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Issue 37, April 1999

When will the bubble burst?

    Propelled by the stock-market bubble
    Rebound from the '98 'correction'
    A new-era economy?
    The coming crash

The US appears to be an 'oasis of prosperity', still swimming strongly while much of the world sinks. Despite last year's turmoil, Wall Street's Dow Jones index is nudging the 10,000 mark. The latest US figures show rapid growth, reduced unemployment and near-zero inflation. The US's demand for imports continues to cushion the floundering economies of Asia, Latin America and even Europe. Has the new era capitalist economy really arrived? On the contrary, argues LYNN WALSH, the recent growth spurt has been propelled by a highly unstable cycle of consumer spending and business investment-fuelled by a crazy stock exchange bubble. Sharpening trends within the US economy and the still spreading world slump mean that the days of the US boom are numbered.

"JOY TO THE WORLD", proclaimed the Wall Street Journal (22 December) just before Christmas: "Despite everything, America still embraces a culture of optimism; Impeachment? Iraq Tensions? Humbug! Markets soar, polls rise, masses spend". The US economy, according to the New York Times (18 December) was a "Hotbed of rest in a sea of crisis and confusion".

"At the first blush", commented the Boston Globe (3 January 1999) in its Business Outlook '99, "the lesson of 1998 seems to be that the US economy can take a licking and keep on ticking - perhaps indefinitely". This is the mood of most wealthy financial investors and business pundits. The present growth cycle, over seven years long, is the longest peacetime recovery in US history. On 14 March, the Dow Jones (the New York Stock Exchange's leading index) broke, for the first time, through the mystical 10,000 barrier - and many speculators, intoxicated by their unbelievable run of profit-making luck, are even looking forward to the 15,000 mark.

Because they weathered the Asian crisis, the collapse of Russia, and the near-meltdown of Long Term Capital Management and Wall Street has bounced back, most investors, big and small, feel that the US is immune from the economic laws that govern the rest of the world. Despite warnings from the Federal Reserve and the US Treasury, they believe in the 'new economic paradigm' (unlimited capitalist growth, without inflation and periodic downturns) - and they believe it is here to stay. They fail to see that the recent surge of US financial markets has been produced by temporary, extremely contradictory, conjunctural factors which will not last much longer.

  Growth (which reached 5.6% annual rate in the last quarter of 1998) has been fuelled by the continued rise of share prices - which in turn has been fuelled by the flood of relatively cheap capital into US financial markets. While the Asian crisis hit US exports, at the same time it directed a flood of foreign capital into the US, helping to drive interest rates down and push consumer spending to even higher levels. There was $218bn of foreign direct investment into the US during 1998, much of it from overseas corporations which were using dollars from the US trade deficit to expand their operations in the US.

The surge of capital into shares - interrupted by the gyrations of major stock markets in August last year - was stimulated further by the action taken by the US Federal Reserve to avert a meltdown of world financial markets after the Russian collapse and LTCM crisis. This gave a new lease of life to the stock market-led consumer boom, reinforcing the economic feel-good factor despite the spread of crisis to Latin America early this year.

An increasing number of commentators, however, are not only predicting lower growth for the US this year (2% or less) but are warning of looming dangers. "There is a lot of potential for getting whipsawed", commented one investment economist. Another said: "If you look at the economy's top-line numbers, they look spectacular; it's only when you look below the surface that you begin to see the cracks". (Boston Globe - Outlook '99, 3 January 1999)

In reality, there are a lot of very deep cracks, spreading all the time. The profits-growth of the corporations is slowing down, and their investment is increasingly financed by borrowing (much of it in the form of foreign-held debt). There is already a marked downturn among US manufacturers (272,000 jobs lost, March-December 1998), who have lost sales in Asia and elsewhere and are at the same time being undermined by cheaper imports in their home market. Consumer spending (up 4.8% in 1998) has remained strong, but has increasingly outstripped income, relying on growing consumer debt. The US trade deficit continues to grow (up from $110bn in 1997 to an estimated $164bn in 1998). Meanwhile, despite some claims that the Asian crisis has stabilised and the world crisis is 'bottoming out', the slump is spreading. It is only a matter of time before these cracks bring about the deflation of the US's bubble economy.

