To most people, August 3, 2007, was an ordinary enough summer day. The American stock market fell about 3%, enough to lead the major newspapers, but hardly anything that would generate panic in the streets.
Yet to many people who work in economic policy or financial markets, that day was the beginning of what eventually be called the global financial crisis.
It was the day that lending froze up among banks within Europe, set off by the breakdown in the market for bonds backed by American home mortgages, and central banks first intervened to try to keep money flowing.
The 5th of August this month felt eerily similar, and not just because it was another August day in which the United States stock market fell by nearly identical amounts: The drop in the 58 P 500 stock index was 2.96% in 2007 and 2.98% on Monday, 5th of August. Markets in the Asia-Pacific region followed suit on Tuesday, led by a 2.4% decline in Australia. Indexes in China and South Korea fell about 1.5%, while indexes in Hong Kong and Japan were down about 0.7%.
For months, people who study economic diplomacy between the United States and China have warned that the world’s two biggest economies are on a collision course, that the trade-and-currency war between the two will have no easy resolution and that this tension could spill into other areas of policy and create dangerous ripple effects for the world economy.
During this month, that pessimistic story has become more real. President Trump said he would place 10 percent tariffs on 300 billion dollar in Chinese goods, ending a period in which there seemed to be some easing of tensions between the two nations. Based on this announcement the Chinese government allowed its currency, the renminbi, to fall below a symbolically important level of 7 renminbi to the dollar, an apparent retaliatory move that amounts to trade tensions spreading into another arena. The United States returned fire by formally naming China a currency manipulator.
The drops in financial markets are in our opinion hard to justify in narrow terms. A slightly weaker Chinese currency shouldn’t have huge consequences for the global economy. Rather, investors are coming to grip with the reality that the trade conflict is further escalating into a trade war and spreading into the global currency market.
While the drop in the American stock market gets the attention-the S&P 500 was down 5.8% by end of July, beginning of August- it is global bond markets that are flashing our attention and the most worrying signs about the outlook for economic growth in the United States and much of the world.
Ten-year Treasury bonds yielded 1.75% during Asian trade, down from 2.06% a week earlier – a sign that investors now believe that weaker growth and additional interest rate cuts by the Federal Reserve are on the way. The Chinese have in our opinion sent a strong signal that they are ready to rumble. To depreciate their currency at such a fraught time sends a strong signal that they are prepared to endure a heck of a lot of pain, and it doesn’t surprise us that markets would finally come around and say “This could be really bad.”
As we’ve seen many times through this trade was, escalation and de-escalation can come at seemingly any time. Mr. Trump could back away from his latest tariff threat and calm things down, or move the opposite direction by increasing the tariff to be charged on that 300 billion dollar in imports from China. But one recurring theme of the last two years is that trade conflicts in the Trump era never seem to become fully resolved, but rather go through more-intense versus less-intense phases.
Whatever happens next – and whether this turns out to be the beginning of a major turning point for the global economy or just one rough day on the markets – for us it is clear that the trade war is no longer confined to trade.
While Mr. Trump has often accused China of seizing advantage in global trade by manipulating the value of its currency to keep it lower, the latest developments reflect pretty much the opposite. In fact, a slowing Chinese economy is creating downward pressure on the renminbi – a pressure that China’s government has resisted, through intervention by its central bank and capital controls, to try to keep people from moving money out of mainland China. The Chinese essentially reduced the scale of that intervention and let the value of the renminbi fall closer to the level it would reach in an open market.
The risk is that Mr. Trump and eventually leaders of other nations will conclude that currencies are now fair game – which they are a good and appropriate weapon to use in trade disputes. For weeks Mr. Trumps has pilloried the Federal Reserve for not cutting interest rates more, arguing that this had made the value of the dollar excessively high, hence weakening American exporters.
Trade disputes and currency disputes have historically gone hand in hand. During the Great Depression of the 1930s, nations competed to devalue their currencies in “beggar-thy-neighbour” policies that ultimately made everyone poorer. It’s less clear what a 21st century currency war would look like. Major economies have mostly agreed not to take action to artificially depress their currencies at the expense of their trading partners. But selling monetary and fiscal policies aimed at helping your domestic economy is considered O.K., even if doing so has implications for currencies. The thing is, it can be debatable which bucket a given policy fits into. For example, countries including Germany, China and Brazil accused the United States of manipulating its currency when Fed engaged in “quantitative easing” policies in 2010 that depressed the value of the dollar.
If Mr. Trump tries to drive the value of the dollar lower using Treasure Department authorities to intervene in markets, or prevails upon the Fed to aggressively lower interest rates in order to depress the value of the dollar, that could embolden not just China but also other economic powers, like Japan and Europe, to do the same. The entire structure of international institutions meant to prevent Depression-era policies would be under threat.
In our opinion, if you don’t change the economic fundamentals, intervening in currency markets won’t be effective. The question for us is, does this end up damaging the core economic institutions?
Nothing about the world economy over the last few years has been linear or predictable. There is no reason that the events of Aug. 5, 2019 need to be the first chapter of future books about the Global Recession of 2020. But to avoid that result, it matters that world leaders understand just what is at stake – and the pervasive pessimism in markets this month was a good indication.
