In 2008 we presented a long term historical overview of among others the Credit Crisis, Inshurance Risks, the Housing Bubble, and Stock Markets and Economics.But while the above was partly approached from a Anglo-European perspective, when the world begins 2009 with its first synchronized recession since 1974, our viewpoint has to shift more towards the US now.
In fact if money is akin to water, then a liquidity crisis is analogous to a very low tide that exposes a host of dangers lurking beneath the surface. And by now , the United States sports the fewest of these dangers. For example, the mortgage brokers who made subprime possible are all already out of business, and most of the investment houses that gorged on securities linked to subprime — up to and including Lehman Brothers and Merrill Lynch — have either gone bankrupt or been acquired by more stable institutions.
This hardly means that the American recession is a fun time — for one thing, the liquidity crisis has triggered a painful broad-based credit rollback — but the United States is not facing any deeper structural issues.
The same cannot be said elsewhere. To extend the low-tide analogy, the aftermath of the liquidity crunch has certainly made American life harder and the water certainly has some murk, but there are no reefs to get caught on. Lower water levels in Europe, however, confront the Europeans with such a maze of debris and navigation hazards that their downward slide into recession is only now beginning.
The primary cultural difference between the United States and Europe is a higher European concern for social stability. The United States has integrated change and disruption into everyday life, while most Europeans prefer a system in which economics are somewhat managed in order to buffer the citizenry from daily shocks. The result may be a more even-keeled system on most days, but it comes at a cost: slower growth, a reduced capacity to deal with major shocks when they do occur, and above all an unwillingness to deal with problems when they are small for fear of rocking the proverbial boat. When a problem does occur — in this case, the U.S. liquidity and credit crises going global— all of the other sublimated problems are exposed at once.
Europe’s primary difficulty at the end of 2008 — which will dominate European life in 2009 — as we indicated was a banking crisis. European banks play a central role in European development that dwarfs the still-important role of American banks to American economic life. Yet European banks are not nearly as well capitalized as American banks. European banks are often used as tools of the state, so their investment portfolios tend to be less profitable, and currency variations have exposed many European banks to massive risks from the carry trade. European companies are more dependent upon financing from banks than their American counterparts (U.S. companies gain more of their financing from stock markets); regions of Europe have their own subprime housing crises which are only now beginning to manifest; the virgin nature of many European regions in financial terms has led to credit gorging and now credit hangovers; European banks find it difficult to compete with U.S. banks in attracting Asian capital; and so on. With less liquidity available, these problems and more are erupting simultaneously, hamstringing Europe’s ability to deal with a “basic” liquidity problem.
And there is more. While many malign the slow decision-making process of the American governing structure, it moves at light speed compared to its European equivalent. The U.S. Treasury and Federal Reserve have remarkable powers to act independently to address problems as they see fit. Within the European Union there are 27 separate treasury departments and legislative oversight bodies and 12 separate monetary authorities, and even those countries who have joined the eurozone have refused to sign over banking oversight to the centralized power of the European Central Bank. The result is a mishmash of competing and even contradictory policies — even on topics on which ostensibly the EU’s member states are cooperating.
While American steps to address a “simple” liquidity crisis have been bold — with many taken as early as a year ago — the Europeans’ steps have been halting and are only beginning to take effect. Consequently, the economic dysfunction that the Americans are well on the way to addressing is putting down roots in Europe. Germany, the core economy of the European Union, is ultimately driven by exports to the rest of the eurozone, making those exports perhaps the best single measure of the EU’s economic health. Those exports will soon register double-digit monthly declines. The result will enervate growth not just in Germany, but in countries that are utterly dependent upon the German market for their growth — most notably the 10 EU members in Central and Southeastern Europe. In short, Europe is facing deeper, bigger and more complex economic problems than the United States — most of which are structural and not cyclical — and because of the decentralized nature of European governance as compared to American governance, is less capable of dealing with them.
If the Europeans face water hazards uncovered by the American liquidity crunch, then the Asians have simply seen their shipping channels run dry. The Chinese and Japanese financial systems run on subsidized credit so cheap that any company can get a loan for any reason so long as it can maintain employment (and thus keep social pressures contained). And South Korea quickly started to cut interest rate.The Chinese in particular have attempted to gradually implement the painful changes necessary to reform their system to make it more sustainable in the long-run, but at the end of 2008, as the global recession bit, such efforts were utterly abandoned. Employment is king, whatever the costs. Asian governments that ignore that fact find themselves quickly out of power.
At its core, the East Asians’ current problem is simple: The United States and the European Union are the final destination for most of their exports. So long as the Americans and Europeans are in recession, the export-oriented, employment-obsessed nature of the Asian economies puts them at extreme risk. But unlike the Americans and (less so) the Europeans who are willing to reduce output (translation: lay off workers) in order to force efficiencies and thus hasten the recession’s end, the Asians cannot reduce employment without risking social explosions.
