Back in the 1930s, the French government constructed what it thought was an impregnable defence system to prevent a repeat of the German invasion at the start of the first world war. The Maginot Line might have looked impressive but proved to be a white elephant because when the attack came in 1940 it was in a different place altogether.
In the past week the financial markets have displayed something of a Maginot Line mentality. They are right to think there is a threat lurking out there but they are wrong to think the biggest danger is a recession in the US. The real threat comes from elsewhere.
To be sure, the US economy is slowing down, but it is not remotely close to recession. Unemployment is rising but from historically low levels. The US central bank, the Federal Reserve, has left it a bit late to cut interest rates but it can make up for lost time over the coming months. The US economy has staying power and – as in the past – is likely to confound the pessimists. After an extreme bout of the jitters, by the end of last week Wall Street seemed to have come round to the idea that the US is on course for a soft landing. That looks by far the most plausible outcome.
There are two other sources of potential trouble: the Middle East and China. Far too little attention is being paid to the risks that the war in Gaza escalates into a full-scale conflict between Israel and Iran. In the past, this kind of ratcheting up of tension would have led to a sharp increase in the cost of crude, but it hasn’t happened. A Middle East-induced oil shock has been the dog that hasn’t barked. For now.
One reason rising tension in the Middle East has not been reflected in commodity markets is that China’s growth prospects have taken a turn for the worse. The belief in the financial markets is that policymakers in Beijing will take action to stimulate the economy and that the slowdown will be temporary. Again, this is a questionable assumption.
China’s problems are structural and have big implications for the rest of the world. For decades it has relied on a growth model based on building up industrial capacity through massive state investment and cheap credit. The concentration on manufacturing has resulted in relatively weak levels of consumer spending coupled with a rapidly deflating property bubble.
A recalibration of this model – shifting the balance away from investment and exports towards consumption – is long overdue. Social safety nets offer far less protection than they do in the west, and it has proved impossible for the domestic economy to absorb all the goods produced by China’s factories. The excess capacity has been sold as exports, leading to huge trade surpluses.
From time to time, China’s leaders flirt with the idea of changing tack but are wedded to the strategy that has resulted in the country becoming the world’s second-biggest economy. In the 1990s, it was this model of export-led growth that helped push down inflation in the west – and it is doing so again. Goods prices in the UK in June were 1.4% lower than a year earlier – partly the result of China flooding the market with cut-priced goods.
Writing in Foreign Affairs magazine, Zongyuan Zoe Liu, a fellow at the Council on Foreign Relations thinktank, notes that China is producing twice as many solar panels as the rest of the world can put to use, while almost a third of car manufacturers are unprofitable.
“China is producing far more output than it, or foreign markets, can sustainably absorb. As a result, the Chinese economy runs the risk of getting caught in a doom loop of falling prices, insolvency, factory closure, and, ultimately, job losses,” she says.
The mismatch between supply and demand has meant Chinese companies have had to cut their prices, resulting in falling profits, and even deeper discounting as they struggle to pay off their debts and remain afloat.
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There are already signs of stress. Growth looks as if it will undershoot this year’s 5% target set by officials in Beijing. Export figures released last week failed to meet market expectations. A measure of the money supply, which has a track record as a lead indicator of future growth, is flashing red.
Two things differentiate the China now from the China of the 1990s. First, the problems of overcapacity and overproduction have intensified. Second, western governments are no longer prepared to sit back and allow their own industries to be wiped out. They have whacked tariffs on Chinese goods and – in the case of the US – offered generous subsidies to domestic producers.
There are a number of ways this could play out. China might bow to western pressure, voluntarily limit its exports, and recast its whole economic model. This seems highly improbable.
Far more likely is that tensions between the west and China intensify rather than ease. Beijing insists it is not guilty of dumping its excess production on global markets, while Washington and Brussels insist it is. China is already trying to divert exports through third countries in order to avoid western tariffs but has so far resisted the temptation to introduce tit-for-tat measures of its own.
A short-term risk is that the west’s protectionist actions lead to higher prices, higher inflation and higher interest rates. A longer-term risk is of the west adding to the global glut goods by ramping up its own production. In that event, the rate of profit would fall and global capitalism would face of a crisis of its own making – just as Karl Marx predicted.