The aftermath of the 1997 ‘currency crisis’


This article was written at the end of October 1999 with a view to being reproduced in the November/December issue of LALKAR. However, lack of space prevented its publication then. The reader ought to keep this in mind when confronted with a reference to expressions such as this year and last year. Nothing has happened in the intervening two months to make the author make any changes to the text. The article will appear in two parts: Part 1 appears below.

Part 1

“Commerce is at a standstill, the markets are glutted, products accumulate, as multitudinous as they are unsaleable, hard cash disappears, credit vanishes, factories are closed, the mass of the workers are in want of the means of subsistence because they have produced too much of the means of subsistence, bankruptcy follows upon bankruptcy, execution upon execution.”

Thus wrote Frederick Engels in 1876 in

Socialism: Utopian and Scientific.

The world capitalist economy is facing a most serious crisis. How are we to explain this crisis? What is the way out of this crisis? Only Marxian analysis, contained in succinct form in the above-quoted words of Engels, offers the key to the understanding of this crisis, as well as the way out of it.

The words of Engels that we have quoted were written about England in 1876, but could just as well have been uttered in response to the shambles of the economies of East Asia, the chaos in Russia and the imminent crash on Wall Street.

Then as now Engels’ words contain the key to understanding the whole crisis:

“the workers are in want of the means of subsistence BECAUSE THEY HAVE PRODUCED TOO MUCH OF THE MEANS OF SUBSISTENCE.”

In other words, these devastating economic crises are caused by Overproduction.

Bourgeois economic science offers little in the way of clear understanding in this regard, not because bourgeois economists are less intelligent, but because their outlook is hemmed in by their belief in the immortality of the capitalist system of production. They have sold themselves body and soul to the service of this parasitic, decadent and moribund system, namely, imperialism.

Thus even when they come pretty close to understanding the underlying cause of the crisis, they shy away from it, ending very often by confusing symptoms and their causes, and appearance and reality. One has to indulge in excavations, as it were, to dig and drag the truth out into the light of day.

Since the autumn of last year, stock markets in the centres of imperialism have melted down, melted up, and are about to melt down again. In this review article, we had to indulge in what can only be described as excavatory work to drag the truth out into the light of day. Notwithstanding their proclivity for confusing cause and effect and their obsession with incidental details, reality forces serious-minded and thoughtful bourgeois experts possessing the least amount of integrity to pick up information about the real cause of the crisis, namely, overproduction under the conditions of capitalism – although naturally they attach no blame to capitalism as such, and continue to express their faith, with the zeal of true believers, in the eternity of capitalism. In the main body of this article, no attempt has been made to allude to Marxism. Instead the bourgeois experts, who cannot be accused of the slightest bias in the direction of Marxism, have been dragged, kicking and screaming, to speak against their will, no matter how inconsistently and feebly, in confirmation of the conclusions of Marxist economic science, while all the time maintaining that Marxism is dead!

The aftermath of the 1997 ‘currency’ crisis

A little over two years ago, everything appeared to be hunky-dory for capitalism. The economies of Asia were booming – the South Korean economy was growing by 7% a year, the Indonesian by 8% and the Malaysian by 9%. The equity markets in the centres of imperialism, as well as elsewhere, witnessed hugely rising share prices and cascading paper wealth. Then suddenly, out of the blue as it were, many countries of the Far East were gripped by a crisis, which announced its arrival on 2 July 1997 with the precipitous fall of the Thai currency. Within a matter of weeks the crisis spread from Thailand to Indonesia, Malaysia, the Philippines, South Korea, Singapore and to Japan – which was already in the grip of economic difficulties. The effects of this crisis have been far more destructive than those predicted by even the most pessimistic of bourgeois economic analysts and commentators. Here, briefly, are the figures that provide such eloquent testimony to the economic meltdown in the Far East.