  top     Propelled by the stock-market bubble

IN THE FIRST place, it was the high level of corporate profits (up from 5.5% of GDP in the early 1980s to 10% now) - restored to the peak levels of the post-war upswing period - which attracted a growing number of investors to the stock exchange. The super-profits (together with lower levels of corporate and personal taxation for the wealthy) was rooted in the enormously increased exploitation of the working class since, under Reagan, US capitalism turned to neo-liberal policies. Wages and benefits were driven down, working hours enormously increased, and workplace rights undermined. The sharpened polarisation between rich and poor produced a layer of wealthy strata with plenty of spare income to invest on the stock exchange. Alongside foreign investors and the corporations themselves, the bourgeois and upper-middle-class investors helped provide the liquidity - the 'barrels of cash' - which rolled into the stock exchange. Mutual funds, which provided a vehicle for many investors, grew ten times between 1990 and 1998, with total funds of $5.4 trillion. Over the same period, the proportion of their funds invested in company shares rose from 25% to 56% (with the proportion invested in company bonds and especially in the money market falling proportionately). (New York Times, 4 January 1998)

The ever increasing demand for shares pushed up their prices even further. In turn, the capital gains which accrued to shareholders through trading (not counted by the government or taxed as income) attracted even more investors.

Stock exchange capitalisation (the total value of shares issued) rose to 150% of US GDP, up from 65% at the end of 1989. This represented a stimulus to the economy of about $11trn - $5trn of which was injected in 1996-97. This largely offset the sharp fall in federal government expenditure, which occurred as a result of cuts under Bush and especially under Clinton, and also counteracted the stagnation in the incomes experienced by the majority of workers until the last couple of years. One commentator, Dean Baker, has ironically referred to this as "Bull Market Keynesianism", a stimulation of demand through stock exchange speculation for the benefit of the rich (The American Prospect - January/February 1999).

  The prolonged rise of the stock exchange, of the so-called 'Bull Market', also has an ideological dimension which is linked to the capitalist triumphalism of the post-1989 period. Expressing the resurgence of corporate profits and fabulous speculative gains, the bull market has reflected - and at the same time reinforced - the renaissance of US capitalism's economic power and self-confidence. Although not in the long run an independent factor, in the 1990s the very existence of the galloping bull market contributed to the strength of the economy, fostering an optimistic, speculative mentality amongst wealthy Americans and attracting a flood of investment from abroad. The concentrated infusion of profits from financial markets, moreover, has had an intoxicating effect on many big business leaders, speculators and market pundits - blinding them to underlying social and economic realities.

While the influence of the stock market has increased, imposing short-term profit targets on corporations, it plays a more and more parasitic role. During the post-war upswing, stocks financed about 5% of real investment. But between 1980 and 1996, far more stock was retired (bought back by the companies issuing it) than new stock issued to investors, making the stock market a negative source of funds, equivalent to about minus eleven percent of total capital expenditure. (See Doug Henwood, Wall Street, p72). In 1997 US corporations brought $41.2bn more in shares than they issued (corporations buy back their own shares in order to keep up the price of the remaining stock or in the process of taking over other companies).

During the early phase of the expansion, corporate profits were such that businesses had enough cash both to increase capital investment and also cover dividend payments to shareholders - and in many cases they also had cash left over for their own speculative activities.

  The stock exchange, then, acts not as a source of investment funds, but as a mechanism for handing out profits to a wealthy layer of shareholders, so-called 'investors'. Part of business profits, in other words, are capitalised in stock values - and the personal wealth of shareholders is thereby raised. A key factor promoting growth during the US growth-spurt since 1996 is that a large proportion of shareholders have increased their personal consumption in proportion to the increase in their personal wealth. The rise in house prices has also had a similar 'wealth effect', with increased property values being transferred into increased consumption.

