July 22, 2001

Did the earth move for you?

Posted in International Economy ·
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The earth’s rigid outer shell, the lithosphere, is broken up into an extraordinary mosaic of oceanic and continental plates. Just underneath is another layer: a more fluid, plasticky surface, called the aesthenosphere. This is the uppermost layer of the earth’s boiling core, which bubbles away below.

When the pressure in the bowels of the earth gets too intense, the core bubbles and occasionally, where the lithosphere is thin or cracked, explodes into violent volcanoes. More typically, the plates are in constant slow motion, sliding glacially and peacefully over the liquidy aesthenosphere.

Where the plates interact and nudge against each other, important geological shifts take place, such as the formation of mountain belts, earthquakes and volcanoes. Probably the best known margin is the San Andreas fault in California. The faultline is about 1,300 km long and in places tens of kilometres wide.

Along it, the Pacific Plate has been grinding horizontally past the North American Plate for ten million years at an average rate of about 5 cm per year (about the same speed as your fingernails grow). The are about ten other main faultlines across the globe, so earthquakes are relatively easy to locate, but predicting precisely when they will happen is almost impossible.

When trying to understand the global financial markets, it is sometimes helpful to think of plate tectonics or the geological study of the earth’s shell.

A financial market, such as the equity or foreign exchange market, is supposed to tell you what is going on under the surface. Thus if telecoms stocks rise, this indicates that activity under the surface in the telecom industry is bubbling away nicely. If a currency rises, the implication is country A is doing better than country B.

As long as there are no cracks in the shell, the market bubbles away under the surface, rising and falling, swelling and compressing without any violent explosions.

However, what happens if the buildup of money under the surface meets an area where the shell is weak, thin or cracked? In this case, bubbles emerge because the surface is too thin to deal with the eruptions underneath.

Take the example of the dotcom craze of 1998-2000. Huge amounts of money flowed into what was a very weak and immature market led by a few start-up companies. The very thinness of the market ensured that when all the cash arrived, prices had to spike up astronomically as there was not enough stock around, and investment banks could not get IPOs (initial public offerings) out the door quick enough.

As more and more cash cascaded into the dotcoms, a financial Vesuvius formed which erupted in March 2000. The resulting ashen cloud has plunged the rest of the technology sector into darkness and, if Mr Greenspan is to be believed, it might not lift for some time. The dotcom market was a faultline in the world’s financial shell.

Faultlines also occur in currency markets. Each country constitutes a piece of the global mosaic and the inter-country exchange rates appear like cracks in the mosaic. Potentially, the biggest faultline is the US dollar/euro rate. The US and European economies can be regarded as two giant tectonic plates that grind against each other.

Movements in the dollar/euro exchange rate reflect the extent of movement and interaction between the world’s two biggest economies. Normally, this movement is modest and well managed.

However, if further below in the bowels of the world’s financial system, other pressures are at work, there is a very real chance of a monetary earthquake affecting those countries situated on the faultline.

This would manifest itself in the dollar rising rapidly to an unsustainable level and then without warning crashing to the floor. In the 1980s we had an extraordinary example of this and today all indicators point towards a re-run of a 1980s-style dollar crisis.

Unfortunately, Ireland lies on that economic San Andreas fault between the US and Europe, being politically European but economically American. Given our exposure to the US, movements in the euro/dollar exchange rate have a bigger impact here than anywhere else in Europe.

Typically when the US economy slows down, the dollar also weakens. For example, in the early 1990s recession, the dollar fell by 20 per cent between 1990 and 1992. In fact, the US economy has never recovered without being preceded by a significant fall in the currency.

So far this year, the dollar has risen by 10 per cent in value and since its 1995 low, the greenback is up 45 per cent. This is startling because all the textbook reasons for weakness, not strength, are present.

First, US money supply (the supply of dollars) is rising; second, growth is slowing; third, the trade deficit is rising and fourth, interest rates are falling. From a purely speculative point of view, as the return on US assets is also falling, there is no fundamental or opportunistic reason for the dollar to be so strong.

However, under the surface, we see that one of the reasons the dollar is strong is the emerging markets crisis that is pushing Argentina, Brazil and Turkey to the brink. Billions of dollars are flowing out of these markets into the safe haven of the dollar, keeping the greenback on steroids.

So what is likely to happen? A strong dollar is amplifying the US downturn and without a recovery in the US, global confidence will continue to ebb. If the US recovery from the 1990-92 recession were a blueprint, the dollar would have to fall about 30 per cent against the euro to make the US vaguely competitive again. This movement, if managed gradually, would not be a problem. However, we know that currency movements tend to behave like earthquakes: suddenly and immeasurably. Thus the euro/dollar rate is like the San Andreas fault: we know the location so financial forecasters, like geologists, can measure the pressure building up, but no one can say for definite when the quake will come and how severe on the Richter scale it will be.

All we know is that we’d prefer to be in New York than San Francisco when it does happen.

Where does this leave Ireland? As we are on the faultline, the inevitable fall in the dollar will make our workforce look very uncompetitive to multinationals. Irish wages could rise, in dollar terms, by as much as 20-30 per cent as happened in 1985-87 and again in 1990-92.

At a time when wage inflation is running well ahead of inflation we are looking at a 35-45 per cent reversal in our competitiveness. This is not a pretty picture at a time when multinationals are retrenching.

Unfortunately, this dollar fall has to happen if the US is to recover rapidly. Either we get a one-off fall in our competitiveness and a sharp rise in unemployment followed by a recovery in the US, or, as Mr Greenspan hinted this week, we get a much longer US slowdown, no real fall in the dollar, continued but gradual lay-offs in the multinational sector (a couple of hundred here, a thousand there) and a prolonged period of domestic economy insecurity.

It is hard to pinpoint what will trigger the dollar’s fall. It could come as easily from Buenos Aries as Boston or Berlin. However, under the surface there is trouble deep down in the core of the financial markets. So far we have only felt the tremors but every time there is another lurch downwards, the market neurotically asks itself whether this is “The Big One”.