In the 12 months following the outbreak of the crisis, which began with the devaluation of the Thai currency on 2 July 1997, $100 billion of foreign capital fled Asia as the currencies of the ‘tiger’ economies tumbled, stock markets crashed, and major banks came face to face with insolvency – with their shares falling from 50%-90%. In dollar terms, compared with January 1997, equities fell by 85% in Indonesia, 83% in Malaysia and Thailand, 70% in the Philippines, 60% in South Korea, 50% in Hong Kong and 40% in Japan. In Asia as a whole, equities registered a precipitous fall of 60%. Within weeks of the outbreak of this crisis, the tiger currencies were in free fall. As against the dollar, the Thai baht suffered a devaluation of 50%, the Malaysian ringgit 40%, the Philippine peso 25%, the South Korean won 40%, the Singapore dollar 10%, the Taiwan dollar 15%, the Japanese yen 15% and the Indonesian rupiah fell from 2,434:$1 just before the crisis to an astronomical Rp 17,000:$1 on 22 January 1998, before rallying.

On 24 November 1997, Yamaichi Securities, one of the largest in the world, went bust. This came hard on the heels of the failure of Hokkaido Takushoku (the 10th largest commercial bank) and Sanyo Securities. Banks in all these countries are saddled with huge portfolios of non-performing debts. In Japan alone, problem debts amounted to over $600 bn – the result of bad loans at home and abroad.

Between 1996 and 1998 the shift towards surplus in the current accounts of the five most afflicted economies was to the tune of $118 billion, equal to 11% of pre-crisis GDP. From a current account deficit of 8% of GDP in 1996, Thailand moved to a surplus of 12% in 1998, making a saving of 20%. In South Korea the adjustment was 16% (from a deficit of 5% to a surplus of 11%). The swing in Malaysia’s current account deficit was 14% (from a deficit of 4.9% to a surplus of 9.4%). And in that of Indonesia the swing was of 7% (from –3.4% to +3.9%). Given this brutal consequence of the flight of capital, the depth of depression in these countries is not surprising. The fall in domestic demand was still more dramatic than in output, though the latter had been startling enough: in the year to the third quarter of 1998, real GDP shrank 17% in Indonesia, 11% in Thailand, 9% in Malaysia and 7% in Hong Kong and South Korea.

Japanese recession

As for that wonder of capitalist countries, namely, Japan, its economy, stagnating for years, went into contraction in the last quarter of 1997 and continued to contract for most of 1998. During 1998, Japanese domestic demand shrank 3.2%, Japanese private consumption fell by 1.8%, private residential investment shrank by 13.5%, and non-residential gross fixed investment dwindled 9.6%.

“If it were not for the improvement in Japan’s net exports, equivalent to 0.7% of the GDP, total output would have fallen still more than the estimated 2.6%” (Financial Times,

23 December 1998). Wholesale prices in Japan fell by 3.6% in the year to November 1998.

No wonder, then, that Japan finds herself in the midst of the longest recession of the past 50 years. Its unemployment rate hit a post-war record of 4.8% in April 1999. In a shock to Japanese national pride, the jobless rate in Japan is now higher than that of the US, with more and more Japanese workers being ‘restructured’ out. With the unemployment rate among men aged 16-24 at 11% (as compared with 7% among men aged over 54) social stability is increasingly under strain. The increasing unemployment is merely a reflection of the struggle of corporate Japan to stay competitive at home and abroad by boosting its faltering productivity and reducing wages and bonuses, whose share, as a proportion of GDP, has risen from 53% a decade ago to 58% today. Even the ‘core’ workers have not escaped this fate: unemployment among ‘bread-winners’ now stands at a post-war record of 3.6%. Japan’s suicide rate rose by 35% in 1998. Homelessness is increasingly becoming an ugly feature of big industrial cities. Clinics report a significant increase in middle-aged men seeking treatment for depression. The ‘jobs for life’ system is being shown the door. The generation that built Japan’s manufacturing might is the real victim. It is being required to be ‘flexible’ and accept jobs as security guards, cleaners and cooks, often for as little as 200,000 yen ($1,730) a month. Men often leave the house every day pretending to go to work, just to avoid the shame of their unemployment.

