Good Luck, Barack

"The size of the financial markets... has become so monstrously huge, there is no other means of maintaining stability than to establish a psychology of confidence. The governments themselves can only project to the markets a sense they know what they're doing." -- David M. Smick, March 2008

Barack Obama arrives at the White House with an ambitious agenda. But with the global economy in the midst of a brutal financial deleveraging -- in which virtually every asset in the world is seeing its value decline -- he and his international counterparts are in for a world of pain.

Begin with U.S. domestic policy. Obama's first budget deficit could easily exceed $1.5 trillion. Various bailout packages and fiscal stimulus plans will push up spending, while the economic contraction will lead to lower tax receipts. State governments are lining up for federal aid. Private pension funds will be next. The FDIC, dealing with the mortgage mess, will no doubt need a healthy injection of capital from Uncle Sam. And that's before you tally up Obama's spending and tax cut promises.

The bill for all this debt will likely come due before 2012. Mortgage interest rates quickly rose after the U.S. Treasury introduced its bailout plan, and the Federal Reserve's balance sheet liabilities have jumped 100 percent. Financial markets are essentially projecting that three to four years from now, the world's central banks, after a period of disinflation, will be forced to confront this massive increase in debt.

Obama could be confronting a banking nightmare reminiscent of Japan in the 1990s. Today, U.S. banks are flush with capital ($400 billion on the sidelines at last count, much of it taxpayer-provided), but they aren't lending. It's a bit of a chicken-and-egg problem. The banks aren't lending because of the weakening U.S. economy. The economy is weakening because the banks aren't lending. Short of nationalization, Obama can do little to force their hand.

Globally, the brief period of schadenfreude toward the United States' economic woes is over. That's because Europe's exposure to risky, emerging-market trade debt turns out to be six times its exposure to U.S. subprime mortgages. In some economies, including Britain's, banks' exposure dwarfs the national GDP.

Here's why this is a huge problem: Developing economies allowed themselves to become dangerously export dependent, while tying their currencies to the U.S. dollar and building mountains of excess savings. That growth model is crumbling fast as global demand is plummeting. But if too many of these emerging markets go down, the IMF lacks the necessary resources to mount rescue operations. To put things in perspective, Austrian banks have emerging-market financial exposure exceeding $290 billion. Austria's GDP is only $370 billion.

The one silver lining is that the world does not lack capital. It's simply sitting on the sidelines, including $6 trillion in global money market funds alone. The faster Obama and his global counterparts can fashion credible financial reforms that enhance transparency while preserving capital and trade flows, the sooner that sidelined capital will reengage. In the end, markets crave certainty -- in this case, certainty that our leaders have a credible game plan. That plan is not yet in place.


A Lethal Shakeout

"If, as I suspect, the American consumer now enters a sustained slowdown, there will be unmistakable reverberations on U.S.-centric export flows in many major regions of the world." -- Stephen S. Roach, October 2006

Before the year is over, no major region of the world will remain unscathed by recession. Indeed, I suspect that 2009 will go down in history as the first truly global recession of the modern economy.

Yes, it began in the United States in the summer of 2007 with the so-called subprime crisis. But there were bubble-dependent growth models in a surprisingly large number of countries -- all now bursting.

In the United States, asset-dependent growth was concentrated in two parts of the economy: home-building activity and personal consumption. Sustained weakness is now likely in both sectors, which at their peak accounted for nearly 80 percent of U.S. GDP.

That brings export-dependent Asian economies into the equation. In effect, they were driven by export bubbles, which, in turn, were a levered play on the U.S. consumption bubble. Asia was also aided and abetted by sharply undervalued currencies. And to keep their currencies cheap, countries such as China had to recycle massive amounts of foreign exchange reserves into dollar-based assets -- suppressing U.S. interest rates and sustaining the very asset and credit bubbles that fueled a bubble-dependent U.S. economy. That virtuous circle has now been broken. And because Asian economies lack vigorous support from internal private consumption, regional growth risks have tipped decisively to the downside.

A similar verdict is likely for the commodity-producing regions of the world -- not just the oil-dependent Middle East, but also the resource-intensive economies of Australia, Canada, Brazil, Russia, and Africa. As global growth slows, so does the demand for economically sensitive commodities -- resulting in a sharp correction in the bubble-distorted commodity prices and growth rates of the major commodity producers.

A second megaforce at work is globalization -- the cross-border linkages that during the past decade have increasingly taken the form of trade flows, capital flows, information flows, and labor flows. The credit crisis itself is essentially a powerful cross-product contagion -- a virus that began with subprime mortgages but then quickly spread to asset-backed commercial paper, mortgage-backed and auction-rate securities, and other instruments throughout the credit markets. But because financial engineers were so adept at distributing the complex products they created, there is a critical cross-border dimension to this crisis as well. Little wonder this is the worst financial crisis in 75 years.

Driven by the confluence of post-bubble shakeouts and increasingly robust global linkages, this recession is likely to be the worst of the post-World War II era. That means it could be more severe than the sharp downturns of the mid-1970s and early 1980s. Back then, it was the aggressive anti-inflation resolve of central banks that led to deep recessions. This time, an implosion of bubble-dependent global imbalances has done the trick.

But don't count on a vigorous (V-shaped) rebound from the post-bubble global recession of 2009. With no other major consumer likely to step up and fill the void left by the United States, a lopsided, bubble-distorted world will experience an anemic recovery at best. It will be a long time before global growth returns to the nearly 5 percent rate of the four and a half years that ended in mid-2007. Post-bubble shakeouts are lethal for any individual economy -- to say nothing for the world as a whole.