|SocialismToday Socialist Party magazine|
Rate increases coming
Greenspan’s signal that higher interest rates are on the way marks an ominous turning point. The days of the debt-driven US consume boom, the locomotive of world growth, are numbered. Together with the surge in the price of oil (see p22), 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, which coincided with the beginning of Bush’s presidency, Greenspan steadily lowered interest rates in order to sustain consumer spending, the main prop of the US economy in recent years. Rates fell from 6.5% in January 2001 to 1% in June last year, the lowest level since 1958. Taking account of price 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 elections on 9 November.
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 to a far greater extent than similar credit-driven expansions in the past. But it has now clearly reached its limits.
On 4 May 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 on US 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 US economic data really 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% (annualised), 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 bubble trouble
THE MAIN PROBLEM for US 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’. No doubt he would like to put off interest rate increases until after November. But most commentators – and the speculators too – believe that he will have to take action during the summer period.
Long-term interest rates, determined by the bond market, have already been rising sharply. Benchmark ten-year Treasury bonds have currently reached a yield of over 4.5% (compared with 3.5% last year). This growing ‘spread’ between short-term and long-term interest rates cannot be sustained much longer.
The housing bubble has been a major support for consumer spending, 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 fuelled by cheap mortgages (with a mortgage rate down from 7.5% in 2002 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. Others have gained higher disposable incomes as a result of lower mortgage repayments.
Over 80% of mortgages are fixed interest and so, it is argued, 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 house purchasers have recently been forced by lenders’ policy 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 $1.52 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’. This involves borrowing cheap on short-term money markets (repeatedly renewing loans) and lending long-term at higher rates. Investors also borrow cheap in the US 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 at a low level 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". (‘Worries grow as Fed takes time raising rates’, International Herald Tribune, 18 May)
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 long-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 US 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". (Quoted by Larry Elliot, ‘Old Greenspan magic is fading’, Guardian Weekly, 20 May)
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 labourers and the dispossessed against the barbarous effects of crisis.
The US, 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, two-speed recovery. Chinese growth depends on US demand for its goods, and is itself in the throes of an investment bubble that could burst at any time (see article p25). 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 the approaching US interest rate rises 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.
WHAT WAS THE plan? Smash Saddam. Take control of Iraq’s oil. Undermine Saudi dominance and break the power of OPEC. And as quick as Rumsfeld could say ‘abracadabra’, there would be a golden age of cheap oil and fabulous profits.
But the spell didn’t work. The plans of the White House/Pentagon neocons have been shattered. In fact, they have rebounded with a vengeance. Iraqi crude oil production has not recovered its pre-war level of three million barrels per day (bpd). In mid-May it fell to 850,000 bpd following new attacks on the southern pipeline. Members of OPEC (Organisation of Oil Producing Counties) are currently proving more effective in limiting output and sustaining prices than ever before. With demand increasing as world economic growth picks up, oil prices surged to record levels in nominal (current price) terms, with US benchmark crude surpassing $40 a barrel.
Some commentators see this as merely an irritant, a disturbing bout of hiccups rather than the onset of a dangerous oil ‘shock’. There has not been a drastic interruption of oil supplies, as after the 1973 Arab-Israeli war or the 1979 Iranian revolution, two mega shocks that provoked serious world recessions. Current shortages are caused by increased demand from the US and China, the result of accelerated economic growth. Higher prices, the bulls argue, will stimulate increased investment in oil production, and then prices will tend to decline. In any case, they say, in real (inflation adjusted) terms, crude oil is still only about half the price it reached at its 1980 peak, about $80 a barrel in today’s prices.
The bears, however, warn that the sharp upward trend in oil prices could cut across the recovery in the US and Asia, the dual locomotives of world growth. Costlier oil is not an isolated factor, but comes together with a turn towards increased interest rates. Dearer credit will bring about a fall in share and property prices, which will lead to a fall – perhaps a sharp fall – in investment and consumer spending. When Greenspan warned early in May that US interest rate rises are coming and oil topped $40 a barrel, there were sharp falls on world stock exchanges, wiping out earlier gains for 2004.