Aware of the damage to Western imperialist interests should complete economic collapse persist throughout East Asia, the IMF dug deep: $17.2 billion to Thailand; $46 billion to Indonesia and $57 billion to South Korea. Reputedly the IMF had only some $25-30 billion left in the kitty, and the banks that provide its funds were less than anxious to provide more.

Devastating effects of the crisis

Since its outbreak in the summer of 1997 in Thailand, the currency and stock-market turmoil, spreading like wildfire to Indonesia, Malaysia, the Philippines, South Korea, Singapore, and to Japan, has wreaked havoc, causing big business failures, throwing millions of workers out of their jobs, and sharpening inter-imperialist contradictions to the extreme. In the words of a leading article in the

Financial Times

, the crisis in the Far East

“has laid waste what was once the most dynamic part of the world economy.”

(‘1998 in the Crystal Ball’).

“Tens of millions of people,” says the

Financial Times

of 24 April 1999, “

have lost a degree of comfort it took a lifetime to achieve.”

According to the

Financial Times

of 28 September 1998

“millions of household in East Asia are being pushed back into poverty by the regions financial crisis, threatening to reverse decades of achievement in poverty reduction and human development, according to a World Bank Report …’What began as a financial crisis has also become a fully-pledged social crisis. Unemployment already has reached record levels, real wages have plummeted, prices for essential commodities have risen and social services have been cut back. Households are coping by rationing food, pulling children out of school, and in some cases resorting to illegal activities. Violence, street children and prostitution are all on the increase and the social fabric is under increasing strain’”.

A Report by a certain Mary Jordan, which appeared in the

International Herald Tribune

(IHT) towards the end of September 1998, paints the following vivid picture of the devastating effect of the crisis of overproduction in the Far East:

“The ambulances, the lawyers and the guards with chains swooped into Seoul Christian Hospital without warning one day this summer. They loaded patients onto gurneys and carted them all away, including a semi-conscious little boy who had lain curled and silent in room 3B since his birth 9 years ago. They chained down equipment and locked cabinets and doors. They took away medicines and machines and all the things that had saved lives there, until the economic collapse in South Korea made saving lives too expensive.

“When the hospital went bankrupt, all that was left behind was the disbelieving staff: more than 200 nurses and pharmacists and medical aides who had stuck by their patients and their hospital long after their pay cheques stopped coming. They were owed an average of $7,000 each in back wages, and when the owner tried to throw them into the street, they simply sat down, too stunned to move and too scared to face life without a job.

“This is what the Asian economic crisis has brought to South Korea. Nearly a hundred times a day somewhere in this country, someone’s dream – a tennis shoe factory, a corner grocery store, a giant automaker, a promising fashion house, even a hospital – is crushed under the weight of the economic collapse. Unpaid bills are paid too high, the ‘closed’ sign is posted, workers are dumped and the economy slips a little lower.

“From the tropical islands of Indonesia to the mountains of Thailand to the factories of South Korea … the abrupt crash has shattered the lives of tens of millions of people. … Hunger and malnutrition are rising, more and more children are dropping out of school, and child labor is increasing as Asia’s miracle dissolves into misery. And those who already were poor are suffering more.

“Relentless waves of bankruptcies and unemployment are battering the region. In Indonesia, there were about 5 million people unemployed last summer. By the end of this year, that number is expected to reach 20 million. Another one million have lost jobs in South Korea this year, and two thousand people a day are losing jobs in Thailand.


“The first attempts at quantifying the human suffering in terms of school drop outs and child labor, rising medical problems, poverty and hunger, are not being made by the World Bank, Oxfam and other international relief organisations and the individual countries themselves. … ‘It is no longer a question of whether the region will recover in one year or two, but whether the recovery will come in five or ten years,’ said Charles Morrison, President of the East-West Center”. (Our emphasis)

The effects of the crisis have wiped out literally over-night the emerging petty bourgeoisie. According to Peter Montagnon

“in Thailand, the middle classes – with their high expectations manifested in newly acquired golfing skills and chattering mobile phones – are being wiped out by the recession. Other countries, such as Indonesia and the Philippines, face excruciating increase in poverty which adds to the risk of social disorder.”


