The Global Economy’s Life Blood

Equal Parts Capital, Free Trade, Information, Oil, and a Dose of Cooperation to Hold It All Together

What is the greatest threat to the world economy? Is it a slowing US economy, inflation, protectionism ,China’s explosive and unchecked growth, a financial or liquidity crisis, global warming, terrorism, or energy? While any one of these and certainly any combination could cripple the unprecedented economic advances we enjoy today, the great barometers, the stock and bond markets remain relatively unfazed. 

The US economy remains strong, but it is slowing at an accelerating pace, while few notables are calling for recession. If the US economy is able to maintain moderate growth the IMF says that “most countries should be in a position to ‘decouple’ from the U.S.economy and sustain strong growth.” Last week Mr. Greenspan said he believes that the global economy would actually cushion the US decline. US exports which remain healthy would bring the economy back. The IMF concluded that stronger demand in other industrial nations makes the world’s economy more “resilient.” A falling dollar would also help reduce trade imbalances, the fund said. The global economy will probably weather a slowdown in U.S. growth as dependence on exports to America diminishes, the International Monetary Fund said.

The Federal Reserve continues to worry about inflation but their actions suggest they remain comfortable that their current interest rate policy is sufficiently restrictive to eventually slow it. Talk earlier this week indicated that they may need to raise rates further, but the likelihood is dismissed by most observers. Just as remote seems the possibility of rate reductions. The presence of ample global liquidity makes it unlikely the Fed will reduce rates any time soon, even if the inflation threat begins to wane faster than expected.

The subject of protectionism is closely linked to China’s growing trade surplus with theUS. Many democrats inWashingtonare making noise that it is past time to penalize Chinese imports due to their unwillingness to allow their currency to appreciate relative to the dollar. There seems to be a fairly significant amount of international cooperation with the US to pressure China to allow their currency to float more freely. A rising yuan would be a much more effective measure to slow the explosive growth of the Chinese economy than their previously failed attempts at regulations, tariffs, and controls.

If an impatient and aggressive Democratic Congress begins down the slippery slope of protectionism, all bets for world growth could be off. It is my hope that they learn from the mistakes of impatient Republican lawmakers Smoot and Hawley just how much damage can be done by impeding world trade with tariffs and other barriers. Although the Smoot Hawley Tariff Act was passed after the stock-market Crash of 1929, economic historians and economists consider the political discussion leading up to the passing of the act as a factor in causing the crash and its eventual passage as a factor in deepening the Great Depression. According to Labor Department statistics, unemployment was at 9% in 1930 when the act was passed, but it jumped to 16% the next year and 25% two years after that.

In response to the act, trading partners retaliated sending world trade plummeting. Jakob B. Madsen in a 2002 study estimated that the effects of increasing tariff and non-tariff trade barriers on worldwide trade over the period 1929 to 1932 that real international trade contracted by around 14% because of declining GNP in each country; 8% due to increases in tariff rates; 5% because of deflation-induced tariff increases; and an extra 6% because of the imposition of non-tariff barriers. Global markets today are far more inter-dependant than they were in the 1930’s.  

The timing of a financial or liquidity crisis is practically impossible to predict. The latest threat caused by defaulting sub-prime mortgages seems to be under control. It is widely expected that the problems are contained and will not spill over to cause greater problems for the US economy or the global economy.

The issue of global warming (whether you believe it is cyclical of man-induced of some combination) is gaining traction in government and industry as well. There exists a fear that if enough policy makers begin believing the worst of the warnings they could overreact with measures restricting industry, energy, and transportation that might severely restrain the competitiveness of the world’s leading economies sending them in to recession or worse.

Finally come terrorism and Iraq– hence energy. Given the determination of the Democrats politically motivated by an overwhelming mood among Americans to abandon Iraq it now seems likely that in only a matter of months that country and the entire Middle Eastwill be left to their own devices to defend against victorious and emboldened terrorists and insurgents. There seems to be this rush to get the troops home at any cost and without regard to the big picture. Do opponents really believe the current Iraqi government can stand against terrorists and insurgents when the full force ofAmerica’s military might withdraw? The problems that will result will stretch far beyond Iraq’s boarders.

And where are world leaders on the issue; particularly Iraq’s neighbors? Do they think that punishing an arrogant US policy by virtually sitting on their hands will in the end make the world safer or improve their economies? The lack of cooperation in this vital core of the world’s energy supply is beyond remarkable. History will likely show it as a global diplomatic failure of enormous scale with plenty of blame to go around for all parties. Beyond the human cost it will also be a huge economic tragedy for Iraq. New analysis of Iraqi oil resources suggest that taking into account the untapped potential of Iraq’s western desert, the war-torn country’s oil reserves could be nearly twice as large as previously estimated, containing more than 200 billion barrels.

Instead of seeking a global solution to a complicated vital problem, a majority of Americans, lead by a new majority in Washington, are prepared to surrender the cause (however flawed from the start) to insurgents, terrorists, opportunists, and thugs to return our troops. It will become a matter of not if but when the Iraqi government and army will crumble. At that point Iraq’s oil production will cease in the chaos of civil war and terrorist upheaval. We saw what happened to stock markets following the disruption in oil flow caused by hurricanes Katrina and Rita. That lost production was a mere drop in the barrel compared to Iraq’s capacity.   

To make matters worse, other insurgents in less stable Middle Eastern countries and Nigeria along with a couple of dictators in South America might be further emboldened to hold the world hostage to advance their own agendas. It seems the course is already set and there is no altering America’s withdrawal. It remains to be seen what other Arab states in the region, Europe, China, and Russia will do to fill the void. But if the past is any indication of the future, we are headed for considerably higher energy costs at best and crippling shortages at worst.

We believe these issues are significant and that portfolio changes might be indicated in the coming quarters. We welcome your feedback on any of these issues.