Shares go up and down - economy going nowhere
Things are probably both better and worse than we are led to believe. PLUS: Why stock market jitters are 'contagious'.
It can get confusing, this modern capitalism. Especially during a week like the past one, when all the headlines about share price crashes and credit crunches seem to bear little relationship to the real world, where life for most people goes on as normal and living standards continue to rise. So what should we make of the current bout of volatility in the rarefied atmosphere of high finance?
In short: things are probably both better and worse than we might have been led to believe.
On one hand, the stumble in the international credit system and the sharp falls in share prices might be a less serious problem than some alarmist reports and reactions might suggest. It amounts to a financial corrective that need not seriously destabilise the wider economy.
But at the same time, these events can be seen as signs of a far deeper malaise than an immediate fall in share prices. They are the latest symptoms of a moribund economy in the UK and elsewhere in the West, sustained by vast amounts of credit and by the capital being created in the increasingly productive economies of the East.
There might appear to have been a lot happening on the surface of the UK or US economy in recent years, in terms of rising house prices, share prices and incomes. But there is little real dynamism beneath the surface to drive the economy forwards. That is why stock markets and huge financial concerns can be temporarily destabilised by a problem in a dodgy sub-sector of the American mortgage market.
Recent events reveal a Western economy that is both resilient and restricted, with little prospect either of descending into a serious depression, or of breaking its bonds and scaling new heights; an economy where such financial markers as share prices and house prices can go up and sometimes down in apparently dramatic fashion, but where the economic fundamentals seem more likely to just keep bumping along.
Behind the confusion of contradictory statistics and forecasts, the current market volatility clearly confirms that the world economy is now divided into two camps (leaving aside for a moment the impoverished nations that used to, and may again, be called the Third World). The dynamic engine of the global capitalism is in the East, where the post-war economic giant of Japan now competes alongside the rising powers of China and India, their productive industries churning out new capital values.
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In the West, meanwhile, the more ‘mature’ - or perhaps we should stay stagnant - economies of older powers such as the UK are maintained by credit flows, great sums of which come from the East. (This helps to explain the ambivalent Western attitude towards the rise of China, seen as both a threat and a saviour.) These economies have relied for growth upon consumption rather than production, and upon financial rather than industrial activity. Both of these sectors have been fuelled by massive credit expansion, which has been facilitated through the creation of new financial instruments (the area where most British ‘innovation’ now takes place), and the intervention of the central banks. Over the past decade, the banks have pursued crisis management policies that entail pushing more money into the markets whenever problems arise.
The current problems reveal how shallow and artificial such credit-fuelled economic expansion really is. The invention of financial instruments such as the ‘securitisation’ of debt has facilitated flows of credit and capital. But it has also created a situation where not only are debts in a dodgy US mortgage sector spread around the Western finance system, but where the complexities mean that nobody seems to know who owes what to whom. This has sparked the crisis of confidence in the credit markets that spread into share markets last week (see below: Understanding the ‘contagion’ effect, by Daniel Ben-Ami).
It is an over-reaction, however, to say that this means, as many have suggested, ‘the party’s over’ and the days of easy credit are in the past. There is no finite limit to how much credit can be extended within an economy, so long as the cash is available. And within days of the latest ‘credit crunch’, the US Federal Reserve and the central banks of Europe had intervened again to pump new liquidity into the markets and make more credit available to business. This ought to help keep things going beyond the current bout of volatility. The ‘correction’ in the finance markets will hit some hard, and there will undoubtedly be casualties; the short-term future of property prices in the UK will be worrying many. But no, it is not an economic disaster, and certainly not an historic crisis of capitalism.
Yet at the same time, this episode reveals a deeper problem of the moribund and parasitic character of the Western economy. In the UK, where the financial sector focused in the City of London and Canary Wharf is the heart of the economy, capitalism is now more dependent than ever on taking dividends and fees from handling wealth that has been produced elsewhere, and being baled out by flows of foreign credit (see An allergic reaction to fat cats, by Mick Hume).
