The past two weeks have
provided us with a tantalizing glimpse of what
lies ahead for the US economy, with the blow-up in
subprime mortgages helping to unravel market
confidence around the world. Global equity
declines have wiped out some US$2.5 trillion of
wealth, the conversion of which to consumption
implies a fall of between 1% and 2% of global
gross domestic product.
That kind of
decline cannot be made good by growth improvements
in China or India; indeed, the decline hits these
countries quite hard unless
they can diversify their own sources of growth.
In a previous article, [1] I wrote the
following:
Dependent on the munificence of
strangers like no other superpower in history, a
US decline is unstoppable. That said, the surge
in the value of Chinese stocks underlines the
desperation rather than genius of global
investors ...
If the sting of a scorpion
surprises a burglar, he is caught between the
need to scream, risking capture, or silently
bearing the pain before gingerly withdrawing
into the night. Much the same logic rules the
financial markets these days, where the poor
returns to be had in the US markets have driven
many investors to search for alternatives, even
if these appear overvalued themselves. This
global epidemic of pseudo-logic will end in
tears for many investors, but at least the
people with the real savings have the ability to
recover, which the US economy appears to
lack.
Both parts of this scenario have
come about, namely an obvious decline in global
stock markets, which was prompted both by economic
concerns in the United States and maladroit
financial-markets regulation by China. [2]
Borrowers and ultimate
lenders It is a good old rule of banking
that when you borrow $1 million from the bank and
cannot repay, you are in trouble, but if you
borrow $100 million from the bank and cannot
repay, the bank is in trouble. In the above
scenario, linkages through the global financial
system mean that Asian banks and investors were
holding a substantial portion of risk linked with
the poor borrowers in the US. These are the same
people whose inability to repay prompted the
bankruptcy of some specialist firms that lend
money to poor Americans, in turn touching off the
crisis described above for global equity markets.
My point in repeating the story is to
highlight the fact that the other shoe has not
dropped yet - ie, Asian lenders who suffered
losses from buying these securities are unlikely
to purchase other US obligations until a clearer
picture of the economy emerges. This translates to
a withdrawal of liquidity from US financial
markets, adversely affecting the prospects for the
rest of the year. Americans, who are used to
consuming more than they produce, will have to
reverse course. The result will be akin to a fat
person going on a bread-and-water diet for six
months: painful, but necessary.
The likely
pain of the adjustment for Americans will depend
much on how quickly the rest of the world goes
into recession with the US. It is important to
note that any "lag" will only make the US
recession more painful for Americans. For example,
if only the US economy goes into recession, then
oil prices will likely remain near current levels,
which, combined with a falling US dollar, will
keep inflation too high for any interest-rate
cuts. Without such cuts, which would help to
reduce monthly mortgage payments for Americans, it
is likely that more people will have to declare
bankruptcy, which feeds the vicious cycle of
falling stock markets. In contrast, if the
rest of the world catches the recession fever from
the US right away, oil prices will fall and
central banks around the world can cut rates. As I
explain below, the second
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