"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.