This year is starting off with the worst performance of stocks in decades. It has many analysts wondering exactly what's driving it and, more importantly, whether there's an end in sight.
For a long time, I have maintained that the U.S. economy has been in a state of "realignment" as opposed to normal cycles of recession and recovery. What's happening now is not a correction of an overvalued marketplace, it is further evidence of that continuing realignment.
Recovery from the last recession continues to be sluggish. Real U.S. GDP has grown a total of 14.34 percent over the 25 quarters following the 2009 recession. Post-recession recovery rates have, in fact, been declining since the end of World War II. This would suggest that the U.S. economy is in the process of an adjustment toward a new lower level of normal economic growth. But if this is true, then what drove stock prices to such high levels prior to 2015?
While complex, a metaphor to describe it is incredibly simple: The world's economy has become a hothouse. Growth in a hothouse is artificial, inorganic and unsustainable. People all over the world are suffering economically because the largest economies have created an artificial environment. Their tools are gradual inflation and leveraged restructuring, much of which has been fueled by massive infusions of monetary "reserves" by the central banks.
It is no coincidence that losses in equity value in the U.S. and China are occurring just about a year after the Federal Reserve phased out its policy of quantitative easing. This increased asset values by keeping interest rates artificially low. Such monetary infusions established the hothouse — and made a true recovery difficult to achieve. Recent interest rate increases may cool things down even more.
Quantitative easing also contributed to rising commodity prices. In the oil industry, this inspired investments in expensive mining and drilling activities, which became profitable in the higher-price environment. This led to employment gains and rising equity returns and values in that economic sector. It also led to excess capacity and oversupply of product.
Now, the hothouse lights have been turned down, and the monetary fertilizer is being withheld. The domestic oil industry, and related chemical companies such as Dow and DuPont, have fallen on hard times. The result? Cutbacks in research and development, curbs in production, reduced workforces and, ultimately, consolidations into smaller entities. Job losses could be permanent.
Falling prices have also had a significant impact on China, which had become the leading worldwide producer of many industrial commodities. Declining titanium dioxide prices delivered a blow to both Chinese and U.S. manufacturers such as DuPont. China also now imports fewer commodities, adversely affecting the economies of their trading partners.
China is now scrambling to manage the value of its currency. The devaluation of the Chinese currency is close to becoming a panic. Chinese bond trading was shut down for nearly an entire day; at one point, it cost as much as 110 percent to borrow the yuan. This exposes China's role in building the hothouse.
For decades now, China has pegged the value of its currency to the U.S. dollar. Rather than allow its currency value to rise as its trade surplus with the United States increased, China engaged in market intervention designed to maintain the peg. This undervalued the Chinese currency and encouraged investors to buy and hold it. Now that investors are seeking to dump it, China is making drastic moves to manage its devaluation and maintain its status as a world reserve currency.
China's response to Federal Reserve quantitative easing made this problem worse. As the supply of U.S. dollars increased as a result of the Fed's strategy, the Chinese had to, at least implicitly, match the expansion of the dollar with its own currency. Much of what investors are seeking to dump is the resulting oversupply of the yuan.
China now needs to become fully integrated into a world-wide market of free-floating exchange rates and financial capital. It needs to respect its trading partners and stop its economic espionage. Otherwise, its model of state capitalism will fail.
Successful realignment for the rest of the world may require some sort of gradual deflation. It would need to settle in over several years — perhaps decades. To avoid massive defaults, most debtors would require forbearance, if not forgiveness. The allocation of income and wealth among U.S. and global populations would shift. There would be winners and losers — but it will be worse if we do nothing.
Nations need to find new and innovative market solutions to achieve wage and employment goals. Massive concentrations of investment capital must be broken up and made available to innovative and entrepreneurial companies, instead of being used to consolidate corporate assets into giant ATM machines serving small groups of investors. The highly-concentrated system of large banks would have to be broken into smaller entities designed to better serve small, emerging and local business interests.
This must be a worldwide movement that cannot be steered by the current political-economic powers that be. We need to create and enable a system of local innovative markets that are both well-financed and able to do business on a global basis. It's challenging, but the alternative of slow economic growth and increasing debt accumulation is unsustainable.
The biggest problem in dealing with the Great Realignment is the moral, financial and political corruption that has been allowed to dominate the globe's major economies. Economists refer to such behavior as "rent-seeking": the use of political and other means to manipulate market conditions to create unfair advantages, reducing competition and redistributing global income and wealth. Markets aren't operating freely — they're being manipulated by the political and economic elite.
The opportunity for citizens to take back their economy begins right here, right now in this 2016 election year. Exercising our democratic rights in the United States can facilitate change at a global level. The electorate still has power, if it ignores the rhetoric and comes to its senses about what is happening and why.
Steven C. Isberg is an associate professor of finance in the University of Baltimore's Merrick School of Business. His email is firstname.lastname@example.org.