And so the make-over has begun: Hillary Clinton’s whirlwind tour of Asia that takes her to China, Korea, Japan and Indonesia may well mark the beginning of new relations with the East Asian economies whose goodwill towards America at the moment will be crucial in President Obama’s attempts to recover America’s lost prestige and bring about a much-needed economic recovery if he is to rescue his country from the brink of disaster.
That Hillary Clinton was assigned to this task is interesting, for it is noteworthy that this time round the Secretary of State for Foreign Affairs has had her world map cut up into chunks. Crucial regions such as Central Asia, Pakistan and India, for instance, are off Hillary’s plate, leaving her with much to do in Southeast and East Asia as well as the Arab world. Ironically her close contact with the Israeli lobby in Washington may serve as a negative factor when she has to show off the new face of America in Indonesia, the world’s most populous Muslim country.
But the task that has been left to Hillary is an unenviable one: For a start, there is the delicate balancing act between China and Japan that has to be played out successfully. America today, thanks to the uneven trade relations it enjoys with China, cannot afford to antagonise what will soon become the second biggest economic player on the planet as well as America’s most important trade ally. Due to the enormous amount of US cash dollar reserves that China has, the fate of the dollar now hangs on the whims of the Chinese government and market.
But then there is the worrying concern that the Japanese have, for if US-China political and trade relations improve at the expense of the former, Japan may well find itself relegated to secondary position in the fragile balance of military and economic power in East Asia. For decades now Japan has been America’s vital ally in the war against Communism and was a proxy front line state staring the might of China in the face. As China alters itself and assumes the ackward avatar of a Communist state with a Capitalist economy in all but name, what will the future hold for Japan?
Indonesia, however, is the most crucial country as far as America’s re-invention of itself goes. As the most populous Muslim country in the world how America is seen by Indonesia’s 200-million plus Muslims will define America’s new relationship with the Muslim world in general. Hillary’s visit to Indonesia was therefore seen as the primer to test the waters, and to pave the ground for the historic visit of Obama himself, who in Indonesia is practically adored as one of their own.
In Obama America now finds its best and most natural ambassador: His African-American origin and his childhood in Asia makes him the most qualified American president to date to play the role of bridge-builder. It is well known in policy circles across Southeast Asia that President Obama plans to make his vital speech to the Muslim world while he is in Indonesia. American policy makers hope therefore that Indonesians will welcome him with open arms, as this would be the first step in improving the image of America following the dark days of Bush junior, whose contribution to America’s image to the world came in the form of the barbed-wire fences of Guantanamo Bay.
What many of us have overlooked however is this: That while the world slowly sinks deeper into a global economic crisis, the American government is now turning to Asia for support and succour. The might of the world’s sole superpower that blasted Afghanistan back to the Middle-Ages and which reduced Iraq to rubble is now being defined and determined of developing countries in the South instead. As Obama seeks to define the new image of the new America that hopes to play the role of honest broker and equal partner in world politics, one wonders if the age of global hegemony is coming to an end, or being checked at least. One thing however is certain: that in its present state an America in economic crisis and suffering a credibility deficit after the mismanagement of the Bush government can no longer swagger around the world with a big stick.
As the once-hegemonic discourse of the ‘war on terror’ that was bandied about by the Bush administration gives way to the softer rhetoric of partnership and respect, a different America performs its make-over in public and realises that the rest of the world matters after all. And that may not be such a bad thing.
I just arrived to Hong Kong and I will next visit India later this week. When the first thing you hear – from your driver upon arrival to the airport in Hong Kong – is that business and occupancy in hotels is down more than 30% you already know this is a very ugly recession in the entire Asian region as Hong Kong is an economic barometer for trade and economic activity all over Asia.
For those who argue that the second derivative of economic activity is turning positive (i.e. economies are contracting but a slower rate than in Q4 of 2008) the latest data don’t confirm this relative optimism. In Q4 of 2008 GDP fell by about 6% in the US, 6% in the Eurozone, by 8% in Germany, by 12% in Japan, by 16% in Singapore and by 20% in South Korea. So things are even more awful in Europe and Asia than the US.