Financial Times,

7 September 1999)

Imperialism, through the IMF bailout packages totalling nearly $120 billion, made efforts to contain this crisis, to limit its damage to Asia. And, for a while it looked as though the conjuring trick had worked. While most of the Far Eastern capitalist countries lay prostrate, devastated by the malign demons of market forces, stock exchanges in the principal countries of imperialism soared to unprecedented heights. In July 1998 they were 60% higher than in January 1997.

In view of the dire economic picture prevailing in the Far East at the time, with the economies of those countries reeling from the hammer blows of a deep recession, and the US trade deficit soaring to unprecedented heights, it may appear a little strange that the stock markets in the US and Europe should have gone from strength to strength. This, however, is only an apparent paradox – not a real one. As Marx explained long ago, the fever of speculation is only a measure of the shortage of outlets for productive investment: the depressed state of industry is reflected by an expansion of speculative loans and speculative driving up of share prices. The crisis of overproduction is a reflection of the over-accumulation of capital, which, unable to find profitable opportunities for productive investment, seeks a way out in stock market and other speculative activity in an endeavour to make a profit. The tendency for the mass of surplus value to increase at a slower rate, as Marx showed, than the total capital employed is expressed in the TENDENCY OF THE RATE OF PROFIT TO FALL, which only goes to show that production for profit is an inadequate basis for the consistent development of society’s material conditions of existence.

The demand for the products of industry was falling in one sector after another, from aircraft to cars, steel to oil, from the products of the engineering industry to semi-conductors – everywhere. Combined with this, the crisis in the Far East – Thailand, Indonesia, Malaysia, the Philippines and South Korea – resulted in a huge flight of capital from these countries to the imperialist heartlands. According to the Washington based Institute for International Finance, there was an adverse shift in net private capital flow to the tune of $109 billion (£65.2) billion) – representing more than 10 per cent of the pre-crisis aggregate GDP of these five countries. All these massive sums, and more, since the Far East ceased to be a good source of profitable investment, were pumped into the US and European stock markets – which explains why these stock markets became so bullish and why they rose by an incredible 60 per cent between the start of 1997 and July 1998.

In the second half of 1997, a massive flight of capital from the far east went straight into the stock exchanges of the US and Europe, thereby temporarily pushing up their prices. According to the

Financial Times

of 6 August 1998, a total of $126.2 billion (£76.4 billion) flowed into equity funds in the first 6 months of 1998 – easily ahead of the $108.3 recorded in the first half of 1997.

Since the buoyancy on the stock market bore little relation to the productive base of the world capitalist economy, which continues to limp far behind, it was only a question of time before speculative bubble bust, as it did with a fall of 300 points in the Dow Jones Industrial average on 4 August, signalling an end, even if temporary, for reasons we shall come to, of the ‘great bull run’, bringing to a grinding halt the so-called Goldilocks economy, whereby corporate earnings moved higher and higher without stoking the fires of inflation.

Twin shocks – crisis jumps continents

Then came the twin shocks of the Russian default and the near collapse of the LTCM hedge fund – enough to wipe the grin off the faces of the imperialist bourgeoisie.

The crisis, which started in Thailand in July 1997, had by the beginning of July 1998, jumped continents, its first victim being Russia, which was propelled into the whirlpool of a crash thanks to the combined effects of the declining yen, a fall in the international oil price, fears of a Chinese devaluation and the soon-to-follow slide on Wall Street.

