Thursday, July 17, 2008

Bursting Of US Bubble Will Be Long And Painful

Source : The Business Times, July 17, 2008


SIX weeks ago, when financial markets were relatively calm, I suggested here that we were 'in the eye of a typhoon' following the sub-prime mortgage crisis, and that worse was still to come. Then came the 'crash' at Fanny Mae, Freddie Mac, and Indymac Bank plus the threat of multiple bank collapses in the US.

Yet, even this appears to be only the start of a perfect financial storm that will be followed by an equally fearful period in the economic doldrums.

The US Treasury has appeared - for the moment, at least - like a merciful deity in the raging storm to save two of the nation's biggest financial institutions that are regarded as being too important to fail. But this rescue will be bought at the risk either of a crippling government debt burden in the US over the coming decade or of hyper-inflation if new money is printed.

The former is most likely and it points to a long period of deflation thereafter in the US and other Anglo-Saxon cultures where finance has been given its head to a point where it has become an all-devouring monster. Needless to say, the rest of the world, including the emerging economic giants in Asia and elsewhere will suffer as the inflated global demand that fuelled their growth collapses.

Most people still fail to comprehend the awful deflationary threat that faces the global economy now. This is a result of over-accommodative monetary policies pursued over the past decade in a misguided attempt to anaesthetise the financial system against the pain of financial shocks, and also because of the fact that governments are being forced to bail out financial institutions that were conduits for this dangerous largesse.

To put it simply, the whole structure of inflated prices for assets, goods and services that was supported by mega credit creation has to adjust back to levels consistent with sustainable economic growth. This process is called deflation and it is the biggest threat the global economy faces today, notwithstanding the recent surge in energy, food and other commodity prices.

What happened to Japan during and after the bubble economy period from 1985 to 1990 is of relevance now. If we do not 'learn from Japan' now, we will be forced to do things in the 'Japanese way' - and it may already be too late to do anything about it anyway, because the truth is that there is no easy way out of the current dilemma. Japan expanded its money supply massively during the bubble economy, not to keep financial markets afloat as the US did following the collapse of the IT bubble and other crises (the so-called 'Greenspan put'), but to compensate for a massive appreciation of the yen after the Plaza Accord of 1985. But the effect was the same in both cases and that was to inflate the price of financial and 'real' (property) assets exponentially. Then came the crash in Japan after the Bank of Japan began a monetary squeeze in 1989.

Over the next few years, the Japanese government was forced to mount massive and very costly rescues of banks and other financial institutions as well as to pump trillions of yen into the economy by way of general fiscal stimulus. Between 1990 and 2007, the amount of outstanding Japanese government bonds soared from 166 trillion yen (S$2.15 trillion) to 550 trillion yen. As a proportion of GDP, it has tripled from around 60 per cent to nearer 180 per cent now.

Japan (household sector, banking sector and state bodies) is stuffed full of this public debt which obviously has a crowding-out effect on productive investment - a fate which now appears to threaten the US, Britain and other Western jurisdictions where the government has to come to the rescue of a profligate private sector.

This portends long-term economic stagnation of the kind that Japan suffered for more than a decade after its bubble burst.

The US bubble has not burst because of rising interest rates but rather because the sheer weight of credit creation and debt within the system became too great. Something had to give.

First, it was the sub-prime mortgage sector and then Bear Stearns and other investment banks that ran cap in hand to sovereign wealth funds. Now it is Fanny Mae and Freddie Mac. And tomorrow, who knows?

Meanwhile, there is no escaping the fact that the prices of everything from property and stocks to consumer and capital goods and services that were forced skywards on a jet of financial liquidity have to sink slowly and sickeningly back to earth in the Western world.

Just how far emerging economies can escape this return to reality is still hard to gauge, and likewise how far demand from these economies can sustain the commodity boom. But be sure that the bust will be long and painful for many.

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