This boom rests primarily on the shoulders of rich consumers. Share ownership, it is true, has become much more widespread (through mutual funds, etc), and over half the population now owns shares. But ownership of shares is highly concentrated: 10% of the wealthiest households own 89% of shares. The spending spree of the rich and the super-rich was a major factor in pushing up personal consumption, which accounted for around 65% of growth in 1997 (while private investment accounted for around 38% and federal state and local government expenditure only 6%). The growth of consumption, of course, stimulated higher business investment, which in turn created more jobs and, in the last two or three years, just about lifted average household incomes above the previous peak level of the 1980s.

The dynamics of this growth phase produced an enormous overvaluation of share prices. The stock of all US corporations is worth roughly 26 times their collective profits - the highest level since 1945 and twice the historical average, which means their stocks are now extremely expensive by historical standards. (Henwood, Left Business Observer, No.87, December 1998) If share valuations (in relation to company profits) were equal to those at the peak of the 1980s boom, just before the 1987 crash, the Dow Jones index would be somewhere between 5,000 and 7,000 - not hovering around 10,000. (International Herald Tribune, 16 March 1999)

Overvaluation on this scale cannot be sustained indefinitely. There was, in fact, a 'correction' last August-October - but it was cancelled out by the subsequent rebound on Wall Street and world stock exchanges - giving rise to the illusion among many capitalists that the bull market can run for ever.

  top     Rebound from the '98 'correction'

EVEN IN 1996 Greenspan, chairman of the Federal Reserve Bank, was warning of the dangers of 'overheating' (inflation) and 'irrational exuburence' on the stock exchange. According to orthodox economic doctrine, rapid growth combined with low unemployment would inevitably lead to inflation. US unemployment was below 6% for four years, and during 1997-1998 dropped to around 4.5%. Greenspan's fears in this direction, however, have not been borne out - so far. The weakness of the US unions and increased job insecurity kept wages low, while after the outbreak of the Asian crisis in July 1997 falling import and commodity prices also helped reduce inflation to almost negligible levels in the US.

The Fed, however, had been tightening monetary policy since the beginning of 1994, with a rise in interest rates from 3% to 6% between February 1994 and February 1995. As inflation was falling, real interest rates (the nominal rate minus current inflation) were pushed up to around 4%, an historically high level. This appeared to have no effect on the US boom, however. In fact, growth accelerated in 1997-1998, as the Asian crisis brought a renewed flood of capital into the US economy.

The situation changed dramatically with the collapse of the Russian economy in August 1998. Although Russia is only about the size of the Netherlands in terms of GDP, its default on its foreign debts had a major impact on US and European banks. At that moment, a number of big banks and finance houses were clearly threatened with collapse, which could have triggered a world financial catastrophe. This was shown by the bankruptcy of the hedge fund, Long Term Capital Management, whose total collapse was only narrowly averted through a rescue organised by the Federal Reserve Bank. There were convulsions on US (and other) stock exchanges between August and October 1998, with a fall of between 20% and 25% in US share values.

The global financial system was a heartbeat away from systemic collapse, a terrifying experience for the leaders of the Federal Reserve and the US Treasury. In response, they hurriedly implemented an expansionary policy, with three interest rate cuts (down to 4.75%) in seven weeks. The US also put enormous pressure on the European Central Bank to reduce European (EMU) interest rates.

  From a domestic point of view, the Federal Reserve was inclined to tighten monetary policy to counteract 'irrational exuberence' in the US. But they were forced to cut rates in order to counteract the effects of the global financial crisis. According to the minutes of their 17 November meeting, the Federal Reserve policy-makers recognised that their third rate cut "might trigger a strong further advance in stock-market prices that would not be justified on the basis of likely future earnings and could therefore lead to a relatively sharp and disruptive market adjustment later". (International Herald Tribune, 11 January 1999)

The Fed's rates cuts, however, gave a further boost to stock prices, which were already at least 30% overvalued. Affluent US investors, who were hardly affected by the August-October turmoil, continued to pour their money into shares. Given low interest rates, shares offered a much higher return (even if they were purchased on the basis of loans). Overseas investors, fleeing from the 'submerging markets' of Asia, Eastern Europe, and Latin America also poured more money in. An additional boost to share prices came from the major buyers of equities, the big corporations themselves, which were buying up their own stock (to keep up their share prices) or who were involved in massive takeover operations (amounting to over $2.5bn in 1998).