The attempt to prevent the Russian collapse through a $22.6 billion IMF rescue package proved no more effective than the proverbial attempt to empty the ocean with a bucket. On 17 August, Russia effectively defaulted. The Russian government devalued the rouble by a third, something that only three days previously Yeltsin had vowed not to do. It imposed a 90-day moratorium on some foreign debt repayments; and it decided to restructure the domestic debt market.

Far from stemming the crisis, these measures only served to exacerbate it. Not only did the foreign lenders to Russia lose their shirts (not a day too early), but the measures precipitated a run on the banks, a further plunge in the rouble and the Russian stock market. The rouble lost 60% of its value in one week and the Russian stock market fell 80%.

The convulsions that followed these shocks sent the stock markets over the next few weeks plunging into a frightening downward spiral. Shares in London suffered their biggest fall since the crash of 1987 as fears about the Russian financial and political crisis sent tremors through the world markets. In just three days the FTSE 100 index fell 405 points, or 7.2%. At its worst, on Friday 28 August 1998, it stood 1,000 points below its all-time high of 6,179 recorded a few weeks earlier.

The Dow Jones Industrial Average fell dramatically. From its peak of 9,337 on 17 July 1998, it plunged to 7,286 – approximately 20% below its mid-July level, losing all the gains it had made earlier in the year. Within less than 3 months of the outbreak of the Russian crisis, the S&P 500 Index dropped nearly 20%, the FTSE 25% and the European markets 35%. The Nikkei 225 average fell to a 12-year low.

Foreign investors in Russian bonds faced losses exceeding $33 billion (£20 billion) because of the Russian government’s default. No wonder, then, that shares suffered badly, as investors responded to fears over trading losses and loan provision – German banks in particular had heavy exposure to Russia. Following the Russian collapse, Deutsche Bank shares fell by DM 6.80, of 5.5%, to DM 115.80 ($66.33). Chase Manhattan closed down $6.125 at $58.12, while Citibank fell $10.50 to $122.50.

“What we are witnessing now in terms of the breadth and depth of value [it should be price]

diminution is the biggest collapse in security markets since the war,”

said Mr Deryck Maughan, joint head of Salomon Smith Barney, following the 512 points plunge in the Dow Jones on Monday 31 August 1998, as the dreadful news from Russia and Asia revived fears of a global slump.

Technology stocks were some of the biggest casualties, with Dell Computers, whose shares had nearly tripled during the previous one year, losing 15%, Microsoft 9% and Intel nearly 8%.

Equity markets in dollar terms fell in all other parts of the world too – by 29% in Argentina, 36% in Singapore, 40% in Mexico, 60% in Indonesia and 80% in Russia.

Thus, what was described as a ‘summer correction’ turned into a full-blown rout.

The bewildering speed with which the crisis spread from Asia, via Russia, to the citadels of imperialism, obliged bourgeois economic commentators to admit that the

“Asian crisis is no local difficulty. It has spread, changing trade patterns, depressing commodity prices and undermining financial markets.”

(‘Threats of depression’, Martin Wolf,

Financial Times,

26 August 1998). And that:

“Already, therefore, this crisis has global significance. It is imposing heavy pressure on the political and social stability of many countries directly affected. It has raised questions about global capital markets. And it is spreading almost everywhere via adjustments in trade, declining commodity prices and the shrinking appetite for risk.” (ibid).

Imperialist response to the stock market plunge

This nightmare scenario unleashed by the scale of the global crisis precipitated by the Russian default and the near-collapse of the LTCM, became clearer in the weeks following the Russian devaluation. Not only did the so-called emerging markets implode, but, more depressingly for the managers of the imperialist economy, the investors took flight from all but the safest of American stocks – instead investing their money in gilt-edged Treasury bonds, the yield on which fell sharply during this period. Over the following two weeks stocks fell 7%. The entire world capitalist economy was peering into the abyss. Then, as one bourgeois journalist put it, the Cavalry arrived – in the form of co-ordinated interest rate cuts. Fearing a potentially devastating market collapse, putting paid to US expansion, and with it the only prop to global growth, the US Treasury, egged on by the Clinton administration, sought to co-ordinate an international response to address market fears. In this, the Treasury needed, and secured, the willing co-operation of Mr Greenspan, the Chairman of the Federal Reserve, who signalled his willingness to cut interest rates and thus help to sustain artificially high equity prices, which in turn kept US growth and the world capitalist economy afloat – pro tem.

