Since this article was written for the June issue of Socialism Today, one of its main contentions has been dramatically confirmed by the Federal Reserve’s increase of the base interest by a quarter a percentage point on June 30. Clearly this is not a one-off increase, as the article argues, and will likely be the first of a series of increases in the months ahead.
Greenspan’s signal that higher interest rates are on the way marks an ominous turning point. The days of the debt-driven U.S. consumer boom, the locomotive of world growth, are numbered. Together with the surge in oil prices, Greenspan’s move is a warning of even deeper crisis in the world capitalist economy. LYNN WALSH writes.
Alan Greenspan has got what he wanted. Bush has nominated him for another term, his fifth, as Chairman of the Federal Reserve Bank. This is Greenspan’s reward for services rendered. No one has done more to help Bush to get re-elected in November.
In the downturn after 2001, Greenspan steadily lowered interest rates in order to sustain consumer spending, the main prop of the U.S. economy in recent years. Rates fell from 6.5% in January 2001 to 1% in June 2003, the lowest level since 1958. Taking account of inflation, real short-term interest rates are effectively zero. Pumping liquidity into the economy, through low rates and a massive expansion of the money supply, has been the Bush regime’s only real economic policy, courtesy of the “independent” Fed. The overriding aim is to sustain growth until after the November elections.
Cheap credit has been the high-octane fuel for a consumer spending bubble, based on a housing boom and an explosion of mortgage and consumer debt. Greenspan has allowed this to balloon into a far greater extent than similar credit-driven expansions in the past. But it has now clearly reached its limits.
On May 4, Greenspan announced that the prime lending rate would remain at 1%. However, in the enigmatic language that he is famous for, he announced that the removal of “policy accommodation” (code for cheap credit to sustain consumer spending) would proceed at a “measured pace” (code for a gradual increase of rates in 0.25% or 0.5% increments). Nevertheless, this apparently vague announcement had a shock effect on financial markets. Coming together with a surge in oil prices and ever louder warning signals from Iraq, it led to sharp falls in U.S. and world stock exchanges.
The capitalists got the message, loud and clear. There is a turn in the economic situation; the trend in interest rates will be upwards. Many speculators believe, moreover, that the change may come much more rapidly than Greenspan suggests.
Greenspan clearly delayed this announcement for as long as he could. But the latest U.S. economic data compelled him to signal a change. The April job growth of over 300,000 shows a continuing recovery, mainly based on the service sector. First quarter GDP growth was 4.2% (annualized), while consumption grew at 3.8% (down from 5.1% in the second half of 2003). Prices rose by 2.5% in the first quarter. Even excluding food and energy, prices rose 2.1%, the highest increase since the second quarter of 2001.
The main problem for U.S. capitalism at this stage, however, is not inflation, which is quite modest. The real danger is that the housing and consumer credit bubble will become absolutely unsustainable – and collapse. Greenspan is promising that he will take action to gently deflate the bubble, bringing about a “soft landing.”
The housing bubble has been a major support for consumer spending, which is the overwhelming component of GDP growth in the last few years. House prices have risen between 30% and 40% more than retail prices generally. This is the result of increased demand, fueled by cheap mortgages (with mortgage rates down from 7.5% in early 2001 to 5.8% in 2002). Housing debt increased by over 50% in three years, pumping $2.3 trillion into the economy. Many homeowners have used mortgage refinancing to supplement their consumer spending.
Over 80% of mortgages are fixed interest, so it is argued that increased interest rates will not have a big effect on homeowners. However, many have borrowed to the limits of their income, and any reduction of income through unemployment or lower wages will cut their already-stretched disposable income. Moreover, an increasing number of home buyers have been forced by lenders to take adjustable-rate mortgages, in order to purchase properties that would previously have been considered far in excess of their income levels.
Overall consumer debt rose 33% between 2000 and 2003, to $27 trillion – pumping an extra $1.5 trillion into the economy. Household debt has risen from 97% of annual disposable income in 2000, to 113% in 2003. Among the bottom fifth of the income range, a quarter of households are paying over 40% of their income in servicing debt. Higher interest rates will impose intolerable burdens on many indebted families.
But it is not only the poor who are up to their necks in debt. Super-rich investors and finance houses have also been speculating on the basis of cheap credit. They have been exploiting what Wall Street calls the “carry trade” by borrowing cheaply on short-term money markets (repeatedly renewing loans) and lending long-term at higher rates. Investors also borrow cheaply in the U.S. in order to invest in foreign financial assets, such as shares and high-interest/high-risk junk bonds.
This is a risky business. Profits depend on short-term interest rates being kept low for a prolonged period. Up until his May announcement, Greenspan repeatedly assured speculators that low rates would be maintained. This explains the shock when he changed his tune.
Some of the hedge funds involved in the derivatives trade have been exploiting the “carry trade” in a big way. The renowned investor Warren Buffett has warned that these practices constitute “financial weapons of mass destruction.” A rapid rise in short-term rates could provoke a serious crisis for some of the hedge funds and investment banks. The collapse of Long Term Capital Management hedge fund in 1998, which brought the world finance system to the brink of systemic meltdown, is a warning of what can happen.
Reckoning Only Delayed
The more responsible strategists of capitalism consider that Greenspan has recklessly delayed increasing interest rates. “The Federal Reserve has been behind the curve,” said Brian Wesbury, chief economist at a Chicago investment firm. “With GDP growth at a 20-year high, with inflation pressures rising, there is no justification for keeping rates this low. In my opinion, they should have started raising rates last year” (International Herald Tribune, 5/18/04).
Some commentators consider that, to come into consonance with long-term interest rates set by the bond market, the short-term Federal rate would have to rise to 5%, a huge jump from the current 1%. Greenspan is promising that any such adjustment will be “measured,” achieved through a drawn-out series of small rises. But the scale of the debt bubble and the growing imbalances in the world economy could force a much more rapid change.
The U.S. economist Kurt Richebächer says: “The stock market bubble of the 1920s ended with an unprecedented consumption boom, and just that has been happening again since 1997, and in particular since 2001. Since then, consumer spending has accounted for 92% of GDP growth. Yet, to keep it rising in the face of grossly lacking income growth, the Fed has invented a policy stance that has no precedent in history: boosting home prices with artificially low interest rates in order to provide rapidly growing collateral for consumer borrowing.”
Greenspan, according to Richebächer, has papered over the “existing maladjustments from the boom through even bigger new bubbles and macroeconomic maladjustments, heralding much worse to come in the future” (Guardian Weekly, 5/20/04).
Even a “soft landing” later this year or early next is likely, at best, to be extremely bumpy. But a “hard landing” is equally likely – a continuation and deepening of the world downturn that followed the collapse of the 1990s financial bubble. This could lead to an explosion of world capitalism, with massive struggles by the working class, rural laborers, and the dispossessed against the barbaric effects of the crisis.
The U.S., in conjunction with China, has led a partial recovery in the world economy since mid-2003. But as the OECD recently warned, it is a very one-sided recovery. Chinese growth depends on U.S. demand for its goods, and it is also in the throes of an investment bubble that could burst at any time. The recent recovery in Japan, after 12 years of stagnation, depends on Chinese growth. Meanwhile, the Eurozone still languishes in a prolonged phase of “anaemic growth” (OECD). The effects of U.S. interest rate increases will reverberate throughout the world economy. The current fragile recovery could collapse at any time.
The attention of world leaders is focused on the deepening catastrophe in Iraq. But they could soon be facing a global economic disaster, too.