But the East Asians do have another option that they can and will select. Their export-oriented systems have generated substantial currency reserves that can be used to flood additional capital into their system in order to surge product output even more. The result is an absolute deluge of cheap — even below-cost — products whose primary purpose is not so much to be sold to generate income, but to be manufactured in order to keep people working instead of taking long marches.
The strategy is not sustainable in the long run. Every day spent on it will make the inevitable correction (the point when the system can no longer maintain the burden of inefficiencies and production and employment break apart) that much more brutal, but it is a strategy that can be sustained for some time. Even with China’s and Japan’s combined reserves of approximately US$3.0 trillion, this cannot last forever (and at the time of this writing, those reserves’ values are showing signs of wavering). In the meantime, East Asian overproduction will hasten an American recovery. While Americans tend to think otherwise, not only is their economic system the healthiest major economy in the world, but investors seeking safety the world over have flooded their cash into the United States, sending demand for the dollar and U.S. government debt to multi-year highs. A stronger dollar magnifies American purchasing power. The flood of cash enables the United States to engage in deficit spending at levels — as a percentage of gross domestic product (GDP) — not seen in the post-World War II era. And the two combined with Asian overproduction not only remove the near-term threat of inflation, no matter how much deficit spending the Americans and Europeans engage in to combat the recession, but actually raise the specter of deflation.
It is within this mixture of factors — and particularly American purchasing power — that the recession will begin to end. The U.S. consumer market — fully 70 percent of a US$14 trillion economy — is the largest in the world by a factor of five. It is also, uniquely among the world’s major economies, shielded from international developments: Only about 15 percent of U.S. GDP is involved in some aspect of international trade. This recession was triggered by the U.S. domestic economy transmitting a problem to the global system, but by virtue of the economy’s combination of huge size and limited exposure, the reverse is extremely unlikely. The recovery will begin in the United States; the only question is when.
Of course, economic impacts will hardly be limited to the three major economic poles of the United States, Europe and East Asia. Prices for commodities of every flavor have plummeted in response to reduced demand. The countries most impacted are those who both massively increased their outlays in recent years — largely due to populist policies — and do not have nest eggs that have been carefully nurtured over the years. The countries furthest out on a limb South American countries like Argentina, Ecuador and Venezuela. But also Iran, Ukraine, Pakistan, and Egypt. Iran and Venezuela in particular are seeing their international influence ripped away: Iran’s ability to finance militant groups such as Lebanon’s Hezbollah or Muqtada al-Sadr’s followers in Iraq is being eviscerated, while Venezuela’s efforts to use petro-diplomacy to expand its reach into Central America and East Asia will largely end. Ukraine’s government is unstable at the best of times, and the combination of economic dysfunction and Russian pressure could well crack the government apart. Angola and Iraq would be in this group under normal circumstances, but since both earned money faster than they could spend it the past two years, both are actually entering the recession with unexpectedly large coffers.
A second group — including Russia, India, Azerbaijan, Hungary, Brazil, Mexico, South Africa and the Baltic states — is overly dependent upon foreign capital. While they do not face the same regime-wrenching problems of the first group, these countries’ economic foundations are being shaken to their core. But for these countries, other methods of growth and influence remain. Russia’s ability to use money to influence its near abroad may be fading, although it maintains robust energy, political, military and intelligence levers that are particularly applicable in Ukraine. India may see growth slam to a halt, but so little of the economy was developed in the first place that the change will not be particularly traumatic. And Brazil has now evolved beyond a mere commodity producer, giving it a much more diversified economy from which to bounce back. Hungary may have made a series of very bad decisions when it comes to economic planning, but its membership in the European Union gives it an excellent safety net.
The final group includes Chile, the Gulf Arab states and advanced states such as Canada, Australia and Norway. All of these states either boast heavily diversified economies of which commodities are only a portion, or have established separate funds for storing a proportion of their commodity income. For these states it is an issue of inconvenience, not survival. These countries have sufficient economic wherewithal to continue to purchase influence in areas of interest to them. For example, Saudi Arabia has some US$2 trillion in funds squirreled away and therefore feels secure enough to produce its largest-ever budget for 2009, knowing full well that even in the worst-case scenario it can afford such luxuries. Again, the recession is hurting pretty much everyone, these states included, but the relative position of this last group of states is increasing nonetheless.
Again, the recession is hurting pretty much everyone, Saudi Arabia and the Gulf States, plus the few others we just mentioned. Falling oil prices as we shall see in p.3 of our forecast, certainly will have its toll also on the Arab States.
Thus the year 2009 will be a trying time for all of the world’s states. The recession is reducing incomes even as it raises the demands on states’ budgets. For more on this, see also the remaining 6 of the 7 part case study to go on line in the following days.