The irrational exuburence has become even more irrational. "This crazy stock market", said the head of a big Wall Street investment bank: "People are mystified by it". But, comments the inteviewer, "As the Dow nears the magic five-digit barrier, it makes sense to stop arguing with this market and try to accept it on its own terms". (International Herald Tribune, 16 March 1999) Less intoxicated strategists and commentators, however, know very well there is certain to be "a relatively sharp and disruptive market adjustment" coming.

But the Federal Reserve policy makers (and the US Treasury) are trapped within the stock-market bubble. In his congressional testimony last June, Greenspan hailed "a virtuous circle" of "rising equity values… providing impetus for spending and, in turn, the expansion of output, employment and productivity enhancing capital investment". At the same time, he warned that "rising expectations" of future corporate earnings and increases in equity values have "driven stock prices sharply higher… perhaps to levels that will be difficult to sustain unless economic conditions remain exceptionally favourable - more so than might be anticipated from historical relationships". (The Independent, 12 June 1998)

  Following the fourth quarter spurt and the rebound of the stock market, Greenspan's dilemma is even more acute. As one commentator put it, "the stock market has shot up quite on its own. Instead of leading the market, the real economy now follows it". (International Herald Tribune, 11 January 1999)

It is now almost impossible, in the present situation, for the Federal Reserve to implement a further cut in interest rates (to avert further international turmoil) - because it would whip-up even further the near frenzy that already exists on US stock exchanges. On the other side, raising rates to dampen the 'irrational exuberence' is equally difficult - it would almost certainly burst the speculative bubble, tipping the US economy into a sharp recession. It is estimated that a 30% fall in share prices over 12 weeks, for example, would reduce economic growth by around 2.3 percentage points, a painful slowdown in itself. But this computer-model estimate does not take account of the dynamic, shock-effect of a fall on the stock exchange - which could well be much more than 30%. Given the key role that rising stock prices played in fuelling consumer spending and business investment, a sharp fall could trigger a very sharp downturn in the US economy.

A stock exchange crash, moreover, which is likely to come through a series of gyrations rather than a single crash, will shatter the confidence and the astounding complacency of US capitalism. "When the bull market ends", writes one columnist, "the impact on the America economy and psyche will be much greater than it would have been before so many Americans pinned their hopes for the future on Wall Street's advance". (International Herald Tribune, 16 March 1999) Not to mention that many people - especially the small investors - will be totally ruined.

  top     A new-era economy?

BUT AREN'T EVER-HIGHER share valuations justified by the boom in high-tech industries, which are fuelling long-term, non-inflationary growth? Under the heading 'The Bubble Won't Burst', a former governor of the Federal Reserve (Wayne Angell) claims that current economic evidence "indicates that America has at last arrived in a new era economy… in which high-tech industries make earnings gains that justify ever-higher valuations". (Wall Street Journal, 4 February 1999)

The new-era optimists point in particular to the spurt in productivity (the amount that a worker produces in an hour) growth at the end of last year. In the fourth quarter of 1998 productivity rose at an annual rate of 3.7%. There was a similar spurt in the fourth quarter of 1996, when productivity rose by 4.2%. For 1998 as a whole, however, labour productivity rose by 2.2%, with manufacturing productivity up by 4.3%.

But most commentators are sceptical about claims that computers are finally producing their much promised efficiencies. "Most experts say that a robust economy and strong demand have forced companies to squeeze more production from their workers, often by running equipment at full capacity". (International Herald Tribune, 11 February 1999)

The latest figures bring the annual rate of productivity increase since July 1990 to 1.4%. This is only fractionally higher than the 1.1% a year average increase for the entire 1980s cycle. It is still way below the 'golden age' average of 2.9% a year increase during 1959-1973.

"The late cycle rise in productivity", writes Jeff Madrick, "can be explained by the fact that when the rate of GDP growth suddenly rises, productivity will also usually rise at an above-trend rate as well. Business is stretching thin all its resources to meet suddenly rising demand. Workers are working harder as businesses cannot take on new hires fast enough… In such one- or two-year situations, it is usually not productivity that is pushing the economy faster, but demand that is pulling more productivity out of the nation's businesses". ('The Treadmill Economy', The American Prospect, November/December 1998)

In the first half of 1998, productivity gains accounted for only 40% of the growth of business output, while gains in hours of work accounted for 60%. During the rapid growth of the post-war upswing period, productivity accounted for closer to 70% of the gain in output, while increases in hours worked accounted for about 30%.