These financial sparks, moreover, coincided with the assassination in Baghdad of Abdul Zahra Othman, president of the puppet Iraqi Governing Council, and further revelations of torture in the infamous Abu Ghraib prison. In Saudi Arabia, there was another attack on foreign technicians, this time claiming the lives of five engineers at the Yanbu refinery. Now, the main anxiety of international big business is the looming catastrophe in Iraq, increased tension and instability throughout the Middle East, and unpredictable potential for conflicts everywhere. Conventional textbook calculations about the workings of the oil market are meaningless in (as one pundit puts it) "the current climate of geopolitical fright".
Oil demand grows
DEMAND FOR OIL has increased for a number of reasons. The growth spurt in the US economy, which accounts for about 12% of global demand, is a big factor. US demand is increasingly for particular types of crude that comply with new environmental regulations in various US states. The Bush regime has also decided to continue pumping oil into the Strategic Petroleum Reserve in Louisiana until it reaches its maximum capacity of 700 million gallons. This policy, in the face of Congressional demands to release reserves on to the market to ease prices, indicates the administration’s fear of another oil shock.
There has, moreover, been a huge surge in demand from China, driven by the rapid growth of manufacturing and massive construction projects. China’s oil consumption in the first quarter of 2004 was 40% higher than the same period a year ago. Internationally, the increased volumes of international trade have enormously increased energy use in transportation – ships, trains and motor vehicles are all gas-guzzling machines.
World supply, meanwhile, of both crude and refined oil has been constrained. Experts appear to differ widely over the real extent of oil reserves (Shell was recently caught out inflating its claimed reserves) and crude output capacity. But even optimists, like Peter Odell, who considers that "more than adequate production capacity exists or can be developed quickly", warns that because of "market anarchy", "excessive price volatility and accompanying problems with security of oil supplies and oil markets seem unavoidable". (Financial Times, 16 May)
Most of Iraq’s pre-war supply (about three million bpd) has been lost for the time being. Last year’s oil shut down in Venezuela, an attempt to bring down Chavez, also reduced global supply. And in March, OPEC agreed to reduce output by one million bpd. The International Energy Authority (IEA) estimates that global demand for oil in 2004 will be two million bpd higher than 2003. They believe there is currently about 2.5 million bpd spare capacity, mainly in the Gulf region. The question is, will OPEC make this available or will it attempt to sustain prices at current levels or even higher?
When oil fell to around $10 a barrel in the early 1990s, some regimes in the oil producing states faced an economic and political crisis. Through the IEA and secretive cooperation with the ‘big three’ OPEC producers - Saudi Arabia, Iran, and Venezuela - the US pushed for a stable price of between $22 to $28 a barrel. The motive was not philanthropy, but a desire to avert social explosions.
Since then, however, tensions have become even more acute. Since 9/11, moreover, the long-standing pact between US imperialism and the Saudi regime – protection in return for cheap oil – has largely broken down. The Saudi monarchy is well aware that the Bush plan to smash Saddam was also aimed at breaking OPEC and Saudi dominance of the Gulf’s oil reserves. Simultaneously, the Saudi regime faces growing rebellion from both extreme Wahhabi and Shia forces that are implacably opposed to the monarchy’s collaboration with US imperialism.
The US was forced to move its military command centre to Qatar. US companies have recently been excluded from developing Saudi gas reserves. And cooperation between the US-dominated IEA and OPEC appears to have broken down. Earlier this year, Saudi Arabia led the OPEC move to cut production to pre-empt stock-building of crude oil by the US and others and to push up prices. But while the Saudi rulers are desperate to sustain adequate oil revenues, they also fear a new downturn in the world economy, which would reduce demand and lower prices. In recent weeks, the Saudis have switched tactics, trying to persuade their OPEC partners to raise quotas. It is not certain that this will be agreed (Venezuela is resisting this move). Even if it is, it is not certain that the increased supply will be delivered to consumers in time to relieve shortages and ease prices.
Far from being weakened by the US occupation of Iraq, as Bush hoped, OPEC, which control about 38% of world output, has been strengthened. "OPEC appears to be more coordinated than ever in its attempts to keep the oil price high… [It] is becoming very efficient at coordinating its policy in the service of high oil prices". (Katrina Bennhold, ‘Return of economic demon: oil shock, International Herald Tribune, 4 May) OPEC’s share of world output, moreover, will increase as other reserves decline.
