Chaos theory proposes that, by merely flapping its wings in the Amazonian jungle, a single butterfly can cause a hurricane in the Home Counties. That is because of the extraordinary complexity of the global climatic system: one tiny bit of turbulence in darkest Brazil can, under the right circumstances, trigger a kind of meteorological chain reaction, the ultimate effect of which is out of all proportion to the initial cause.
The scientists have a great phrase for this: “stochastic behaviour in a deterministic system”. What it means is that every particle in the earth’s atmosphere is linked in a chain of cause and effect so intricate that it is extremely hard to make accurate predictions about the behaviour of the system as whole. The weather forecast for tomorrow may be reasonably accurate. But the weather forecast for next week will be much less so. And every now and then an apparently random whirlwind will catch even the weatherman out, as happened in the “hurricane” of 1987.
Something similar can be said of financial markets, as we saw last week. The butterfly in this case was the fledgling Shanghai stock market – a mere winged bug by comparison with New York or London. But when Chinese investors flapped on Tuesday, driving down the Shanghai composite index by nearly 9 per cent, the result was a storm, if not quite a 1987-style hurricane, in nearly all of the world’s stock markets.
As the world revolved last Tuesday, the value of publicly quoted companies tanked in one market after another. European stock markets went down nearly 3 per cent. In New York, the Standard and Poor’s 500 dropped nearly 3.5 per cent. So-called emerging markets like Argentina, Brazil and Mexico were hit even harder. No fewer than 45 of the world’s 53 major stock markets ended the month below where they had started.
By the end of the week, however, sceptical commentators were questioning the chaos theory version of events. How could a stock exchange with a market capitalisation barely 5 per cent the size of New York’s possibly be responsible for such international turmoil? There had to be some other reason. Maybe recent losses in the American “sub-prime” (high risk) mortgage market? Maybe the former chairman of the Federal Reserve, Alan Greenspan, using the word “recession” in an interview? Maybe just new evidence of slowing growth in the United States?
To be sure, there was nothing entirely new about Tuesday’s Shanghai “correction”. The market, which out-performed nearly every other in the world last year, has been like a rollercoaster for weeks. And no wonder. Chinese investors have been flocking to their new equity markets the way Irishmen flock to bookies on Derby Day. The Chinese government itself quite explicitly warned against irrational exuberance more than a week ago. Indeed, this was virtually a planned crash.
Yet the fact remains that China’s sell-off was the real catalyst, not an American event. Blaming Greenspan is just absurd. Guys, please: he retired as Fed Chairman over a year ago.
Actually, you don’t need chaos theory to explain this; economics does the job pretty well. For what we witnessed last week was a symptom of a deeper structural shift in the balance of global economic power. Ask yourself why last year was such a remarkable year in financial markets; why nearly every stock market ended the year at a record high; why emerging market bond yields ended the year at record lows; why volatility all but vanished from the system; why there seemed no limit to the money to be made by investment banks, hedge funds and private equity groups.
Some analysts say it was excessive liquidity. Others talk of a shortage of assets. But the most compelling answer is the seismic impact of China’s entry into the global economy. It has been the effect of China’s vast, cheap labour force on global wage levels that has driven up US corporate profits from around 7 per cent of gross domestic product in 2001 to 12 per cent last year. At the same time, it has been the flood of Chinese savings into the global capital market that has driven down global long-term real interest rates from around 5 per cent seven years ago to 2.8 per cent last year.
Just think about it. Corporate profits growing to the sky. Real interest rates way below their long-run average. Anyone with any appetite for serious money knows what to do. Borrow as much as you possibly can and buy the highest-earning companies.
Of course, many economists fret about the global imbalances associated with China’s rise. On one side, they point to an explosion of Chinese exports that last year generated a current account surplus of more than $230 billion; on the other, a yawning American trade deficit equivalent to more than 6 per cent of US GDP. They see China’s central bank sitting on dollar-denominated currency reserves in excess of $1 trillion. They see the United States slipping ever deeper into debt to what remains, after all, a Communist regime. Recalling the upheavals caused by much smaller imbalances in the 1970s and 1980s, these Cassandras prophesy the collapse of the dollar, the annihilation of hedge funds who have borrowed in yen, and sundry other horrors.
Yet there’s another way to see these supposed imbalances: as no more worrying than the doubtless very large imbalances between, say, California and Arizona. Think of the United States and the People’s Republic not as two countries, but as one: Chimerica. It’s quite a place: just 13 per cent of the world’s land surface, but a quarter of its population and fully a third of its economic output. What’s more, Chimerica has accounted for around 60 per cent of global growth in the past five years.
Their relationship isn’t necessarily unbalanced; more like symbiotic. East Chimericans are savers; West Chimericans are spenders. East Chimericans do manufactures; West Chimericans do services. East Chimericans export; West Chimericans import. East Chimericans pile up reserves; West Chimericans obligingly run deficits, producing the dollar-denominated bonds that the East Chimericans crave. As in all good marriages, the differences between the two halves of Chimerica are complementary.
But isn’t it kind of crazy for the Chinese to be lending money to Americans, who are on average roughly 25 times richer? Shouldn’t it be the poor country that borrows from the rich to finance its industrialisation? Not any more. By piling up its holdings of dollar bonds, the People’s Bank of China is not merely financing American profligacy. It is systematically slowing the appreciation of the Chinese currency, and hence keeping Chinese exports cheap and irresistible. At the same time, the PBOC is creating the ultimate stabilisation fund. When you have a trillion dollars in the locker, you are more or less immune to the kind of currency crises that caused mayhem in other Asian economies in 1997-98.
And that is one of many reasons why last week’s stock market volatility represented a “correction”, not a crash, much less the beginning of a protracted bear market. Of course, financial disasters can happen. There were eight months in the past century when the US stock market declined by 20 per cent or more, which helps put February 2007 into perspective. Sometimes (as in September 1931), the cause was economic policy: monetary mistakes and rampant protectionism. Sometimes (as in August 1914 and May 1940), the cause was geopolitical crisis.
But, much as American legislators like to huff and puff about China’s cheap exports, they are surely not so deranged as to want to repeat the mistakes of the Great Depression. And, dangerous though the world can seem when you read the international news pages, we are very far from another world war. Indeed, paradoxically, the more dangerous the Middle East becomes, the more resilient Chimerica looks, because geopolitical risk encourages Asian investors to pile into the safe haven that is the United States.
No doubt there will be many more ups and downs as Chinese investors learn the hard way that “past performance is no guarantee of future results”. But their periodic flaps are unlikely to cause more than short-lived bouts of global financial volatility – mere rain showers compared with the secular summer of Sino-American symbiosis. Chimerica, despite its name, is no chimera.