Despite the rising asset prices and living standards this system can finance, however, there is little dynamic growth in the economy. UK economic growth is forecast to be around 2.8% this year, falling to 2.2% in 2008. American growth is also sluggish. By contrast, the Chinese economy grew by an annual rate of 11.5% in the first half of this year. The result is a widening gap between the financial sector and the ‘real’ economy in the West, so that the price of shares and other assets can rapidly expand - and then sharply contract, as they have lately - while the wider economy and society just plod along.
These are peculiar times, when the Western economy can appear both anaemic and adaptable. Thus, one reason why corporations are equipped to cope with problems today is that many are cash-rich - which is partly a consequence of their failure to make serious productive investments.
But perhaps the main reason why the economy is now so adaptable to problems, and why the central banks have the flexibility to maintain financial support, has more to do with politics than economics. In the past, financial crises often coincided with major political conflicts and class struggles in societies and clashes between rival international powers. For example, this was an important factor in turning the Wall St Crash into the Great Depression. Today, however, in the age of TINA (There is No Alternative), there is no political contestation over the future of capitalism or society. As a result of this coincidence of political decline with economic anaemia, the central banks and financial institutions have more scope to act and to stumble on through a temporary crisis.
Some might think it enough that we now live in a more stable, risk-averse (though never risk-free) market economy, with little prospect of a return of depression. But the flipside is that this is a moribund, dynamism-free economy going nowhere slowly. Despite the flashy shows in the share markets and credit sectors on the surface, there is little here that can address the remaining problems in our society - from the health system to the conquest of space - and offer any realistic prospects to break free from the restraints of the past.
So long as we live in the age of TINA, Western capitalism will be able to cope with some instability in the markets. But at what price in terms of economic and social stagnation? The danger is that our wider aspirations and horizons are falling further while we remain fixated with the ups and downs of share and property prices.
Mick Hume is editor-at-large at spiked
UNDERSTANDING THE CONTAGION EFFECT
by Daniel Ben-Ami
A key lesson of the recent bouts of volatility in the financial markets is that risk cannot be eliminated completely. Although it is possible to manage and sometimes reduce risk in one area it tends to manifest itself in different forms and new areas. This shift in risk is central to explaining how problems in one market – the American mortgage market – have recently been transmitted to global bond and stockmarkets. Yet this ‘contagion’ effect is rarely explained properly in media coverage of the turmoil.
The backdrop to this contagion effect is a fundamental change in the way finance works over the past quarter century. The financial system used to be centred on banks. Banks lent money to borrowers and if the borrowers got into trouble the banks also suffered. Yet over time the system has changed. Finance is now centred on the capital markets rather than banks. This means that debt has become securitised – essentially turned into IOUs – and is traded between different institutions. So a company might issue a bond on the markets to raise money, then the bond might be sold to an insurance company which might sell it on to a hedge fund.
Such securitisation has come to play a central role in the American mortgage markets. As far as individuals are concerned they might see themselves as borrowing money from a mortgage lender as before. But the lender is likely to bundle mortgages together – creating what are known as mortgage-backed securities - and then sell them on to other institutions.
This is exactly now the problems in the American mortgage market became transmitted elsewhere. Institutions which are not directly involved in the American mortgage market, such as hedge funds and European banks, found themselves in trouble when US borrowers started suffering repayment problems. To make matters worse, no one knew exactly who held the bad debt or its exact amount. The contagion then had a knock-on effect on other areas of the market. For example, liquidity dried up as banks became reluctant to lend to each other. As investors became nervous they also demanded greater compensation for taking risks – making it more expensive for companies to raise funds.
Eventually the world’s key central banks felt compelled to intervene by pumping money into the markets. America’s Federal Reserve, the Bank of Japan and the European Central Bank all injected substantial funds. The Fed also lowered one of its key interest rates.
It is important to recognise that the process of securitisation described here does not necessarily increase risk overall. On the contrary, by spreading risk more widely it can often give increased resilience to the financial system. But it can also leave the financial markets more vulnerable to contagion effects.
There is no escape from risk. In finance, as in life in general, it always exists in one form or another.
Daniel Ben-Ami is a financial journalist and author based in London. Visit his website here.