivatives,
the Fed's interest-rate policy no longer holds
dictatorial command over the supply of liquidity
in the economy. Virtual money created by
structured finance has reduced all central banks
to the status of mere players rather than key
conductors of financial markets. The Fed now finds
itself in a difficult position of being between a
rock and a hard place, facing a liquidity boom
that decouples rising equity markets from a
slowing underlying economy that can easily turn
toward stagflation, with slow growth accompanied
by high inflation.
Wealth effect
exhausted, dissipated by
maldistribution The wealth effect from
rising equity prices has been caused directly by a
debt bubble fed by overflowing liquidity created
beyond the Fed's control, by the US trade deficit
denominated in dollars returning to the US as
capital-account surpluses. This debt-driven
liquidity boom is exacerbated by a falling dollar,
which artificially inflates offshore earnings of
transnational corporations
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