The Goldilocks World

A look back at our economic forecast of 18 months ago. Has anything really changed in the economic situation?

"Here’s a prediction. The US economy is heading for slump. By the end of this year, that reality will start to emerge behind the smoke and mirrors of stock market exuberance and big business bluster. Since 1945, all world slumps have started in the US. This time will be no exception. Europe is just beginning to pick up steam. Its budding boom will be cut off by the frost of the American recession. Japan and Asia are already freezing. Before the millennium is reached, the world will be ice." June 1998.

This is what I said in Socialist Appeal over 18 months ago. Since then, apparently, events have proved me wrong. Far from being ice, the world economy appears to be picking up. The US is going from strength to strength at a real growth rate of 4%-plus and has now achieved its longest boom on record, of over 110 months. Europe is beginning to surge, with growth heading for the 3% rate. Far from descending into recession, as many of us expected 18 months ago, the UK economy has leapt forward again on the back of the US boom. It will grow by up to 3% this year and sterling is even stronger than it was back in the days of before Black Wednesday 1992, the time of its last currency collapse. Sure, Japan remains the doldrums, but even there, there are signs of a limited recovery.

Also, the crisis of the so-called developing or emerging economies seems to be over. Asia has made a dramatic recovery from the depths of 1998. Korea is pumping along at a 10% rate, Mexico is sustaining 4% growth, Brazil is swinging back from the disaster of early 1999 and rising again. Even Russia is showing some signs of growth on the back of the oil boom. And India will be the fastest growing developing economy this year (even faster than China).

At the same time, there is little evidence of inflationary pressures, apart from the huge rise in the oil price. If you exclude energy costs, US prices are rising at just over 2% a year. In Europe, inflation (excluding oil and gas) is under 1% a year. Even the UK can boast inflation at under 2.5%. And, as for Japan, its stagnant economy has deflation (falling prices).

The capitalist commentators think they have the answer. It’s the new productivity paradigm led by the high-tech and internet revolution. There will be no capitalist crisis. The 20th century was the American century, but so will the 21st. Globalisation, the internet and American military will ensure Pax Americana. The New Economy will ensure continuous low inflation and productivity-driven growth. Wealth and better standards will spread to all the world’s six billion people.

That’s why the capitalist commentators remain ecstatic about their system. It’s a Goldilocks economy - not too hot and not too cold - growing at a good pace without overheating. And when the world’s capitalists leaders, both in business and in politics, met for their annual informal summit in the Swiss ski resort of Davos in January, they exuded confidence about the future (at least in their public pronouncements).

Sure, outside the conference halls and hotels, demonstrators tried to disrupt proceedings as they did at the World Trade Organisation meeting in Seattle last December. But inside, President Clinton told the invitation-only participants of the World Economic Forum that "globalisation", the modern mantra of capitalism, had created the foundation of sustained prosperity for the world’s people. It was essential, said Clinton, to bring down trade barriers further and free up regulations so that international big business could invest and move capital around as they liked. And above all, the forces of the labour movement should not interfere. After all, had not global capitalism proved that it was the only way to achieve ‘prosperity’.

I don’t need to tell the readers of SA that Clinton’s claim of world prosperity, while billions are below the basic standards of life and millions suffer from war and disease, sounds sickeningly hollow. The information technology revolution may be with us, but in 2000, still more than half the world’s population have never used a telephone! But Clinton’s paean of praise does tell you the mood of the capitalists.

Does all this mean that socialists are wrong about the instability of capitalism and the eventual slump in the world economy? My prediction at the top has been proved wrong. I can say that it is just of question of timing. But timing is important. If the world boom were to continue another five or ten year without serious break, the arguments of Marxism would be looking pretty sick. But if it has less than one or two years to run, the boasts of Davos will be exposed.

So why was I wrong? If we can work out why, we can learn better what is going to happen in the future. What is it that has happened in the last two years which explains the continued boom?

The answer must start with the US economy. During 1999, American households have gone on spending like there was no tomorrow. Consumer confidence is at record highs and as a result, consumption is up by 5% or more a year. Real disposable incomes cannot keep pace. Despite low unemployment, average real wages (after taking into account inflation) are growing less fast than household spending. In other words, Americans are living beyond their means.

They are doing this because they believe that their wealth (as represented by the value of their retirement nest eggs) is rising faster. The huge rise in the US stock market in 1999 has created the paper wealth that has convinced millions of Americans to go on spending. The value of stocks and shares held by American households compared to their total income rose from 3.5 times in 1995 to 3.8 times in 1999.

And it’s not just households that are keeping the US boom going. US companies are spending at unprecedented rates on new equipment. Capital spending is rising at a 10% clip as US corporations invest more and more in high-tech equipment and above all into the internet revolution. They are doing this because they have to. Competition is intense. And corporations are convinced they must invest in the technological revolution or die. They believe that the resultant increased productivity will keep them in business. But most of all, they are counting on the move into the internet producing a huge leap in their share prices, so increasing their wealth and buying power.

