Opinion: Behind the madness on the markets
26th Sep 08, 10:39am
Loss of American pre-eminence -Alice in Wonderland Alice advanced into a rabbit hole (in Lewis Carrol's classic) encountered a bizarre world with strange kings, queens and the delightful March Hare and Mad Hatter. "Curiouser and Curiouser!" she exclaimed. Curious indeed has been a week when banks crashed, insurers melted, the US government went socialist, and the witch hunt focused on naked short sellers. The gold market, a prescient observer, joined Alice in saying said the real world was mad. Gold and oil advanced by record amounts. And as Alice comes up for air, I wonder if the world is the same place. I suspect it is not. I suspect that history will say this was the week that America lost its financial ascendency. The big dip Last week was the most turbulent ever in financial markets. It was a panic above all panics. My research on panics, which occurred in London in 1847, 1857, 1870 and 1890; in New York's great panics in 1907 and 1929; suggests that 2008 is like 1929. Each day brought something more staggering. I was amazed that three banks could end with a whimper. Merrill Lynch and Lehman Brothers epitomized Wall Street's record for hand's on management of financial instruments. HBOS was Britain's biggest lender combining two very proud institutions, the Halifax Building Society and the Royal bank of Scotland. The runaway train almost brought down the smartest of them all, Goldman Sachs. US Taxpayers in the gun The Treasury's rescue plan was trillion dollar addition to the tax payer burdens. The Treasury took assets that doubled the Federal government's current US$5.4 trillion debt. Moreover, the Housing Bill to nationalize Fannie Mae and Freddie Mac, added gross liabilities of another US$5.4 trillion. The state also propped up the mutual funds industry by extending federal insurance to several institutions. It has taken over AIG and Bear Stearns, which have billions of dollars of risky assets. Perhaps Treasury prevented a meltdown of the financial system. The cost is almost incalculable. The federal deficit of US$438 billion (equivalent to 3% of GDP) will become to at least US$800 billion next year, perhaps more. Moreover, Democrats in Congress intend to assist homeowners directly. Revenues might also fall in response to recession. The fiscal problem of funding the deficit is colossal, especially as the cost of the Iraq and Afghanistan wars are not included. Tax increases appear to be mandatory. US place in the world It is rather premature to ponder upon the political consequences of the crisis. As an economic historian I am aware that financial crises have played significant roles in the world leadership struggle. On the positive side, mid-nineteenth century financial crises cemented Great Britain's strong leadership. A strong currency, a Bank of England, an Indian army and a Royal Navy extended Pax Britannica across the globe in the nineteenth century. London became the financial centre of the world with a reputation for stability, probity and innovation. It was the place to go for banking, insurance and other financial services as well as issuing shares and bonds. London's supremacy passed to New York in the twentieth century. It is hard to pick a precise date for passing the baton, but I would pick September 1931 when Britain was forced off the gold standard. Sterling became a fiat currency. It is important to add that the US did not rise to assume global responsibility until it was engaged in the second word war. Few people recognize that the US exacerbated the 1930's depression by its "beggar-thy-neighbour" protectionist policies. The world system needed a core that delivered capital to the periphery. The British had done this by running a vast trade deficit. London welcomed trade. The US declared war on the world in the depression with the Smoot-Hawley tariff, which penalized imports. Instead of exporting capital, the US hoarded it, and damaged European stability with demands for repayment of war debts. From a financial point of view, New York has now lost important capabilities. Banks have been destroyed; the survivors will hunker down and be too timid to serve customer needs. US dependency Several venerable American institutions have been scrutinized severely by international investors this year, but increasingly the US Treasury will be obliged to take cognisance of the views of foreigners. At present a vast proportion of US securities are held by China, Japan, Holland, Russia, and the Gulf States. This huge capital flow has served the US very well. Its saving record is poor and it needs access to capital on a giant scale for depreciation, investment and even for consumption. Foreign capital has been secured readily for these functions. Moreover, the supply is almost excessive, it has driven down interest rates. Were foreigners to expatriate their capital, the US would lose enormous power and leverage. Given the sudden acquisition of massive government debt, this is possibly the moment when the US dollar plunges almost irredeemably in relative value. Perhaps it will lose ground as a reserve currency and store of value. Euro stronger The Euro is gaining ground. It is now the currency of 15 countries and four more are expected to join this year. It is also a reserve currency with a growing share of the world's foreign exchange holdings (around 27%). During 2007, the value of Euro notes in circulation exceeded those in dollar denominations. The Euro has also appreciated from a low of 0.80 to 1.45 in exchange with the US dollar. The Euro is increasing the favorite currency for bond issuers. London London is the banking centre of the world. 550 international banks have offices there in contrast to 280 in Frankfurt, 270 in Paris and 250 in New York. The London foreign exchange market has a turnover much larger than Tokyo and New York combined. London will grow at New York's expense. Summary The world financial system's 'de-centering' has been greatly advanced by the destruction of many US financial institutions. The key currency has been wounded by US debt. London will be an immediate beneficiary. Other centers will challenge, notably Shanghai and Tokyo. Commodities will surge on the back of a weak dollar.