In part 1 of this column, I discussed:
-- The increasing trend of the owners of capital from wealthy countries to be withdrawing that capital from developing countries.
-- The drag this causes on the potential for global economic activity.
-- The increasing concerns about the ability of both private and public debtors to be able to continue to service debt.
-- The response by monetary authorities of implementing negative interest rates in an attempt to prevent the process from cascading by punishing capital owners if they park capital vs. continuing to invest it.
The easiest way to think of the accounting for global trade in aggregate is that it works very similarly to the way Social Security works in the U.S. The "investment," by way of FICA taxes, we each make in funding our future withdrawal from the system is not set aside. The government spends that money to stimulate economic activity that affords the FICA taxes taken from the generations behind us to pay for what we withdraw later.
In the private sector, that is called a Ponzi scheme.
In the public sector, it is allowed because countries are afforded the opportunity to finance themselves based on the assumption that they will exist in perpetuity and as such will always have future citizens who can be taxed to service previously issued debt and pay for Social Security withdrawals and other kinds of government benefits.
With respect to global trade, the returns available to investors from wealthy countries into developing countries is dependent more upon other wealthy foreign investors following them into the developing country than it is about a particular investment made by a capital owner.
It is a networked, circular and self-validating system as long as capital flows continue in that direction.
What keeps the flows moving in that direction is the demand for goods produced from the developing country. If that demand decreases, the flows will slow, stop or even reverse until it increases again.
However, the debt service requirements remain.
In the normal ebb and flow of business and trade, governments provide countercyclical monetary stimulus by lowering the cost of debt capital in an attempt to convince capital owners to overcome fear and continue to invest.
They also provide direct fiscal stimulus by way of government spending to create the demand that is in what is expected to be a temporary lull by the private sector.
The problem now, however, is that neither stimulus measure is proving to be a catalyst for an increase in private-sector demand.
Since part 1 of this column was submitted, the Economic Cycle Research Institute (ECRI) has published an excellent primer on the global risks of what is increasingly looking like a systemic breakdown.
As investors are becoming more aware of this, fear levels are driving them to park assets, rather than invest, as Bank of America (BAC) recently noted and of which Business Insider provided an excellent synopsis. (Bank of America is part of TheStreet's Action Alerts PLUS portfolio.)
If this process continues, it could very easily become a vicious cycle of fear. Investors withdraw from markets globally, causing asset prices to fall and causing consumers to decrease spending, causing investors to withdraw further, etc.
The risk of this occurring is one of the principal reasons the Federal Reserve has been attempting to get Congress to provide it with a mandate that allows the FOMC to unilaterally anticipate such a breakdown. The FOMC would monitor global capital market activity and implement pre-emptive, rather than reactive, monetary policy before the market action metastasizes into an economic event. By the time the flight to safety by capital is evidenced in economic reports, it may be too late for monetary policy to successfully thwart the damage and prevent cascading debt defaults and the deflationary environment that would inevitably result.
I discussed this last May in the column, "The Fed Needs a New Mandate."
While it is most probable that the Fed will not be provided such a mandate in the near future, the fact that it is pursuing such is evidence of the members' awareness that systemic and structural faults in the economic models used by every country are appearing, and will require unconventional policy means to respond.
If there is to be a global market and economic crisis that materializes from the nascent flight to safety by capital owners globally, the epicenter will be the nexus of capital and trade between China and Japan, not between China and the U.S., which I will discuss tomorrow in part 3.