OPEC is likely to adopt a new target price of $32 to $34 a barrel. But prices have been pushed up to $40 a barrel by frenzied speculation on oil markets. "The oil sector is currently in the hands of short-term traders", comments one London financier, "and subject to many conflicting influences". The big hedge funds, in particular, have been aggressively buying futures, contracts for the delivery of oil consignments at a later date. They are betting that prices will rise even more, so they can sell on their consignments at a profit. This kind of speculation may well push oil prices up to unsustainable levels, leading to sudden drops and new rises, a roller-coaster of market anarchy.
Impact on GDP
RISING OIL PRICES, though not (yet) on the scale of the 1973 and 1979 shocks, are already having an impact. Pump price have topped $2 a gallon in the US, $2.27 on the West Coast. This clearly does not favour Bush’s chances of re-election. A $10 a barrel hike in ‘gas’ prices is the equivalent of a $70 billion ‘tax’ increase on US consumers, levied through inflation. Wal-Mart estimates that higher ‘gas’ prices are taking more than $7 a week from the disposable income of its average customer. In Britain, the prospect of pump prices rising above £1 per litre has brought murmurings of another populist fuel protest, as in September 2000.
Because of currency differences, the effect of the oil price increase is not the same for all economies. The oil price is denominated in the dollar, which has been falling against other currencies. A rise of about 90% since 2002 in dollar terms equals a rise of about 40% in euro terms and 60% in yen terms.
For the world economy as a whole, a $10 a barrel rise in crude prices will take about 0.5% off global GDP growth. But the impact is much heavier on poor and semi-developed countries. Advanced capitalist countries have significantly reduced their ‘energy-intensity’ (energy consumption per unit of GDP) over the last two decades, partly through de-industrialisation, partly through increased efficiency. "But China and Africa are more than twice as energy-intensive as the OECD average, and India almost three times, in terms of oil use per dollar of GDP. The IEA estimates that a $10 a barrel oil price rise sustained for a year would take 0.8% from the GDP of China, 1 % from India, 1.8% from Thailand, and 3% from sub-Saharan Africa". (Financial Times, 17 May)
The fast-growing, semi-developed Asian economies now account for about 25% or world GDP, and a substantial share of world trade. A downturn induced by higher oil prices would have a serious knock-on effect on the US and other advanced capitalist countries. Because of globalisation, the semi-developed economies are much more closely linked to the advanced economies than in 1973 or 1979.
SPECULATORS, IT SEEMS, are forever optimistic. Most capitalist commentators assure us that ‘it is not like 1973 or 1979’. Doubts, however, are increasingly creeping in. The Guardian considers that "the industrialised economies of the west are perhaps better placed to cope with higher oil prices than they were in the 1970s or 1980s… [but] a sudden shock of a similar magnitude would still most likely lead to a recession as they struggled to adjust". (‘Crude calculations’, Leader, 17 May)
Oil expert, Andrew Oswald, still regards the price of energy as the best predictor of the economic cycle. All four slumps in the past three decades, he points out, were preceded by a surge in oil prices. "We are just as vulnerable to higher oil prices today… If prices keep rising, we should certainly be worried about the recovery". (‘Return of economic demon’, International Herald Tribune 4 May)
Another oil shock would not simply be a repeat of past events, of course. "Still", writes Paul Krugman, "if there is a major supply disruption, the world will have to get by with less oil, and the only way that can happen in the short run is if there is a world economic slowdown. An oil-driven recession does not look all that far-fetched". (International Herald Tribune 15 May).
The Iraq quagmire is destabilising the whole Middle East. Iraqi oil production is unlikely to be fully restored in the near future. The Saudi regime is fundamentally unstable. All-out internal conflict or the coming to power of right-wing Islamic forces would, without a doubt, mean a ‘major supply disruption’, a major oil shock. And Venezuela? Nigeria? Algeria?
This is a period of world-wide capitalist crisis. By invading Iraq, US imperialism has intensified all the contradictions internationally, making convulsions and explosions inevitable.