Alphabet of global downturn—pessimism about financial future

By Jim Mellon, The Observer (London), Sunday 25 September 2005

Financier-turned-economic pundit Jim Mellon sees no reason to be optimistic about the world's financial future

The unwelcome arrival of Katrina and Rita in the US has swept away illusions about American society. The competence of the authorities, the standard of living of many of its people, the fabric of the country's infrastructure—all have been cast in doubt by the storms' effects. Third World scenes of starvation, looting and rampage have emphasised the fine line between ordered society and the law of the jungle. No country is ever that many steps away from anarchy and chaos.

The same is true of financial markets. Although a natural optimist, I am going to make a prediction that is almost apocalyptic. In a short time—a few years at most—the rich West and Japan will have a terrible shock. Living standards will fall precipitously, companies will fail en masse and established institutions will find themselves in financial peril. Asset prices—particularly those of houses—will fall dramatically in some countries, notably the US and UK, and world trade conditions will deteriorate significantly.

Worse, global tensions will rise and China will not only be a threat to Italian sock and bra manufacturers, but a potential military threat to the Pax Americana.

There will be no warning of the arrival of this downturn, but the early signs are clear. Simplistically, I distil these threats into five categories, A, B, C, D and E. All of them represent confluent trends that herald the end of a long period of human advancement in the rich world. Six decades of technological advance, growth in material output, extension of human longevity, and unbroken peace in our cosseted part of the world, is coming to a conclusion.

The five trends are:

** Anti-Americanism and the beginning of the end of US hegemony.

** Balances—trade, fiscal and societal—which are out of kilter as never before.

** China's growth which has put it on the way to being the world's largest economy and the main Pacific power.

** Debts run up by consumers, companies and governments are at all-time peaks, and a dramatic and painful correction is the only remedy.

** Environmental: even ardent Bushites must be beginning to think man is having some effect on the planet's climate. The world's population has quadrupled in 60 years, and the problems of waste and consumption, as well as of pollution, are not going to get any better.

The anti-Americanism is a feature of nightly TV news bulletins. Since two-thirds of the world's population—the part that is young and growing - live in relative poverty, there will be frustration about and antipathy towards the Big Brother of the affluent world.

The US policy of acting as a roving cop has added to Second and Third World disaffection, and fundamentalism and terrorism are the children of disaffection. Efforts to help the poor world with rock concerts and debt cancellations are noble but insufficient, especially as Western farm subsidies do more harm to developing countries than our aid does good.

This anti-Americanism, and the US forays into hot spots around the globe, are in themselves not major factors in my economic predictions. But they add a backdrop of malaise to an already deteriorating situation, and will complicate any recovery from what is going to be a period of decline.

Balances—the B on my list—are glaringly awful. The US imports half as much again as it exports, and it pays for the deficiency in its own, self-printed currency. Trade's obese twin deficit—the fiscal one—is largely paid for by Asian central banks recycling surplus dollars they receive for selling goods to America, through the acquisition of US government debt.

These negative balances—which apply to the UK as well—have been around for a long time, but we are close to the limits of their expansion. Any refusal by the Asians to keep on funding US profligacy, or any serious moves to protectionism by the major Western nations, will tip us into a rerun of the 1929 Wall Street crash.

There is only one way out for the US, and it involves pain. I forecast that a deflationary period of adjustment is imminent and that while, confusingly, we are in a short period of commodity-induced price inflation, ultimately asset prices will fall.

The Anglo-Saxon housing bubbles are close to popping, and that will drag down consumption—the great driver of the world's economy—by more than anyone now imagines.

And that brings me to China. Its growth and ambitions are well known. Nearly a quarter of the world's population are prepared to work for wages which are on average one-hundredth of those in Germany. Whatever Germany, or the US or Italy, try to do, they cannot compete with that. More and more production will go to China, protectionist pressures will intensify and diplomatic tensions will grow with them.

All sorts of potential flashpoints exist, but if I had to pick one it would be Taiwan. China wants Taiwan back and one day it will have a go at getting it. The US response to that should be of more than casual interest to us.

In a way, we are in 1912 again. British supremacy was waning then and a new military power rising, one based on economic achievement. Then, of course, it was Germany. We have to hope a similar conflict doesn’t result with China.

The first problem with debt is that US and UK consumers have been using rising house prices as a kind of ATM machine to take out equity to spend, often on imported goods. When the merry-go-round stops—as is beginning to happen—the consumption stops too. A slump in consumption lasting a decade or more, as happened in Japan, is possible for both nations. American debt is higher today relative to the size of the US economy than it was in 1929, and all the monetary and fiscal tinkering in the world can’t cure its pernicious effects.

Last there are environmental issues. Wind farms, solar power and carbon credits will be nowhere near enough to combat the effects of population growth, China's higher consumption of commodities and the obliteration of the rainforests. Less consumption and more nuclear power are the only solutions.

In short, within three years the world economy will be in a significant downturn, and the correction process for the Anglo-Saxon economies will last as long as a decade.

Pay, and therefore living standards, will have to adjust to the effect of Chinese competition. Stock markets will collapse, house prices in the over-extended markets of the UK and the US will fall by up to 50 per cent, and major investment banks and other financial institutions will go bust.

Opportunities will abound for those with cash and little or no debt, but remember that the people who threw themselves from Wall Street windows in 1929 were generally not those who got caught up in the early part of the Crash. They were those who bought when shares had halved. Cheap can and will get cheaper.