Is the Big Bust yet to come?

The trading week from February 26 to March 2 was fascinating and chastening. Some have seen it as bringing an end to complacency; but has it been more than that?

In some ways, it undoubtedly has been. Once again, we were impressed with how some unlikely development - something that we had not really focused on - was responsible for a sudden, severe shudder in global markets.

There were few who had their eyes focused on what was happening in the Shanghai stock market - or at least focused in any way beyond what was happening to day-to-day stock movements. There were worries about capital-gains taxes but few anticipated any serious run-on effect from those worries to the local Chinese market and then, lo and behold, to Wall Street and other major world markets.

But there was this run-on and that indicates to us again - yet again - how unpredictable may be the causes - the proximate stimulants - to major turnarounds or crises or collapses in world markets.

What we must ask now is whether we were in the midst of or at the beginning of a major market collapse - one affecting most markets around the world. Are we now, as we look forward, on the edge of a major crisis or collapse?

The actual figures for the percentage drop in the Dow and other stock markets are not too terrifying in historical terms. We have come through worse in the past without any ultimate catastrophe.

After the first shock in Shanghai, there have been after-shocks, more especially in Asia and Europe than in the United States, but these have not been of such a magnitude as to spark a global panic.

Nevertheless, we should perhaps investigate a little more deeply than that. Perhaps we should look less exclusively at the statistical record of the actual stock-market movements themselves - the market dropped 200 points for a percentage fall of 3 per cent or whatever - and more closely at some of the side effects.

One phenomenon of which we must be particularly aware is that of the carry trade, a phenomenon that has grown - blown itself up - enormously in recent months and years and that has been at the centre of much of the "liquidity" that has been sloshing around in a variety of markets. Capital flows linked to the carry trade have nourished housing markets, stock and bond markets, art markets and, for example, have helped to close the gap in trade and payments between what the United States receives from abroad monthly and what it pays out.

To some extent - and it may be to an important extent - the carry trade has been helping to hold the rather fragile global financial "system" together.

The key to this fascinating and apparently crucial trade is that there should be a sufficient margin between borrowing and lending rates and no more than a tolerable risk that the margin will be diminished or destroyed. The decisive borrowing environment in the recent past has been Japan, with near to zero borrowing rates and an exchange rate that has been low and tending to be moved still lower by the very operation of the carry-trade phenomenon itself.

A crucial question therefore must be what has the recent flurry on global stock markets done to the value of the Japanese yen and to the assurance with which the carry traders can continue to pursue their exploitation of this highly rewarding arbitrage.

According to the Daily Pfennig which reports on the currency markets, "The Japanese yen is the best-performing currency in the world this week [26 February to 2 March]. The South African rand and the New Zealand dollar (higher yielding currencies that have benefited from the carry trade) are the two worst performers in the week."

That's bad news for the carry trade but, much more importantly, it is potentially extremely bad news for all those markets which depend for their dynamism to any significant extent on the "liquidity" which the carry trade provides.

That could mean a very wide range of markets. For example, it is likely that funds from the carry trade have helped support the housing bubble and, more recently, have been slowing the decline in the size of the housing bubble - in the United States and elsewhere. Some of the carry-trade funds may too have been taking up Treasury bonds and that makes an important contribution to closing the current US payments gap through an inflow of funds into the capital account.

These are important considerations. If the housing bubble deflates too rapidly, the impact will cause not only more and more mortgagees to default and lose their properties but also cause lending institutions to fail and the whole housing industry to enter what could be the most serious depression of all time, with an enormous loss of many of the jobs which have built up during the boom years of the recent past.

With that housing-industry depression will go, almost certainly, a dive in the consumer boom of the past many years. Deprived of the ATM that their overvalued house provided, consumers will be forced to mend their big-spender behaviour or face the disciplines of the bankruptcy court. This sort of outcome will not be uniquely characteristic of the United States but could apply also in such economies as those of Australia, New Zealand and the United Kingdom.