And up to now, they have been right. The internet revolution not only continues to fuel the stock market mania, it is accelerating it. Every time any company announces that is going to sell its products via an internet service (e-commerce, they call it), its share price rockets. Take Rupert Murdoch’s BSkyB. Last autumn the share were priced at £6. Murdoch had been saying up to then that the internet was bad for business not good. Then the company announced a reversal of strategy. It was going to launch internet initiatives with other companies on its TV service. The shares are now worth £20! And yet, in its latest report, the company was shown to be losing money.

At the beginning of January, the American Association of Investors announced that 75% of its members thought that the US market would go on to new heights. Then we had the largest merger deal in the history of the world, as internet company America OnLine took over the media conglomerate, Time-Warner. The merger mania in 1999 reached nearly 20% of US GDP compared with 3% in 1990. The only time it has been any near as high as this was in 1900! Of the money that flowed in to drive up share prices, over 75% went into these high-tech companies.

But in this lies the achilles heel of the US boom. These huge price rises must be justified at the end of the day by increased productivity that feeds through to increased corporate profits. And the reality is that the profits are not there to justify the US boom. Take the consumer. American households are spending more, but their incomes do not justify it. So they are relying on the booming stock market. And they are borrowing more and more. Mortgage borrowing is up 10% a year as is credit card debt. At the same time, borrowing to invest on the stock market rose by an all-time record in 1999 to reach $204bn. This can only last as long the stock market keeps on going up and the cost of borrowing does not rise.

But already there are signs that the US stock market boom is wavering. The technology stocks have continued to rise, but the rest of US company share prices are falling back and have been for some time. The technology sector cannot hold up the rest for much longer. Increasingly, the merger mania which is boosting technology company shares is being financed, not by cash but by paper. In the first half of last year, takeovers funded by cash reached $220bn. In the second half of 1999, that fell to just $60bn. So companies are buying other companies by exchanging their shares or by borrowing money. Combined with the huge expenditure on technology, US corporate debt has reached all-time levels, way above anything seen in US history.

And the much-heralded productivity boom is not delivering the profits. Many US companies continue to publish higher and higher earnings results. But this is an illusion. Under US accounting procedures, company profits include ‘inventories’, in other words, notional profits from gains in share prices of investment held by companies. So company profits go up, because the stock market goes up. And the stock market goes up because company profits are reported as going up! If you strip out these gains, then company profits from actual production in the US fell in the last half of 1999. Only profits from abroad kept US companies in the black. And if you take out financial institutions like the banks from the figures, then US industry, and especially, the technology sector, made losses. The manufacturing sector’s profits have fallen 7% over the last two years.

And inflation is on the rise if you include oil prices. That’s forced the Federal Reserve Bank to start to push up interest rates this year. So the cost of borrowing to spend in the shops, to buy new equipment and to buy other companies is rising. Corporate debt rose 11% last year, more than double the pace of output and now net interest payments are starting to eat into profits.

So we are heading for the end of the Goldilocks economy. From not being too hot and not too cold, the US economy, by the end of this year, could be too hot and too cold. Inflation could be reaching 3% a year as the productivity boom slows. At the same time, with profits disappearing and the cost of borrowing to finance the boom accelerating, investment by companies and spending by households will slow. If the stock market turns nasty at the same time, then boom could swing into slump very quickly - just as in 1929.

Of course, many capitalist commentators reject this scenario. They expect the US economy to slow down gently in a ‘soft landing’ without any deflationary bust. That’s because the productivity boom in the US economy is here to stay. As Fed Chairman Alan Greenspan says; "It may no longer be the case that an acceleration of demand presages an overheated and unstable economy if demand growth is caused by a growth in the overall trend of productivity".

This is the illusion of capitalists at the height of a boom. It was the same in 1900 when capitalism was in a boom that had begun in 1895 after a whole epoch of instability with the Great Depression of the 1880s. But Mr Greenspan is in for a rude awakening, just as capitalism was at the beginning of the last century. There is no escaping the inherently unstable nature of the ‘free market’.

The information technology revolution is for real. But there have been many similar technical advances in human history, and in modern capitalism. And capitalism always wildly overreaches itself in speculating on the gains from new technology. Over investment is now evident. Corporate debt to finance this investment is completely out of control. A tip down in the stock market will turn a virtuous circle of share price rises, climbing consumer spending and fast growth into a vicious circle of consumer and corporate spending slump, increased costs and falling output very soon.

And, in direct contradiction to the benefits of globalisation and breaking down of national economic barriers, a slump in the US will spread quickly to the rest of the world. Then all the things that have driven globalisation will turn into their opposites. Since the beginning of the 1960s, prices of internationally-traded goods have fallen in real terms while world trade as a share of world economy has doubled. That expansion is similar to that achieved in the early part of the last century. But by the 1960s, world trade had slumped back to previous levels.

The technology boom may boost productivity but it forces prices down and squeezes profit margins. And the last great technological boom under capitalism in the 1930s was accompanied by the worst capitalist depression ever seen.

And this time globalisation and deregulation have taken off all the controls over international capital. There is not even the regulating power of the gold standard of the 1920s, which at least helped keep currencies stable for a while. This time a world recession will see huge collapses in currencies, Mexico and Asian style, in those advanced capitalist economies with the biggest deficits and debts with the rest of the world. A sterling slump and a dollar disaster - that’s the message of the future. The crash is coming in financial markets. That will lead to end of Goldilocks.