So let us discuss next why there is a rising risk of a global L-shaped depression that would be even worse than the current ugly and painful U-shaped global recession:
First, note that most indicators suggest that the second derivative of economic activity is still sharply negative in Europe and Japan and close to negative in the US and China: some signals that the second derivative was turning positive for US and China (a stabilizing ISM and PMI, credit growing in January in China, commodity prices stabilizing, retail sales up in the US in January) turned out to be fake starts. For the US, the Empire State and Philly Fed index of manufacturing are still in free fall; initial claims for unemployment benefits are up to scary levels suggesting accelerating job losses; the sales increases in January is a fluke (more of a rebound from a very depressed December after aggressive post-holiday sales than a sustainable recovery).
For China the growth of credit in China is only driven by firms borrowing cheap to invest in higher returning deposits not to invest; and steel prices in China have resumed their sharp fall. The more scary data are those for trade flows in Asia with exports falling by about 40 to 50% in Japan, Taiwan, Korea for example. Even correcting for the effect of the new Chinese Year exports and imports are sharply down in China with imports falling (-40%) more than exports. This is a scary signal as Chinese imports are mostly raw materials and intermediate inputs; so while Chinese exports have fallen so far less than the rest of Asia they may fall much more sharply in the months ahead as signaled by the free fall in imports.
With economic activity contracting in Q1 at the same rate as in Q4 a nasty U-shaped recession could turn into a more severe L-shaped near-depression (or stag-deflation) as I argued for a while (most recently in my Sunday New York Times op-ed). The scale and speed of syncronized global economic contraction is really unprecedented (at least since the Great Depression) with a free fall of GDP, income, consumption, industrial production, employment, exports, imports, residential investment and, more ominously, capex spending around the world. And now many emerging market economies – as argued here for a while- are on the verge of a fully fledged financial crisis starting with Emerging Europe.
Fiscal and monetary stimulus is becoming more aggressive in the US and China – again less so in the Eurozone and Japan where policy makers are frozen and behind the curve. But such stimulus is unlikely to lead to a sustained economic recovery. Monetary easing – even unorthodox – is like pushing on a string when the problems of the economy are of insolvency/credit rather than just illiquidity; when there is a global glut of capacity (housing, autos, consumer durable, massive excess capacity because of years of overinvestment by China, Asia and other emerging markets) and strapped firms and households don’t react to lower interest rates as it takes years to work out this glut; when deflation keeps real policy rates high and rising while nominal policy rates are close to zero; when high yield spreads are still 2000 bps relative to safe Treasuries in spite of zero policy rates.
Fiscal policy in the US and China has also its limits. Of the $800 billion of the US fiscal stimulus only $200 bn will be spent in 2009 with most of it being back-loaded to 2010 and later. And of this $200 half is tax cuts that will be mostly saved rather than spent as households are worried about jobs and about paying their credit card and mortgage bills (of last year’s $100 bn tax cut only 30% was spent and the rest saved). Thus, given the collapse of five out of six components of aggregate demand (consumption, residential investment, capex spending of the corporate sector, business inventories and exports) the stimulus from government spending will be puny this year.
Chinese fiscal stimulus will also provide much less bang for the headline buck ($480 billion). For one thing you got an economy radically depending on trade: trade surplus of 12% of GDP; exports above 40% of GDP and most of investment (that is almost 50% of GDP) going to the production of more capacity/machinery to produce more exportable goods. The rest of investment is in residential construction (now falling sharply following the bursting of the Chinese housing bubble) and infrastructure investment (that is the only component of investment that is rising). With massive excess capacity in the industrial/manufacturing sector and thousands of firms shutting down why would private and state owned firms invest more even if interest rates are lower and credit is cheaper: given the glut of capacity monetary and credit easing is like pushing on a string. Forcing state owned banks and firm to lend more and to spend/invest more will only increase – after a short term boost spending and economic activity – the size of non-performing loans and the amount of excess capacity. And with most economic activity and fiscal stimulus being capital-intensive rather than labor intensive the drag on job creation will continue. So without a recovery in the US and global economy there cannot be a sustainable recovery of Chinese growth. And with the US recovery requiring lower consumption, higher private savings and lower trade deficits a US recovery requires China’s and other surplus countries (Japan, Germany, etc.) growth to depend more on domestic demand and less on net exports. But with domestic demand growth being anemic in surplus countries (China, Japan, Germany, and emerging economies relying on export led growth) for cyclical and structural (demography, weak household income growth as massive and excessive corporate profits/savings that are hoarded rather than transferred back to households in the form of dividends). So recovery of the global economy cannot occur without a rapid and orderly adjustment of global current account imbalances.