  The US growth spurt of the last two-and-a-half years has been based on more workers working longer hours. This reflects the problems the majority of workers have in making ends meet, following years of stagnant or declining wages. On the other hand, the bosses have been able to hire more workers without significantly raising wage levels, at least until the very recent period. In other words, the recent boom has been based not on new technology and productivity growth, but overwhelmingly on the intensified exploitation of workers.

Despite the corporate profits boom, average real growth of GDP during the 1990-1998 business cycle has averaged only 2.43% - compared with 2.75% in the 1980-1990 cycle. Both these figures are way below the levels of the post-war upswing (5.38% during 1948-1953 and 4.33% during 1960-1969). Even the Wall Street Journal, in one of its saner editorials, was forced to concede "America has not been able to create a new golden age". (30 March 1998)

Since 1997 there have been some modest gains in earnings for a broad layer of workers, including unskilled workers and minorities. The demand for labour has forced the bosses to concede some increase in nominal wages, while lower prices have increased the real value of workers' pay. This has done nothing, however, to close the widening chasm of inequality that has opened up in the US since the early 1980s.

On the basis of an analysis by Edward Wolff of New York University, "the wealthiest 1% of households now control nearly 40% of total wealth. By contrast, the bottom 40% of households control a pitiful two-tenths of a percent of total wealth. If housing (a necessity rather than a liquid asset) is subtracted from the calculations, the bottom 40% of families have more debt than assets. Moreover, from 1983-1995, the poorest 40% of households lost 80% of their wealth, while the wealthiest 1% of households gained 17%". (New York Times, 4 January 1999)

"The downside of US (labour) flexibility", writes one commentator, "is growing income inequality and fraying of the safety net, factors that could tear society apart when the wave ends. What rises higher falls deeper". (Robert Levine, International Herald Tribune, 17 March 1999)

  top     The coming crash

THERE ARE SEVERAL trends, within the US and internationally, which will undermine the current boom in the coming months.
Corporate profits are falling in the US (down 3% in 1998), as sales are eroded by falling sales or lower profit margins (due to overcapacity and increased competition from cheap imports). The big corporations are still paying out high dividends to shareholders, but are increasingly having to borrow money (issuing company bonds on the money market) to finance new investments.

"For much of the recent expansion", comments Charles Clough (chief investment strategist at Merrill Lynch), "businesses could finance capital expansion, cover dividends and have cash left over. Ominously, in 1997 that began to change - heavily committed to capital spending, businesses began to haemorrhage cash, and many must now borrow heavily to plug the deficit. Since 1996, non-financial corporations have doubled the amount of new bonds they are issuing, to $36bn annually". (New York Times, 17 November 1998) Much of the borrowed money has come from overseas lenders, which accounts for a big chunk of the US's $220bn 'current account deficit'.

Despite the recent spurt in productivity growth, most of the growth during the recent expansion came from growth of employment and working hours. The expansion of the labour force and the working year is almost certainly approaching its limits. Apart from anything else, there is a demographich problem: employment is growing approximately twice as fast as the growth of the labour force. There are already signs that this effect has begun to push up the wage levels in the last couple of years. As it is extremely difficult for businesses to put up prices (because of intensive competition), this is likely to cut into their profits.

Although many households have increased their assets through the rise in the stock market, they are nevertheless relying on a record level of credit to sustain their living standards. The ratio of total debt to disposible income increased from 77% in 1986 to 92% in 1997, and is now around 100%. Home equity loans account for the largest share of this debt, but some of these loans (which are cheaper than consumer credit and allow tax-deductable interest payments), have been used to finance other purchases (eg motor vehicles). Many of the top 20% of households have bought shares on the basis of loans (given that interest rates are much lower than the return from share ownership). Credit card debt has also risen, with about 12% of households having a debt/interest repayment burden over 30% of their annual income. These levels of debt may be sustainable in an upswing, but (as after the 1980s debt-driven boom) they will deepen and prolong the coming downswing.