Meantime, shorn of support by the speculators in the carry trade and unable to find any longer enough funders for the chronic massive deficit in the United States balance of trade and payments, the once mighty dollar will risk going into what might increasingly resemble free fall. Instead of $600 to $700 to buy an ounce of gold, it might take $1,000 or $2,000. Oil might go to over $100 a barrel. The Euro might be worth $2 or more and it might take many fewer than 100 yen to buy a US dollar.

In other words, the whole financial world might be thrown into turmoil and it might be extremely difficult to restore any kind of stability. This will not necessarily be the direct result of a fall on the Dow or other American and global stock markets but rather because of indirect effects on other elements in the highly technical, sophisticated and complex structure of American and global finance.

How will any such developments be managed?

There have been hints that the stock-market volatility of recent weeks has alerted what is known as the "Plunge Protection Team" in the United States. This is an emergency "control" body that was brought into some kind of formal or informal existence at the time of the 1987 stock-market crash.

Still highly mysterious as to its composition, its terms of reference and its procedures, it is reputed to have been given a more formal status in recent years. America's Suicidal Statecraft says:

In 2001, George Stephanopoulos revealed publicly for the first time that a Plunge Protection Team from the United States Department of the Treasury, Wall Street and the Federal Reserve, brought together informally after the 1987 financial crisis to avoid a meltdown, had become more formal since and now stands ready to make whatever adjustments might be necessary to enable the “free” financial markets to survive a crisis and avoid a comprehensive collapse.

One sobering consideration is that, in the last ten years, those countries - the United States, Britain, Germany, France, Luxembourg, Switzerland and Japan - most likely to team together to meet a crisis have been joined by China, India, Russia, some Latin Americans and others who may not be so able or willing to bail out the old world of established finance capitalists.

Moreover, financial transactions have become so huge and complex that a small miscalculation or anomalous or freakish event may unhinge the whole financial system. With “trillions of dollars ... presently held in shaky hedge funds and derivatives markets,” Mike Whitney says, “there’s nothing anyone will be able to do if the market takes a steep and sudden downturn … The Plunge Protection Team and the CRMPG [Counterparty Risk Management Policy Group, the self-appointed 'authority' from hedge funds and big banks formed to preserve 'their' financial system] illustrate the collusive relationship between the banking establishment, the uber-corporations and the state.

“They’ve worked assiduously to remove the safeguards which have traditionally protected the average investor from hucksters and scam-artists, and paved the way for a full-system breakdown. The market is more vulnerable now than anytime since the late 1920s … The country now faces the growing probability of an economic tsunami triggered by the rickety hedge funds, the falling dollar, and the rapidly deflating real estate bubble. The solid foundation of government oversight and regulation has been eroded by the persistent attacks of the corporatists and banking giants. The entire system is now on shaky ground. When the scaffolding starts to fall, the futile manoeuvrings of the Plunge Protection Team won’t make a bit of difference.”

We do not know for certain whether the Plunge Protection Team was convened into emergency session or not. It would be surprising if it were not and it would not be at all surprising if there was some actual intervention in the markets to smooth away some of the volatility and to prevent the market from going into too sharp and sustained a fall. It would be surprising too if there was not close co-operation among the central banks at least of the Group of Seven although we can only conjecture what form that co-operation might have taken and how effective it might have been.

It might have been so effective - in collaboration with the activities of the Plunge Protection Team and other devices - that the recent flurry will turn out to be no more than that and that, at least for a time, order will return to world markets.

We cannot be sure but at least that is a possibility. However what is much more certain is that the underlying instabilities, the ever nascent volatilities and the limitations on what might be optimistically regarded as "control mechanisms" have not been removed nor have they gone away.

They are waiting there, quietly but arrogantly, in the wings. If their time has not yet quite come on this occasion, they will still be patiently waiting there for the next unpredictable event to detonate a climactic explosion on the world's financial markets. The odds seem increasingly to be that they will not have long to wait.