In the meanwhile the adjustment of US consumption and savings is continuing. The January personal spending numbers were up for one month (a temporary fluke driven by transient factors) and personal savings were up to 5%. But that increase in savings is only illusory. There is a difference between the national income account (NIA) definition of household savings (disposable income minus consumption spending) and the economic definitions of savings as the change in wealth/net worth: savings as the change in wealth is equal to the NIA definition of savings plus capital gains/losses on the value of existing wealth (financial assets and real assets such as housing wealth). In the years when stock markets and home values were going up the apologists for the sharp rise in consumption and measured fall in savings were arguing that the measured savings were distorted downward by failing to account for the change in net worth due to the rise in home prices and the stock markets.
But now with stock prices down over 50% from peak and home prices down 25% from peak (and still to fall another 20%) the destruction of household net worth has become dramatic. Thus, correcting for the fall in net worth personal savings are not 5% – as the official NIA definition suggests – but rather sharply negative. In other terms given the massive destruction of household wealth/net worth since 2006-2007 the NIA measure of savings will have to increase much more sharply than has currently occurred to restore the severely damaged balance sheet of the households. Thus, the contraction of real consumption will have to continue for years to come before the adjustment is completed.
In the meanwhile the DJIA is down today below 7000 and US equity indices are 20% down from the beginning of the year. This author argued in early January that the 25% stock market rally from late November to end year was another bear market suckers’ rally that would completely fizzled out once an onslaught of worse than expected macro news, worse than expected earnings news and worse than expected financial shocks (bankrupt banks and other financial firms, continued deleveraging of hedge funds and other highly leveraged investors selling illiquid assets in illiquid markets, contagious financial crises in emerging markets) would emerge. And the same factors will put further downward pressures on US and global equities for the rest of the year as the recession will continue into 2010 if not longer (a rising risk of an L-shaped near-depression). Of course you cannot rule out another bear market sucker’s rally in 2009, most likely in Q2 or Q3: the drivers of this rally will be the improvement in second derivatives of economic growth and activity in US and China that the policy stimulus will provide on a temporary basis: but after the effects of tax cut will fizzle out in late summer and after the shovel-ready infrastructure projects are done the policy stimulus will slack by Q4 as most infrastructure projects take year to be started let alone finished; similarly in China the fiscal stimulus will provide a fake boost to non-tradeable productive activities while the traded sector and manufacturing continues to contract. But given the severity of macro, household, financial firms and corporate imbalances in the US and around the world this Q2 or Q3 sucker’s market rally will fizzle out later in the year like the previous 5 ones in the last 12 months. In the meanwhile the massacre in financial markets and among financial firms is continuing. The debate on “bank nationalization” is borderline surreal: with the US government having already committed – between guarantees, investment, recapitalization, liquidity provision – about $9 trillion of government financial resources to the financial system (and having already spent $2 trillion of this staggering $9 trillion figure). Thus, the US financial system is de-facto nationalized as the Fed has become the lender of first and only resort rather than the lender of last resort and the Treasury is the spender and guarantor of first and only resort. The only issue is whether banks and financial institutions should also be nationalized de jure rather than only de facto. But even in this case the distinction is only between partial nationalization and full nationalization: with 36% (and soon to be larger) ownership of Citi the US government is already the largest shareholder of Citi. So what is the non-sense about not nationalizing banks? Citi is already effectively partially nationalized; the only issue is whether it should be fully nationalized.
