Historically, October has been the month for big financial busts. But this year, October could come early.
Investors and ordinary citizens have good reason to worry about a perfect economic storm -- a deepening loss of confidence in the dollar, leading to higher interest rates; higher rates and anxious creditors bringing a crashing end to a hedge-fund, private equity and merger binge that depended heavily on cheap borrowed money and that kept the stock market pumped up; the boom in "sub-prime" bait-and-switch mortgages ending in a morning-after of sinking housing values; inflationary pressures in food, oil, and other commodities further spiking interest rates -- all unsettling financial markets, and putting a new squeeze on consumers borrowed to the hilt.
The historical parallels aren't comforting. In the years 1971-73, the United States devalued the dollar and went off the gold standard. Oil exporting countries, compensating for a weaker dollar and angry at U.S. support for Israel, hiked the price of oil. This triggered a decade-long period of stagflation -- high inflation, tight money, sluggish growth, shaky banks.
If anything, the U.S. is more vulnerable today. In that era, America enjoyed a net inflow of earnings from global investments, ran a trade surplus, and lent far more than we borrowed. As tourists of the 1960s appreciated, visiting Europe on a pittance of five dollars a day (in 2007, $5 buys coffee), the dollar was over-valued relative to Europe's play-money currencies, and overdue for a correction.
Today, however, our trade deficit is more than 6 percent of GDP, and we borrow heavily to finance both private capital needs and government debt. Until lately, optimists insisted that cheap foreign debt-financing would continue indefinitely and prop up the dollar, because it was in China's interest to keep underwriting American purchases of its ever-expanding exports.
But, swollen with dollars, China is behaving more like an activist investor. The Chinese government's investment arm has begun buying not just debt but real assets, including 9.9 percent of the private equity fund Blackstone and a big chunk of Barclays bank. We can't count on China -- or anyone else -- funding America's burgeoning foreign debt at bargain rates indefinitely.
If the dollar slide turns into a crash, the Federal Reserve would face the unhappy choice of either hiking interest rates to raise foreign confidence in the dollar (thus deepening domestic recession) or letting the dollar sink further and increasing imported inflation.
With three billion new consumers in Asia putting pressure on oil supplies, oil exporting nations warn that a declining dollar means further oil price hikes. Food experts, pointing to everything from global warming to diversion of farmland to ethanol production, project rising food prices. Increasing inflation could lead central banks to tighten money generally
And the prospect of tighter credit and a weaker stock market unnerves Wall Street. The Wall Street Journal recently tallied 21 credit deals ranging from $150 million to $20 billion since mid-June that had to be scrapped or delayed because nervous investors balked at the proposed terms.
Meanwhile, the backlog of unsold homes is at its highest level in 15 years, according to the Financial Times, which reports a 57 percent decline in the stock price of home building companies in the past two years. Busted private equity deals and predictions of a deeper housing slump sent the Dow plummeting by 520 points last Thursday and Friday.
Ironically, what economists call the "real" economy, as opposed to the financial economy, is highly dynamic (leaving aside its gross mal-distribution of gains -- which is another source of underlying weakness.) Every day brings stories of fabulous new uses of the Internet, dazzling applications of advanced technologies, and ingenious new consumer products. But every economic depression since the early 19th century has resulted from excesses in the financial sector undermining the real economy. 1929 was also a banner year for new technologies and nifty products.
When historians sort out what could well be the recession of 2007-2008, they will wonder why regulators did not act before the speculative binge in hedge funds, private equity, derivatives, and subprime mortgages pushed the larger economy into a general downward spiral. As always, the details will be complex, but the basic reason is pretty simple -- too many well connected insiders were making too much easy money.
A version of this column originally appeared in the Boston Globe.
