Just in case the world as we know it ends, I would like to say a couple of good things about Wall Street before it happens. By causing a collapse in global economic activity, it has helped nip the nascent inflation threat in the bud. Never mind that the solutions that are currently being whipped up to solve the problem would cause its resurgence two years later. The second good that has come out of the collapse in economic activity is that global warming would worsen at a much slower pace (not my original insight).
Having said that, I am now allowed my usual quota of broadsides. By pushing Lehman Brothers Holdings Inc. into bankruptcy, the US government effectively repeated the financial equivalent of Hiroshima and Nagasaki. The only difference is that it was dropped on the whole world. It is not that the US government set out to achieve that. But that has been the impact.
The collapse of Lehman Brothers caused bankers to freeze in their tracks. They have clammed up on their bad assets and been grateful for the US treasury’s capital injection that came practically without strings attached. The cash has been pretty much hoarded. Their failure to engage in financial intermediation has caused short-term funding to dry up for banks in many developing countries. What was, until then, a manageable sell-off in equities markets in the developing world has now turned into a full-blown classical emerging market economic crisis engulfing many countries.
While many economists make a distinction between liquidity and solvency crises, in situations such as the one we face now, a fine line divides the two. Liquidity shortage, if not addressed quickly and relatively cheaply, could turn into a solvency crisis. That risk is real for many developing countries now. That would be needless and one that would come back to hurt the US next year.
This brings Bare Talk to a confession. Call it irrational or stupid, Bare Talk could not help feeling terribly annoyed at the “relief” expressed by talking heads on Bloomberg that the sell-off in the US on Friday was orderly and of a much smaller magnitude compared with the carnage that went on in the developing world and almost equally badly in Europe. US contribution to the grave economic crisis that the world faces has been colossal. Regret and remorse rather than relief would have been appropriate emotions to display.
But this is going to hurt the US. Next year, if US households decide to buckle down to the task of paying off their debts and rebuild savings (they had better), the US will be left with no other avenue for growth now that it has dragged the developing world into the mess squarely.
However, if US households continue to borrow, then one must expect emerging economies to be extremely wary of accumulating claims on the US considering their recent experience. Certainly, the superpower that it is, the US has dragged the rest of the world down with it so that its relative position is unaffected. It would reap the whirlwind for doing so.
In the process of doing so, certainly the US has quietly allowed another bubble to develop. That is the US dollar bubble. The dollar has gained 20% in the last three months after sinking to a historical low in the second quarter. That is a bubble. Talk of flight to quality or flight to safety driving the dollar higher is drivel.
Whenever US consumption slowed and US current account deficit shrank, the dollar has strengthened. It happened in 1988-91 and in 2001. On such occasions, no other fundamental matters. The dollar strength just reflects its relative shortage in a world used to being awash with dollars. Recent dollar strength and its converse, emerging market currency weakness and asset price crash in the developing world, are likely to result in an economic contraction far more severe than many imagine in the US for the next few years. This is not quality but quagmire.
The economic slump has the potential to prod the US financial sector back into crisis, as it would stymie any recovery in borrowing needs and asset prices. The piecemeal approach to financial sector repair in the US and in Europe, and the reluctance to separate the good institutions from the bad ones that deserved to fail perhaps do not stem so much from incompetence as much as it reflects a frightening reality of banks’ asset quality that defies neat solutions. If the patient is not fit for surgery, prolonged sickness (credit crunch) and prolonged medication (more fiscal support) are inevitable. Therefore, we are still on track for an eventual collapse of the dollar and rise in US long-term interest rates.
However, the economies and asset prices in the rest of the world, particularly the bulk of the developing world, deserve a lot better.
V. Anantha Nageswaran is head, investment research, Bank Julius Baer & Co. Ltd in Singapore. These are his personal views and do not represent those of his employer. Your comments are welcome at firstname.lastname@example.org