November 23, 2003

Dread thoughts in a time of war

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What an extraordinary week! Al Qaeda back in business, George Bush holed up in Buckingham Palace, and being cooked for by Nigella Lawson.

In New York, foreign exchange traders were arrested for possibly the biggest fraud ever perpetrated in financial markets and around the world, the dollar headed south at a rate that surprised perennial bears.

Equity markets worldwide have had the worst week in months, as investors naturally get worried about the US. And all this following the announcement by the US of tariffs against China while, Pascal Lamy, the EU trade Commissioner visiting Dublin over the weekend, did not rule out retaliatory trade strikes against the US.

Of all the developments, trade, tariffs and terrorism are by far the most worrying, and the impact on the US in the medium term and the dollar in the short term are the most concerning. This column has used the geology metaphor before to analyse exchange rate, stock markets and other asset price movements,but its worth revisiting, because we could now be in a dollar crisis.

The problem with earthquakes and volcanic eruptions is that they are not precisely predictable. However, as a result of their knowledge of tectonic plates, geologists have a fairly good idea where eruptions will occur. The earth’s plates consist of an outer layer, the lithosphere, which is cool enough to behave as a more or less rigid shell.

These crustal plates constantly grind against each other driven by the ocean floors that are continually, moving, spreading from the centre, sinking at the edges and regenerating. Currents beneath the plates move the plates in different directions and driving all this is radioactivity deep in the earth’s mantle which keeps the under layer – the asthenosphere – molten.

Occasionally the hot asthenosphere of the earth finds a weak place in the lithosphere to rise buoyantly as a plume or hotspot, causing earthquakes or volcanoes.

These hotspots are not evenly distributed and are located on the boundaries between the plates called faults. The most famous is the San Andreas Fault in California.

Geologists who study and measure the sub-lithosphere movements can predict that something is about to happen. However, no one can pinpoint to the day or the hour the location and severity of the eruption.

A bit of geology is helpful when looking at the world economy, because the modern global economy works is a remarkably similar fashion. The eruptions manifest themselves in dramatic corrections in asset prices.

Since the peak of the Nasdaq in 2000, the world’s financial asthenosphere has been bubbling away looking for a weak spot. Granted, there was a large correction in stock markets, but it was not significant in historical terms. And more important, one bubble simplygave way to another one – an overvalued stockmarket, morphed into an overvalued US currency.

This is how it happened: the US realised that the blueprint for what not to do was Japan in the 1990s, where the authorities, in the face of a bust in the housing and stock market, did nothing. The result was a catastrophe. Japanese stock and house prices spiralled downwards for a decade.

Forewarned, the Americans cushioned the blow of a falling stock market by printing money, cutting taxes and borrowing from the rest of the world.This caused money to flow into the US economy, pushing the dollar upwards. But the dollar could only continue to rise as long as the rest of the world was prepared to finance US spending.

Then the bombshell. Last week, official American data showed that inflows of foreign money to the US slowed to less than $5 billion in September. Since the US economy needs around 10 times that amount just to make it through the month, this suggested that the world is tiring of financing American overspending.

The prospect that the rest of the world would slow or stop its funding of the US has been one of the favourite horror scenarios among financial analysts in recent years. As the US deficits on trade and the balance of payments kept swelling, the mutterings about the potential threat to the US have grown louder. Now, it appears, the threat is becoming reality.

But that wasn’t the only nightmarish economic scenario that inched a little closer last week.

The Bush administration announced measures to slow the torrent of Chinese textile imports into the US – proving once again that, despite its fondness for pro-free-trade rhetoric, when it comes to policy decisions, it prefers protectionist measures.

The only thing most economists regard as a grimmer prospect than the US being unable to fund its deficits comfortably is for the US to lead the world into a trade war.

The US not being able to find its deficits will cause the dollar to slump and US interest rates to soar, triggering a recession in the US that will spread across the world. A trade war would be much worse: it would affect everybody, with poor countries hit worse than rich ones. Its impact would be stronger and it could last much longer. It would be disastrous for Ireland, because we trade more than any other economy in the world and we live on the financial faultline between the European and American economic plates.

Almost incredibly, the economic nightmare scenarios are on the verge of becoming secondary issues. The primary issue is that the world is in the grip of war.Events in Iraq andTurkey, and, a few weeks ago, in Saudi Arabia, make it clear that al Qaeda – specifically and as a generic term – is now dictating the global agenda.

It wasn’t supposed to be that way. Twenty-six months into the war against terrorism, the bad guys were supposed to be dead or in hiding. Instead,they’re on the offensive, striking with apparent impunity at targets all over the Middle East and beyond.

The ultimate nightmare scenario – that the House of Saud, which runs the world’s biggest family business, called Saudi Arabia, is overthrown – no longer the stuff of thrillers. It is now a genuine possibility,with a growing chance of becoming reality.

That’s why the price of oil is above $30 a barrel today, not below $20, as had been hoped, following the war in Iraq. In the past, geopolitical scares have led to a flight to the dollar as a `safe haven’. This week the opposite occurred, reflecting just how far the greenback has fallen.

All these pressures, economic, financial and geopolitical, have been bubbling under the surface for some time, but only now are the cracks in the lithosphere becoming evident. For Ireland, the challenges are both economic and political.

Sitting squarely on the economic faultline between Europe and America, we have an enormous interest in diplomatically using whatever leverage we have to make sure a trade war does not get out of hand. Politically,we hold the presidency of the EU from January.

It is essential that we use whatever `soft power’ a small country has to try to bring the EU and the US closer together. Despite all the cheap rhetoric of the past week, it is not in our interest that George Bush fail, particularly when the EU has no global Plan B.