A great global switch is upon us

To understand what is now happening in share and currency markets you need to realise that two fundamental changes are taking place at once. Australia finds itself not far away from the centre of this turmoil. 

The first and most publicised of these changes is the looming reduction of quantitative easing – the so-called taper, which is beginning to create a severe disruption in the currencies of many emerging countries. 

But before coming to tapering turmoil we must recognise that a more fundamental change is simultaneously taking place in the global economic model that has driven the world (and Australia) for the last couple of decades. It is in that second change where Australia is in the front line. 

In oversimplified terms Australia and other commodity producers supplied China with raw materials (which they added to their own raw materials) and produced infrastructure and manufactured goods which China exported to the US. These low-priced manufactured goods were eagerly bought by American consumers and the US shut down vast areas of its manufacturing. The Chinese loaned the money to the US to buy the goods.

It was marvelous while it lasted. But fundamental changes are taking place in the US. Other low cost suppliers like Mexico have emerged and American consumers are now a more fickle lot. They have been damaged by the housing fall, while large numbers have found their incomes reduced as the middle class was hollowed out when manufacturers closed. Today’s new jobs often are lower paid than the old ones. As a result US consumers can't afford big borrowings to buy goods (and houses). At the same time the days of big country borrowing are over – China does not want to fund further US deficits and the US wants to reduce its deficits.

And so the US-China model that has dominated the world is changing and Chinese consumers must be stimulated to replace the Americans. In time Chinese consumers will stimulate China and, perhaps, drive the world. The Chinese leadership understands this but changing the model will not be easy, particularly as the population is ageing. Japan tried a similar switch and failed.  

The Chinese change is made more difficult by the fact that to avert the blows in the global financial crisis China gave its bankers a lending ‘quota’ and, as a result, a vast number of loans were made to borrowers who could not repay the money. There are enormous bad debts in the Chinese banking system. Accordingly this changeover, at a time of difficulty in banks and an over-investment in infrastructure, will be bumpy. Australia’s mining industry is therefore also headed for a bumpy ride, particularly as supply is rising in iron ore, coal and gas.

If that was the only major change the world had to manage, times would be easier. But the big US investment banks, flush with quantitative easing cash once again, went for short-term, high-risk profits, so vast amounts of the QE money found its way into emerging countries which have no hope of repaying it – particularly given the change in the China-US model. No one knows just where the money is and what sort of ventures were funded. India and Indonesia were among the major recipients. Some came to Australia. At the moment Turkey, Argentina and Russia, which have problems separate to a possible exit of QE money, are seeing a run on their currencies (Markets are taking out the garbage, January 28). There is grave danger that this will spark runs in other emerging countries if there is further tapering of the QE program.

Meanwhile on the back of low-cost labour, abundant low-cost energy and great technology the US is experiencing a revival, although the middle class still struggles. There can be no return to the old US-China model.