In his now famous remarks to an audience in San Francisco on 4 September 1998, Greenspan said:

“It is just not credible that the United States can remain an oasis of prosperity unaffected by a world that is experiencing greatly increased stress.”

This was a coded message that the Fed had changed its view as to the risks to the US economy, since only a few weeks earlier and now had

“to consider carefully the potential ramifications of ongoing developments”.

In parallel with the developments at the Fed, the G7 issued on September 14, 1998, a statement to the effect that

“the balance of risk in the world economy



away from inflation towards much slower growth. In the words of the

Financial Times:

“The strategy then was in place – the Fed was signalling interest rate cuts in the offing. The rest of the world had signed on to a promise to promote growth; markets were showing early signs of stabilising.” (‘Cooling the global markets’, Gerard Baker,

Financial Times,

30 December 1998).

Meanwhile, on 23 September, while Greenspan, appearing before the budget committee of the US Senate in Washington, was busy sending a reassuring message to the much-troubled markets, two hundred miles away in the Manhattan headquarters of the New York Fed, its President, William McDonough, was sitting round a table in complete secrecy with some of the biggest sharks in Wall Street, haggling over the terms of a deal to rescue LTCM, brought to the brink of collapse by the Russian crisis – with exposures of more than $200 billion.

Under the deal, some of the largest players on Wall Street agreed to contribute $3.6 billion to avert LTCM’s collapse, which would have threatened horrendous global financial turbulence and ushered in a world-wide recession in the autumn of 1998.

Following the LTCM rescue, the Fed, beginning with September 1998, made three interest rate cuts of 0.25% in quick succession. Following the first interest rate reduction in the US, according to reports, central banks in 22 countries, including Germany, France, Italy, Britain and several other European countries, cut interest rates, in an unprecedented set of 55 steps. 13 October 1998- the date of the second cut in interest rates – was the turning point in the temporary economic fortunes of world capitalism. The Dow rose 300 points in the remaining 45 minutes of trading and continued to soar the following week as traders became confident that the Fed stood ready to man the pump of monetary stimulus and far less worried that the Central Bank’s emergency measure must be indicative of the situation being really grave.

All this co-ordinated activity on the part of the US Treasury, the Fed, and their counterparts in other countries, had the intended effect of first arresting and then reversing the slide in equities in the US and across Europe and other parts of the globe. By 25 November 1998, the Dow Jones Index had returned to its 1998 high levels. Stock exchanges across Europe, including London, quickly recovered the ground lost during the previous three months.

Since then the Dow Jones has surged further ahead. On 16 March this year [1999] it broke through the 10,000 barrier. At the time of writing it stands at an unsustainable 11,028 mark. While the FTSE 100 is at 6191.

The Japanese and other Asian economies are also showing signs of a fragile recovery. The South Korean economy, which shrank 6% in 1998, accompanied by a 10% contraction in consumer spending and a 29% drop in investment, is expected this year (1999) to grow by 5%. The Malaysian economy, having shrunk 6.7% last year, is expected to grow 0.5% this year. Hong Kong is expected to show zero growth this year, compared with a contraction of 5% last year. The Indonesian economy is likely to contract by a mere 3% following last year’s plunge of 13.7%. Thailand’s economy is set for a growth of 1% in 1999, following a decline of 8%. And the Japanese economy, after a decline of 3% last year, is like to grow by just over 1%.

Exceptional circumstances

The Fed was persuaded, and much helped by these exceptional factors in opting for the policy of cuts in interest rates:

First, in view of the flight to safety from the Far East and Eastern Europe into US bonds, there was not much danger of capital fight from the US consequent upon interest rate reductions, for there was nowhere for it to go.

