Clouds Gather
Over
World Economy
By Nick Beams
17 May 2005
World
Socialist Web
While
the official forecasts are still for strong economic growth, a number
of storm clouds are gathering over the world economy. They include:
recession or near-recession conditions in a number of eurozone countries,
doubts about the direction of the US economy and concerns that financial
markets could face considerable turmoil if major hedge funds start to
run into trouble.
The continued failure
of the eurozone to provide a stimulus to world growth was highlighted
by data from Italy and France last week. Italy has now officially moved
into a recession with figures showing that the countrys gross
domestic product (GDP) fell by 0.5 percent in the first quarter, following
a 0.4 percent decline for the previous three months. The downturn is
one of the deepest experienced by a eurozone country since the introduction
of the common currency in 1999.
France could shortly
go the same way. Up to now it has been one of the strongest of the eurozone
economies but the latest figures show that manufacturing output was
down by 0.3 percent for the first three months of the year, with a drop
of 0.9 percent from February to March. While Italy has now joined the
Netherlands in recession, the eurozone as a whole is still growing.
Overall GDP rose by 0.5 percent in the first quarter, after a 0.2 percent
increase in the previous three months. But there are concerns that the
trend could be soon reversed because of the impact of higher oil prices
and the increase in the euros value against the dollar that took
place last year.
Across the Atlantic,
the US economy is slowing amid warnings that it is entering another
soft patch. Last month the Bureau of Economic Analysis reported
that real GDP increased at an annual rate of 3.1 percent in the first
quarter, down from the rate of 3.8 percent in the last quarter of 2004.
While these figures indicate that the US is still on a recovery
path from the recession of 2001, a different picture emerges from employment
and wage numbers.
These figures show
there are still 22,000 fewer private sector jobs than when the recession
started in March 2001 and that real wages have fallen in the past six
months. Since the start of the recovery in the fourth quarter of 2001,
real private wage and salary income has only increased by 5.3 percent.
As the Economic Policy Institute noted, the average increase for all
economic recoveries lasting 11 quarters or more from 1947 to 1982 is
18.3 percent and even in the jobless recovery of the early
1990s there was an 8.1 percent growth in wages. What these figures indicate
is that rather than experiencing a recovery, the US economy may well
have entered a period of sustained stagnation.
Unlike previous
recoveries, growth has not been sustained by increased business investment
and rising consumption, driven by expanding employment and rising wages,
but by historically-low interest rates and a corresponding expansion
of debt.
In the four years
from 2000 to 2004, home mortgages have risen from an annual rate of
$386.3 billion to $884.9 billion while credit has expanded by almost
$10 trillion over the same period, compared to a growth in nominal GDP
of $1.9 trillion. In other words, unlike the experience in all previous
turns in the post-war business cycle, the growth of debt has been the
biggest factor in sustaining the present US recovery phase.
Perhaps the most
telling symptom of the real state of health of the US economy is the
May 5 decision by Standard & Poors to downgrade the debts
of General Motors and Ford to junk grade status. The downgrades cover
a total debt of $453 billion$292 billion for GM and $161 billionan
amount bigger than the GDP of a number of countries and equivalent to
around three quarters of the GDP of a medium-sized capitalist country
like Australia.
In a comment on
the downgrade, the Economist noted that in the credit-default swaps
market where protection against the possibility of default is bought
and sold, the cumulative probability that GM will default
in the next five years is rated at 63 percent and the default probability
of Ford, GMAC and Ford Credit at between 52 percent and 42 percent.
That does not mean the companies will default, but it does suggest
that people take the risk seriously enough to pay for protection.
Even though it was
widely expected, the downgrade has nevertheless sent shock waves through
financial markets, in particularly focusing attention on the role of
hedge funds, some of whom were wrong-footed by the decision. As the
Financial Times noted in an editorial on May 12, while there was no
evidence that any hedge fund faces a big liquidity crisis, market jitters
over their potential exposure highlight the sensitivities surrounding
these sophisticated investment vehicles.
Hedge funds,
it continued, have become such large and integral players in the
global financial system in recent years that their exposure and investment
strategies need to be better understood by regulators. Hedge funds regularly
account for a quarter to a third of equity trading volume in New York
and London. They have become some of the biggest and most profitable
customers for investment banks.
The increasing importance
of hedge funds in the global financial system and the potential dangers
they bring was the subject of a major speech last month by Timothy Geithner,
the president of the New York Federal Reserve.
Speaking to the
Bond Market Associations annual meeting, he pointed out that while
the US financial system seemed less vulnerable and better able to absorb
large shocks than in the past, changes in the structure of the
financial system and an increase in product complexity could make a
crisis more difficult to manage and perhaps more damaging.
According to Geithner,
while the probability of a major crisis induced by the failure of a
major institution was lower, the damage associated with such an event
could be higher than in the past.
The substantial
increase in the role of hedge funds in our financial system also complicates
the task of risk management. Although hedge funds help improve the efficiency
of our system and may also contribute to greater stability over time
by absorbing risks that other institutions would not absorb, they may
also introduce some uncertainty into market dynamics in conditions of
stress.
The rapid
growth in instruments for risk transfer, most recently in the credit
world, has produced a large universe of exposures in complex products,
whose future value is uncertain and difficult to model. The risk-reducing
benefits of these innovations, for individual institutions and for the
system as a whole, are substantial, but these benefits are to some extent
qualified by the limits of our knowledge of how they will perform in
conditions of stress.
In other words,
no one really knows how financial markets will function in response
to a major crisis. In September 1998 when the hedge fund Long Term Capital
Management collapsed, the Federal Reserve Board organised a $3 billion
intervention to prevent a global financial crisis. In the six and a
half years since then, banks have become more dependent on hedge fund
profits and the global financial system has become more complex with
the development of new financial instruments aimed at lessening risk.
In theory, these
instruments should bring increased stability as they allow some investors
to lessen the risk in their portfolios and others to increase theirs
if they believe the returns will justify it. However such a balancing
may not always occur.
As the Financial
Times columnist Philip Coggan noted in an article last Saturday, a hedge
fund collapse would cause a few institutional investors to suffer a
loss in part of their portfolios, but not a disaster. But a problem
could emerge if a number of hedge funds had all made a bet in the same
direction and had been backed up by the trading desks of investment
banks. That would lead to a mad dash for the exits with everyone trying
to leave the same positions at once.