23.06.2016

Brexit, China and the Fed

The prospect of a global recession is very real, writes Michael Roberts

Over the long term, whether the UK is in or out of the European Union would not have a decisive impact on the relative health or otherwise of British capitalism. Much bigger damage could be expected from the next global recession, which is coming up like a storm on the horizon at increasing pace.

It had seemed that the growing possibility (not probability) that Brexit could be a reality was really exercising the decisions of international investors (banks, hedge funds, etc) in financial assets. World stock markets, after a significant rally towards previous highs in the last three months, started to turn down.

Three things drove this reversal. First, the fear of ‘Brexit’: that it would not only lead to a severe downturn in the UK economy, as the tortuous negotiations for withdrawal began (lasting up to 2019, according to the ‘leave’ camp!), but also trigger a new recession in the rest of Europe.

Second, the renewed worry that China, the world’s second biggest economy, is showing further signs of economic slowdown, with the risk of a credit bust.

And, third, that the US economy, the relatively best performer among the major economies since the end of the great recession, is also showing weaker economic activity, just at a time when the US Federal Reserve reckons it needs to hike interest rates to ‘cap’ inflation (and wage rises). ‘Uncertainty’ is the word of the moment - and, as mainstream economists continually tell us, ‘confidence’ about the future is paramount for investment.

Indeed, only this week, economists at the US investment bank, Morgan Stanley, voiced their concerns:

We think that the current macroeconomic environment has a number of significant similarities with the 1930s, and the experiences then are particularly relevant for today. The critical similarity between the 1930s and the 2008 cycle is that the financial shock and the relatively high levels of indebtedness changed the risk attitudes of the private sector and triggered them to repair their balance sheets. In 1936-37, the premature and sharp pace of tightening of policies led to a double-dip in the US economy, resulting in a relapse into recession and deflation in 1938.¹

 

What was worrying financial markets was that a vote for Brexit would have a damaging impact on the UK economy. And that is surely right - at least in the short term. There have been many estimates of the gain or loss from withdrawal for the UK economy. But the latest from the UK treasury reckoned UK GDP would be 3.6% lower after two years than if the UK voted to stay, unemployment 520,000 higher and the pound 12% lower. The Institute for Fiscal Studies has added that - instead of an improvement of £8 billion a year in the fiscal position if the net contribution to the EU fell - the budget deficit might be £20 billion-40 billion higher in 2019-20 than otherwise.² These fears have already hit sterling, which has fallen 5%-6% against other major currencies since the referendum campaign got under way.

But the main reason why the UK economy would suffer is because it is weak anyway. British capitalism has increasingly turned itself into a ‘rentier’ economy,³ where it get its surplus value not mainly from the production of things and services to sell at home and abroad, but increasingly from acting as a banker, investor and business advisor for other capitals overseas, and raking off a percentage in interest, rents and fees. That means the British population must import more and more goods from elsewhere to be paid for by monies ‘earned’ from financial and business services; and, most important, from the willingness of foreign capitalists to put their money into banks and financial institutions in the City of London.

So the UK runs a massive current account deficit on goods and services with the rest of the world (currently 7% of GDP). And it finances this deficit through what Bank of England governor Mark Carney has called “the kindness of strangers”. By this he means the inflow of foreign direct investment: the purchase of UK government bonds and corporate stocks, and what has been called ‘hot money’ - the movement of short-term cash and deposits into British banks.

Now these ‘capital flows’ are beginning to swing from the positive to the negative too. Direct investment in British companies, or the setting up of foreign companies on British soil, has been pretty steady - but who knows if it would continue after a Brexit. Portfolio investment shows that foreigners still want to buy and hold UK government bonds and stocks (as a ‘safe haven’), but the ‘hot money’ was flowing out big time up to 2015, and actually accelerated in 2016. If that outflow continues, then there will huge downward pressure on the pound, which may help exports down the road, but in the short term will drive up import prices and inflation, cutting into real incomes for the average household and raising costs for British industry.

China

Talking of capital outflows, that has been the issue in China as well. As economic growth has slowed from double digits to under 7% a year now (possibly lower), the Chinese currency has weakened and Chinese billionaires have been trying shift their money into dollars and out of the control of the Chinese authorities. Dollar reserves have plummeted.

I have previously argued that China’s slowdown will not bring the world down.⁴ But renewed worries about the failure of the Chinese government to turn things round and growing talk by the likes of the International Monetary Fund⁵ of the dangerous levels of debt (particularly corporate debt) owed to Chinese banks has recently revived concerns that China could implode.