Second, the huge inflows of capital into the US strengthened to dollar, thus negativing any loss suffered by foreign investors in US bonds following interest rate cuts.

Third, the willingness of many a European country to agree with the US to a co-ordinated policy of interest reductions, partly because, having already met the EU’s convergence criteria for Monetary Union, they were in a position to loosen monetary policy, and partly because they too were convinced of the need for such action to avert a meltdown on the stock exchanges.

Lastly, the collapse in commodity prices, resulting from a steep decline in growth in East Asia and Japan, with its disinflationary effect, persuaded the Fed not to worry unduly about fuelling inflation through reductions in interest rates. At the end of 1998, Brent Crude oil fell below $10 a barrel and non-oil commodities cost 70% less in real terms compared with two decades earlier. Between the middle of 1997 and the end of 1998 alone, copper prices collapsed by 40% and wheat prices by a quarter during 1998. While revenues declined in the oil and other primary commodity producing countries, huge amounts of extra wealth was transferred to imperialist countries through low prices, further widening the gap between the rich and poor nations of the world.

If the sluggish growth in the Eurozone, the Japanese recession and the crisis in the Tiger economies had not exercised downward pressure on prices, the surge in US demand (which grew by 5% in 1998 – up from 4.25% in 1997, accounting for half of the increase in total demand) would certainly have been inflationary enough to oblige the Federal Reserve to raise interest rates and thus put a brake on growth and knocked the stuffing out of the inflated equity valuations into the bargain.

Luckily for imperialism, US imperialism especially, the Japanese recession and the Asian crisis by coincidence were perfectly timed. Writing at the end of 1998, and explaining how the world economy escaped a global recession in that year, Martin Wolf made the correct observation that the recession in the world’s largest creditor nation and the exuberant expansion in the largest debtor nation complemented each other -–thus preventing world capitalism, if only temporarily, from stepping over the precipice:

“The global economy got through 1998 without a recession thanks to two offsetting mistakes: an excessively expansionary US policy was balanced by excessive contraction in Japan and other parts of Asia. In normal times, the US expansion would have been much too inflationary. As it was, the impact was cancelled out by unexpectedly severe contraction in Asia, and strong US growth helped support Asian exports. Only an optimist would expect another such miracle in 1999.” (Cauldron bubble,

Financial Times,

23 December 1998).

Stock market –driving force behind the US boom

Over the past few years, since the outbreak of the present crisis in the summer of 1997 in particular, the strength of the dollar has enabled the US to play the dual role of an engine of global growth and an importer of last resort for the world economy. US consumers, buoyed by cascading paper wealth, have been able to indulge in a spending binge without any need to save since foreigners have been willing to step in with the necessary capital for US investment.

Besides financing the huge US trade deficit,

“These strong capital inflows have helped finance a stock market and corporate investment boom at a time when US households are spending in excess of their income. So the economy has continued to grow despite a growing current account deficit that reflects the shortfall of domestic savings against investment.”

(‘The wobbliest month’, John Plender,

Financial Times,

13 August 1999).

The unprecedentedly high stock market valuations have been the driving force behind buoyant US spending, for households owning shares feel richer as the prices of the shares they own go up, and they save less. This assumes great significance in view of the fact that the number of households that own mutual funds in the US has risen from 10 million at the beginning of the bull market to 40 million today.

“The average American household,”

according to Richard Waters,

“has more than a quarter f its wealth on the stock market; more than half of its financial assets are in the form of shares. Fifteen years ago, with the stock market suffering the after-effects of 1970s stagflation, equities only made up 8 per cent of household assets.”

(‘Stock market odyssey’,

Financial Times,

17 March 1999).

Likewise corporations, finding their capitalised values increasing build new facilities.

“Research at the Federal Reserve suggests that the decline in net private savings that lies behind the strong growth in domestic demand is largely explained by increase in equity values.”

(‘Greenspan’s asset markets,’

Financial Times

leader, 19 December, 1998).

