From the February 2007 issue of Research Magazine • Subscribe!

February 1, 2007

The Next Economic Crisis

After graduate school, I went to work for maverick Wall Street economist A. Gary Shilling. Gary was a follower of the Kondratieff Wave Theory, which holds that global economic history is divided into extended S-shaped cycles, each lasting some 50 to 60 years.

Under the aegis of the dominant economic power of the day, each long K-wave starts with bunched-up technological innovation, or a technological revolution, which translates into a period of strong output growth and ends in a major slump. Each new wave is associated with a change at the top, when the old world leader gives way to the new.

Gary's interpretation of Kondratieff's writings -- which appeared in the 1920s -- tended to be a bit mechanical. Each leading power gets about a century to run the global economy. Deep economic crises occur every half-century or so, and each leader presides over three of them -- first as a newly minted power, then as a 'co-chair' with an emerging rival and finally as a has-been.

For a junior economist like me, the implications of this theory spelled weeks in the stacks of Columbia University's business library, mining for stats on 18th century Spain, France during the Napoleonic Wars and Britain thereafter. Having just marked the 50th anniversary of the Great Depression, we were looking for another major economic debacle just around the corner.

The Depression came at the end of the "Roaring Twenties" in the U.S., when technological novelties such as electricity, motor cars, airplanes and radios started to attain broad commercial applications. Other sectors benefited from the development of transportation, communications and business and financial infrastructure. The Depression began with a crash on Wall Street, but it promptly spread around the world. When the smoke cleared and the world economy returned to growth, the U.S. emerged as an unchallenged new leader, whereas Great Britain and its pound faded into irrelevance.

This being the early 1980s, Gary naturally pinpointed Japan as a power destined to eclipse the U.S. Drawing parallels with the Depression, he expected the next crisis to start with a market crash in Tokyo, and was looking for ways to short Japanese stocks.

Shorting Nikkei was a great idea. After Tokyo shares peaked in the late 1980s, they went through a protracted bear phase and even now are trading more than 50 percent below their all-time highs. But the rise of Japan -- as well as the decline of American economic might -- clearly did not follow the Kondratieff scenario.

Or did it? Japan may have turned out to be a paper tiger, but its economic model -- based on technology transfers in manufacturing and relentless price-driven penetration into rich export markets -- has been successfully adopted all over the Pacific Rim. A similar development model has now propelled China into the ranks of global economic superpowers.

After 25 years of growth averaging nearly 10 percent a year, China's GDP is now approaching $10 trillion, gaining inexorably on the U.S. Its annual exports have increased six-fold over the past decade alone, and measure close to $1 trillion.

China is now flush with cash. Its stock of direct foreign investment is approaching $500 billion, while central bank reserves have reached $1 trillion. It has become a pivotal player in the global financial system.

More to the point, China has become indispensable for the functioning of the U.S. economy. In two decades, imports from China went from less than 2 percent of total U.S. imports to 25 percent. China controls entire segments of American consumer goods markets. Given its enormous bilateral trade surplus, China's willingness to hold U.S. Treasury bonds has largely financed our current economic expansion, propping up the dollar and helping keep Treasury bond yields -- and mortgage rates -- low.

During the Cold War, the Soviet Union could annihilate the United States with its nuclear weapons -- and face instant annihilation in return -- but it could not do much damage to the American economy. Since World War II, China has been the only nation in the world with the ability to undermine the U.S. economy single-handedly, and wreak havoc in U.S. financial markets.

China is a much more plausible candidate for global economic domination than Japan. Japan lacks natural resources and has only a tiny army, depending on Washington for military protection. Its domestic consumer market is relatively small and hemmed in by regulation. While Japan failed to create a trading bloc in Asia in the earlier post-World War II decades, China's enormous domestic market has laid the foundations of such a bloc in just a few years. When its export-led growth model sputtered under the weight of regional competition, the Japanese economy simply wilted. Unlike the Chinese, who have been very successful entrepreneurs and financiers throughout Asia, the Japanese do not function well outside rigid corporate constraints.

Over the past decade, economists have been warning about "imbalances" in the global economy. They have been concerned about an enormous -- and growing -- U.S. trade deficit, outflow of dollars into the world economy and dramatic rise of American debt to foreigners.

Actually, the situation has been remarkably stable. American consumers buy cheap imports from China, paying for them with pieces of green paper. Both sides tacitly agree that this is money, Americans because they can cheaply print as much of it as they want and Chinese because they can use it to further develop their economy. Money is a form of IOU on American assets -- Chinese investors will eventually be able to use all those dollars to buy American companies, real estate and technologies. But for now they are happy to lend their accumulated dollars to Americans -- so that demand for their goods does not weaken.

Communist China, which at one time egged on North Korea to attack South Korea and backed insurgents in Indo-China and elsewhere, is now obsessed with stability. Beijing leaders are highly unlikely to rock the boat. However, while China's economic growth has unleashed tremendous energy and creativity in its population, it has also created severe domestic pressures -- social, political, economic and demographic. Hundreds of millions of peasants have abandoned their centuries-old way of life and migrated to urban centers. The gap between the rich and the poor has widened. The communist party retains a monopoly on political power, while its apparatchiks and their families are notoriously corrupt. Massive industrial investment, which continues despite government efforts to slow it down, is creating excess capacity. These pressures could plunge China into crisis. Financial crises and political upheavals have repeatedly blindsided smaller exporting nations along the Pacific Rim over the past two decades. It would be unreasonable to hope that China will avoid them indefinitely.

The longer the period of stability, however, the more severe the blowout is likely to be. If China suffers an economic, financial or political shock, the United States, and the rest of the world, will likely be plunged into a severe recession -- if not an outright depression. The Kondratieff wave theory is certainly not deterministic, and depressions and changes in global economic leaderships do not have to come with clockwork regularity. However, it would be short-sighted to deny that U.S. influence in the global economic system has declined because of the rise of China. For the first time in over a century the American economy has become vitally dependent on the political and economic stability of a foreign country.

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Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at abayer@kafanfx.com.

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