Ditto for AIG that lost $62 bn in Q4 and $99 bn in all of 2008 and is already 80% government-owned; with such staggering losses it should be formally 100% government owned. And now the Fed and Treasury commitment of public resources to the bailout of the shareholders and creditors of AIG has gone from $80 billion to $162 billion. Given that common shareholders of AIG are already effectively wiped out (the stock has become a penny stock) the bailout of AIG is a bailout of the creditors of AIG that would now be insolvent without such a bailout. AIG sold over $500 billion of toxic CDS protection and the counterparties of this toxic insurance are major US broker dealers and banks.
News and banks analysts reports suggested that Goldman Sachs got about $25 of the government bailout of AIG and Merrill Lynch was the second largest benefactor of the government largesse. These are educated guesses as the government is hiding which are the counterparty benefactors of the AIG bailout (maybe Bloomberg should sue the Fed and Treasury again to have them disclose this information). But some things are known: Lloyd Blankfein was the only CEO of a Wall Street firm who was present at the NY Fed meeting when the AIG bailout was discussed. So let us not kid each other: the $162 bailout of AIG is a non-transparent, opaque and shady bailout of the AIG counterparties: Goldman Sachs, Merrill Lynch and other domestic and foreign financial institutions. So for Treasury to hide behind the “systemic risk” excuse to fork today another $30 billion to AIG is a polite way to say that without such bailout (and another half a dozen government bailout programs such as the TAF, TSLF, PDCF, TARP, TALF and a program that allowed $170 billion of additional debt borrowing by banks and other broker dealers with a full government guarantee) Goldman Sachs and every other broker dealer and major US bank would already be fully insolvent today.
And even with the $2 trillion of government support most of these financial institutions are insolvent as delinquencies rates and charge-off rates are now rising at a rate – given the macro outlook – that expected credit losses for US financial firms will peak at $3.6 trillion ($1.8 trillion for US banks and broker dealers that had a capital of only $ 1.4 trillion in Q3 of 2008). So, in simple words, the US financial system is effectively insolvent.
This is indeed the worst financial crisis and economic crisis since the Great Depression and, unless policy makers all over the world start waking up rather than being asleep at the weel and start to implement Powell-style overwhelming policy force we may end-up with a multi-year near depression or stag-deflation as we have not seen since the Great Depression. This aggressive and front-loaded and pre-emptive policy response needs to include: ·
massive and more unorthodox monetary policy easing to defrost credit markets even if this may imply central banks widening collateral and taking greater credit risk; ·
massive and front-loaded fiscal stimulus more on the spending than tax side and with income relief to agents with high marginal propensity to spend (poor, unemployed, state/local governments); ·
rapid takeover of insolvent banks – full nationalization – and their quick clean-up and re-privatization; ·
aggressive credit growth incentive for banks and financial institutions to stop the collective action coordination problem leading them to contract credit to even creditworthy households and firms; ·
use of proper and constructive credit forbearance (on capital adequacy ratios, on mark-to-market marks, on rating agencies destructive lagged downgrades); ·
Across the board reduction of the face/principal value of mortgage debt and other consumer debt for insolvent households as a case-by-case debt re-stretching of debt will not work; ·
Immediate doubling of the IMF resources and provision of loans/liquidity to emerging markets under liquidity and financial stress (with conditionality for those economies with severe macro/financial/policy weaknesses; with very light conditionality for the emerging markets with sounder fundamentals).
As I argued in my NYT op-ed on Sunday: “We now face a 1 in 3 chance that, if appropriate policies are not put in place, this ugly U-shaped recession may turn into a more virulent L-shaped near-depression or stag-deflation (a deadly combination of economic stagnation and price deflation) like the one Japan experienced in the 1990s after its real estate and equity bubbles burst.”
Thus, to prevent such a financial and economic disaster the time to forcefully act is now; policy makers in Europe, Japan, other economies and even in the US and China are falling behind the curve and time is not running in their favor. The current delayed reaction to worsening financial and economic conditions rather than pre-emptive forceful action to prevent such conditions from materializing would ensure that the bad equilibrium of a global near depression will occur.