Thus, while rising equity prices lead to buoyant spending, the latter in turn, in the short term to be sure, drives equity prices up further still. Equities in the US have done exceptionally well. The current stampede into US stocks goes back to 1982, since when Wall Street has put in an astonishing performance, with an average annual price appreciation of 14.5% (only in 1990 and 1994 did the indices end down). During the past four years – 1996 to 1999 – alone, the annual price appreciation has been 28%. While US corporate earnings have expanded at about 7% over the past 17 years (and for that matter, since the end of the Second World War), this accounts for a mere third of the S&P’s gains, the remainder coming from an expanded price/earning (PE) multiple, which has risen from single digits to a peak of 38:1 earlier this year. If the Dow Jones index stood at 1,000 at the end of 1982, on 16 March this year it burst through the 10,000 barrier. If in 1982 equity prices were the equivalent of 25% of the US GDP, today they represent a staggering 125% of its GDP.

Additional factors behind the phenomenal rise in equities

In addition to the huge amounts of foreign capital flowing into the US (in 1997 alone, $60 billion of foreign capital poured into US stocks – more than the previous 9 years combined), three other factors have contributed to the phenomenal rise in equity valuations. First, there are the take-overs and mergers, which offer companies the opportunity of cost cutting, improved market gains and achieving economies of scale. As investors recognise this trend, blue chip shares have outperformed small companies – thus providing added incentive for companies to grow even bigger by acquisition – characteristic of the Dow’s rise since the latest bull market is the domination by a handful of companies. Since 1982, while corporations such as Coca-Cola, Merck and Walt Disney have risen 40-fold, others have done far less well.

Second, the practice of share buy-backs, which has been gaining strength over the past decade, has an even larger effect in driving share prices up. Companies, instead of hoarding surplus cash, which is productive of low return in the current economic conditions, return it to shareholders in the form of buy-backs. The rather low cost of borrowing presently, combined with the fact that debt is tax-deductible, only encourages companies in this practice – to the extent of persuading them to borrow money for the purposes of buying back their own shares. It is hardly surprising, then, that over the four quarters to September 1998, the US corporate sector accumulated some $359 billion of debts – the highest ever figure for any 12-month period (see Philip Coggan,

Financial Times,

13 March 1999).

Not only were there very few new issues of shares, in the four quarters to the end of September 1999 in the US there was net retirement of about $158 billion, while in Britain there was a reduction in the supply of equity to the tune of £30 billion in 1998. With more and more large investors chasing fewer and fewer blue chip shares, it is hardly surprising that their prices have been pushed up beyond belief.

The third factor contributing to the high valuations on Wall Street has been the so-called moral hazard, the belief that the Federal Reserve is putting a safety net under the market following the 0.75% cut in interest rates last year – that the Fed will not allow the stock market correction to go so far as to push the US economy into recession, that it will come to the market’s rescue by opening monetary sluice gates – as it did last autumn [1998] or back in 1987 after the collapse of US equity markets in October of that year.

Mr Greenspan, the Chairman of the Fed, admitted with great candour in December 1996 that

“Irrational exuberance”

on the stock market has been the price of an activist monetary policy aimed at

“maximum sustainable growth of the US economy.”

The result of such an interventionist policy has been, as was to be expected, to send the wrong signals, resulting in inflated asset prices and, to use the apposite terminology of Hans Tietmeyer, the former President of the Bundesbank, to

“move the financial markets in the direction of casino capitalism,”

which are threatening to cause a systemic failure and bring the markets to a scandalous collapse. Doubtless

“…a policy of responding directly to sudden falls in asset prices, and to the consequent drying up of liquidity, provides a degree of central bank insurance to investors against the risk of being trapped in a collapsing market. If so, central banks may help to create the bubbles whose destabilising consequences they so justly fear.”

(Martin Wolf, ‘Bubble trouble’,

Financial Times,

24 September 1999).


To be concluded in the next LALKAR]

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