One Ugly Week in Global Finance (Deflation 2015 Update)

Yesterday, the Dow Jones Industrial Average dropped 531 points, on top of a fall of 358 Thursday. That is a vicious fall over a two day period, and the weekly drop of over 1,000 points has not been matched since the depths of the financial crisis.

Nevertheless, that was probably not the worst news of the week. In fact, the US stock market is late to the real horror show--which is a deflationary vortex that is rapidly spreading throughout the global economy, particularly in Asia and emerging markets. Consider the following news from last week:

1) On Monday morning the WSJ reported: "Japan’s economy contracted in the second quarter as overseas demand for Japanese goods slumped and households spent less, raising the possibility the government will act to bolster an anemic recovery. Japan’s gross domestic product shrank 1.6% on an annualized basis in the April-June quarter, according to data released Monday by the Cabinet Office." Japan teeters toward recession.

2) On Monday the FT reported that: "Russia, Turkey, Malaysia and Taiwan headed a lengthening list of emerging market countries seeing their currencies pummelled by markets’ continued fixation with China’s slowdown and an imminent US rate rise." Emerging market currency devaluations means more exported deflation worldwide.

3) On Tuesday USA Today reported that China's main stock index "plunged more than 6% . . . and other Asian markets also declined as investors appeared to show a delayed reaction to news that China's market regulator would allow market forces to play a greater role in determining stock prices.The mainland China stock benchmark's 6.2% drop to 3,748.16 was its biggest decline in three weeks. The index fell 8.5% in late July as worries about China's ability to maintain high economic growth levels undermined investor confidence." China's stock market crash now mirrors the Crash of 1929.

4) On Wednesday USA Today reported that: "The stock market closed lower Wednesday after minutes from the Federal Reserve's last policy meeting showed the central bank was 'approaching' its first rate hike in nearly a decade. . . .The Dow Jones industrial average ended down 162 points" and "[t]he energy sector was the hardest hit as oil prices tumbled about 4% after a government report showed that U.S. crude stockpiles rose. U.S. benchmark crude fell $1.82 to $40.80 a barrel." Oil prices now stand at a six year low threatening a huge part of the global economy with an oil depression.

5) On Thursday CNBC reported that "China, which is at the heart of the region's deflation challenge, has seen 41 consecutive months of falling producer - or wholesale - prices. In July, the country's producer prices index (PPI) fell 5.4 percent from a year earlier, the worst reading since late 2009, during the aftermath of the global financial crisis. Over the past nine months, PPI deflation pressures have reached nine out of ten economies in the region." Virtually all of Asia is now in a "deflationary funk."

6) Yesterday Bloomberg reported that: "The Bloomberg Commodity Index of 22 raw materials dropped Wednesday to its lowest since 2002, paced this year by declines in nickel, sugar, and crude oil" and that "[s]lumping prices for raw materials have wiped out $2.05 trillion from the shares of mining and oil companies since the middle of last year." Emerging markets now face a "death spiral" of falling commodity prices and falling currencies.

7) Yesterday the WSJ reported that: "[t]he Caixin China Manufacturing Purchasing Managers' Index . . . fell to a 77-month low in August." This private survey contradicts official sources and proves China is in much worse shape than previously thought.

All of this highlights that serious deflation haunts the global economy with China, Japan and other emerging markets suffering serious economic slowdowns accompanied by severe crashes in the market price of almost all commodities. Now, these nations are exporting deflation through falling currencies which effectively slash prices on everything they produce. This constitutes a serious threat to the global economy.  On top of those problems, Greece and the Eurozone are still a mess.

This blog first discussed this "perfect storm" of financial threats on December 12, 2014 and again on December 14, 2014. At that time I bemoaned the lack of any effective mechanism for sound fiscal and monetary stimulus for the global economy. I have made the same point with respect to the Eurozone. I wrote a law review article (a book review of Globalization and its Discontents by Joseph Stiglitz) on this point in 2003, and I addressed this flaw in global financial architecture in Lawless Capitalism. I have also blogged on pro-growth reforms that would help lift the global economy out of its structural deflationary malaise, such as empowering people to move freely to their highest and best use or banking currency reserves.

The other major problem with all these extreme market moves relates to the world's unregulated and opaque derivatives markets. Here, the question of the day relates to the exposure of the megabanks to the oil patch, the emerging market sector and China. My bet is that the megabanks booked big profits on all that soon-to-be distressed debt and now face the losses from those derivatives deals. If so, this meltdowm in Asia and the energy sector is about to hit home on Wall Street and our dysfunctional financial sector. Think MF Global or the London Whale.

Right now, the US economy does not face any Doomsday threat; but, that can change quickly if it turns out our oil sector collapses or the megabanks must book huge losses on derivatives transactions involving commodities, Asia or emerging markets.