The most significant sign that all is not well is the recent drop in investment growth in China. For the first five months of this year, investment rose ‘only’ 7.5%. That may sound a lot, compared to the pathetic rate achieved by the top capitalist economies (where investment is even falling), but historically, the current Chinese rate is way too low to sustain economic growth at even current levels. Even more worrying is the fact that investment by private firms has slowed to a record low, with growth cooling to 3.9% from double-digits last year. Private investment accounts for about 60% of overall investment in China. And this investment and debt is having less and less effect on sustaining growth and productivity.

The government has tried to boost infrastructure spending to compensate, yet not allow credit growth to get out of hand, causing a financial bust. It is a dilemma that has provoked disagreement among the Chinese leadership, between the president and the prime minister, who is in charge of economic policy. The former wants ‘structural reform’ - ie, cuts in ‘zombie’ state companies - while the latter wants to engage in more credit injections. And the battle between those who want to move further down the capitalist road towards privatisation and a market economy (backed by the World Bank and the IMF) and those who want to preserve ‘Chinese socialism’, with its state-owned, Communist Party-controlled planning mechanism, smoulders on.

But the third point in the current nexus of worry is the US economy. As Larry Summers, former US treasury secretary, promoter of the thesis of ‘secular stagnation’⁶ and regular Financial Times columnist, pointed out,

Any consideration of macro policy has to begin with the fact that the economy is now seven years into recovery and the next recession is at least on the far horizon. While recession certainly does not appear imminent,⁷ the annual probability of recession for an economy that is not in the early stage of recovery is at least 20%.⁸ The fact that underlying growth is now only 2%,⁹ that the rest of the world has serious problems, and that the US has an unusual degree of political uncertainty, all tilt toward greater pessimism. With at least some perceived possibility that a demagogue will be elected as president or that policy will lurch left, I would guess that from here the annual probability of recession is 25%-30%.¹⁰

 

Last month’s US jobs report was particularly weak and the US Federal Reserve’s own measure of employment conditions is falling at a rate that often presages an economic slump. The Fed is still dithering over whether to raise its policy interest rate or not this year. It is still desperately hoping that the US economy is going to pick up in the second half of the year. But, at best, real GDP growth will be no more than 2%, as it has been more or less for the last five years. At worst, it could slow or even contract.

And do not forget the best indicator of the health of a capitalist economy: profitability and business investment. The latest data show falling corporate profits in the US, which usually presages a fall in business investment and from there a recession. So if the Fed does go through with a hike in rates,¹¹ that could add another negative to the conjunction of events (Brexit, China) tipping the world into a new recession.

The world economy has been in the grip of a long depression of below-trend economic growth, near deflationary conditions, stagnant business investment and very weak productivity growth. Most significantly, world trade growth has slumped well below trend. And at the same time, the great ‘globalisation’ of capital expansion around the world has reversed. Capital flows between the major economies had reached 45% of their GDP in 2007. Now that has fallen to just 5%. And the latest estimate by JP Morgan of global manufacturing output growth, the key sector of productive expansion, shows a level near zero.

All this helps explain why the EU referendum had assumed a global significance.

Michael Roberts blogs at https://thenextrecession.wordpress.com, where this article first appeared.

Notes

1. www.newsmax.com/Finance/StreetTalk/world-economy-1930s-scars/2016/06/18/id/734508.

2. www.ifs.org.uk/uploads/publications/comms/r116.pdf.

3. https://thenextrecession.wordpress.com/2016/02/24/british-imperialism-the-city-of-london-and-brexit.

4. https://thenextrecession.wordpress.com/2016/01/14/will-china-pull-down-the-world.

5. www.imf.org/external/np/speeches/2016/061016.htm.

6. See https://thenextrecession.wordpress.com/2013/11/30/secular-stagnation-or-permanent-bubbles.

7. See James D Hamilton’s ‘GDP-based recession indicator index’: www.frbatlanta.org/cqer/research/gdpbased_RII.aspx.

8. See www.nber.org/cycles/cyclesmain.html.

9. https://fred.stlouisfed.org/graph/?g=3Eux.

10. www.washingtonpost.com/news/wonk/wp/2016/06/14/larry-summers-the-fed-is-making-the-same-mistakes-over-and-over-again.

11. See https://thenextrecession.wordpress.com/2016/01/18/the-fed-interest-rates-and-recession.