  The 1990s consumer boom has reduced the savings rate of US households to virtually zero, down from around 6% in 1993 (itself an historically low level). This is nothing to worry about, many commentators argue, because at the same time the distribution of capital gains from share trading has raised the average 'net worth' of households to a record level of six times disposible income (though this is extremely unevenly distributed, of course, concentrated in the wealthier households). But as soon as the stock market falls - or there are widespread fears that it is about to fall - the more affluent consumers will stop spending and begin to rebuild their savings accounts. A turn from consumption to saving will amplify the general effect of a stock exchange downturn.

Both the trade deficit and the current account deficit have grown markedly during this upswing. The trade deficit ($164bn) is, in itself, not unsustainable, given that it is around 2.5% of GDP. The deficit indicates the important role that the US plays as a market for exporting economies: without it the crisis in Asia, Latin America and even Europe would be much deeper. The $220bn current account deficit (the difference between incomings and outgoings on trade, repatriation of profits and other financial transactions), however, is more problematic. The payments deficit is sustained on the basis of the massive inflow of capital into the US, which is still seen as a profitable, 'safe haven' for capital. This flow has not only financed the trade deficit, but has provided the capital for financial investment and consumer expenditure.

In the past, however, overseas investors were mainly putting their money into US government bonds, which were seen as a rock-solid investment. Now most of their money is going into corporate bonds and stocks, which are potentially much more risky. Any slowdown in the US economy (with a fall in profits), particularly if (as is likely) it is accompanied by a fall in the value of the dollar, and the flow could be reversed - with profound consequences for the US economy. Without the incoming flow of funds from overseas, the gap between US income and expenditure would have to be closed by domestic loans (which would mean much higher interest rates) and savage cuts in investment, state spending, etc.

As a result of running huge trade deficits over a long period, the US has sunk deeper and deeper in debt internationally. Since the early 1980s, US foreign liabilities - claims held by private investors and central banks (which hold reserves in US government securities) - have strongly outgrown US assets abroad. In 1980 the US was still a net creditor, with net claims on the rest of the world equal to around 7% of GDP, a post-war peak. Last year, the net debt of the US was 29% of GDP: the US owed the rest of the world $2.3 trillion more than the rest of the world owed US capitalists (Left Business Observer No.88, 25 February 1999)

  How much longer will this situation be sustainable? International trends will put increasing pressure on the US economy. World financial markets appear to have stabilised in the last few months, and there has been no shortage of claims that 'the worst is over'. In reality, the slump (already gripping over 40% of the world) continues to spread. Japan, the second capitalist power, is now in its eighth year of zero or near-zero growth, with no real signs of revival. At the same time, China is clearly heading for a crisis - which could trigger a new phase of the general Asian crisis (Asia accounts for 30% of US exports). A devaluation of China's currency, the reminbi, under pressure from cheaper Japanese exports following last year's devaluation of the yen, could trigger another wave of competitive devaluations. Even cheaper Asian exports, moreover, would further widen the US trade deficit.

In Latin America (which accounts for 20% of US exports), the crisis in Brazil is only just beginning. Far from being a 'rescue', the IMF's package of $41.5bn loans to Brazil merely allowed foreign investors to get their money out of the country before the slump sets in. The flight of capital, together with $20bn cuts carried out by Cardoso's government, will push Brazil into a deep downturn. This will inevitably pull down other Latin American countries, including the continent's second biggest economy, Argentina.

Since the Asian crisis broke out in 1997, the US has acted as a 'market of last resort', purchasing an increasing amount of goods from Asia, Latin America and Europe - cushioning them against the effects of the crisis. This cannot continue indefinitely.

Both internal contradictions and the growing pressure of spreading world crisis will undermine US growth - the last remaining pillar sustaining the global economy. The galloping bull market will come to an end. The world financial system, together with production and trade, will be thrown into deep crisis. How long this will take cannot be precisely predicted, but there can be no doubt that, in the coming months, the US economy will enter a serious downturn - which will plunge the world economy into a new phase of crisis.

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