Sunday, March 08, 2009

Global Economies and Markets: From Debt Deflation To Creative Destruction?

``Yet “revolutions” every generation, as was recommended by Thomas Jefferson, are not the solution. We know that “revolution” is not achievement and the new dawn. It results from senile decay, from the bankruptcy of ideas and institutions, from a failure of self-renewal. The only way in which an institution – whether a government, a university, a business, a labor union, an army – can maintain continuity is by building systematic, organized innovation into its very structure. Institutions, systems, policies, eventually outlive themselves, as do products, processes, and services. They do it when they accomplish their objectives, and they do it when they fail to accomplish their objectives. Innovation and entrepreneurship are thus needed in society as much as in the economy, in public service institutions as much as in business. The modern organization must be a destabilizer; it must be organized for innovation.-Peter Drucker, Modern Organization Must Be a Destabilizer

The mainstream has argued sternly about the “myth of decoupling”, when the term decoupling has been a palpable misnomer.

In the globalization heyday of yesteryears, which means the integration of finance, trade, investment and labor, “convergence” was obviously the natural outcome. Thus, global markets and economies had been mostly coordinated or harmonized as the bubble blossomed.

But when the US originated global credit bubble imploded, this globalization platform have effectually been reduced, as world trade is expected to decline by more than 2% (, and capital flows around the world is also expected to crater- world Foreign Direct Investment (FDI) is expected to slump by 21% ( and capital flows to Emerging Economies is likewise expected to tumble to $165 billion from $466 billion according to the Institute of International Finance (

In addition, ongoing debt deflation in major economies have been reversing capital flows, as major financial institutions vie to meet capital requirements hence repatriate capital from liquidated overseas investments.

And as we previously argued, the recent surge of the US dollar’s price against most of the world’s currencies has been a function of dollar shortage in the system, the BIS recently issued a report which essentially validates our view [see The US dollar's Vitality Stems From Debt Deflation Prompted US Dollar Shortage]

Worst, the rising protectionist sentiment seen in many diverse forms are being resurrected and may further add to negatively impact trade and financial flows [as discussed in Will Deglobalization Lead To Decoupling?].

Hence, the natural incipient impact from deglobalization was also a synchronous meltdown seen late last year.

Now a new trend seems to be evolving.

In contrast to the macroeconomic perspective, whose penchant is to view the world in terms of aggregates and who seem to believe that people behave like automatons and tend to think alike, we think that people respond differently to the circumstances, hence may lead to diverse reactions. In short, people act based on purposeful behavior or incentives.

The carnage in October of 2008 instigated by the institutional run or “electronic run” in the US banking system seems to have posed as a severe mental shock known as the Posttraumatic Stress Disorder (PTSD) to the world economic activities and the financial markets. In some accounts, such mental discord has been labeled as the “After Lehman” syndrome [see our latest post, Global Posttraumatic Stress Disorder (PTSD): The After Lehman Syndrome].

And as the world fell in into a transient suspended animation from such anxiety disorder, the consequent spillover to the real economy have been transmitted through a deep retrenchment of the credit driven demand and the subsequent sharp downside adjustments in the global supply chain, which reflected on the abrupt dismantling of the production structure built around the bubble global paradigm.

This means that the compression of the supply chain had been equally manifested in the mass closure of relative excess capacities, the efforts to reduce existing surplus inventories and the reduction of labor and or rationalization of wages. Likewise, expected valuations in on diverse asset markets during the bubble days are being intensely reappraised, as the once euphoria outlook seems to have transmogrified into a depression mentality.

In short, as explained in Fruits From Creative Destruction: An Asian and Emerging Market Decoupling?, the world’s financial markets and economies appear to be undergoing ‘creative destruction’, where the speculative excesses from the bubble structure is being undone by market forces, despite government’s exhaustive travails to futilely sustain them.

As Friedrich Hayek once wrote, ``The thing which is most needed to secure healthy conditions is the most speedy and complete adaptation possible of the structure of production. If the proportion as determined by the voluntary decisions of individuals is distorted by the creation of artificial demand resources [are] again led into a wrong direction and a definite and lasting adjustment is again postponed. The only way permanently to 'mobilise' all available resources is, therefore to leave it to time to effect a permanent cure by the slow process of adapting the structure of production.” (bold highlight mine)

Signs of Positive Impact From Creative Destruction?

However, considering the scale and depth of collapse, much of these precipitate changes may have been overdone. Yet, combined with the idiosyncrasies of the political, capital and production structure of each nation, signs of creative destruction may have started to reinforce signs of “divergence dynamics”- in a world where globalization trends have apparently been on a descent.

Proof? See figure 1.

Figure 1: Danske Bank Weekly: Last In, First Out

China appears to be leading the way out of the global economic morass, as industrial (manufacturing) activity, credit growth and car sales appear to be markedly recovering even as the US remains in doldrums.

According to Steen Bocian Chief Economist of Danske, ``China was one of the last countries to be dragged into the global financial crisis, and now looks set to be one of the first to come out the other side.”

And it's not only China but other East Asian countries as well.

And this development seems congruent to what we wrote in July of 2008 in Phisix: Learning From the Lessons of Financial History,

``This I think is what the global financial market has thus far priced in, aside from the ongoing delevaraging process that has fomented the forcible selling of most liquid asset classes by institutions caught in the web of illiquidity stasis.

``And if Asia is not a bubble then the likelihood is that the bear market arising from the present contagion conditions as mentioned above could be likewise be cyclical and temporary in nature. If our analysis is correct then we should see the rendition of the same patterns even amongst our neighbors.”

While much of Asia’s equity markets hasn’t been lifted by these developments yet, but instead dragged by dreary global sentiments, China’s Shanghai index remains as the world’s market leader up 5.29% for the week and up 20.4% over the year.

It should be a reminder that in every cyclical transition there will always be a change in market leadership and perhaps, China could be assuming such a role, if the recovery will be sustained.

Economic Restructuring Will Restore Global Growth

Nevertheless, it would be a misguided collectivist notion to think that China would even attempt to save the world. China will only act to protect its political, financial or economic self-interest. And any spillover will mostly be coincidental than intended, except perhaps for extraordinary circumstances which is exigent to their self-interest.

Take this report from, ``Chinalco’s $19.5 billion capital injection into Rio Tinto, so far the largest foreign investment of any Chinese enterprise, is believed to signal China’s holding’s transition into strategic resources. Officials and leaders of state-owned enterprises also suggest the government inject some of the reserve into state-owned enterprises to help them invest overseas or establish funds for overseas acquisition.”

Ironically, common sense tell us, where everyone wants to be saved, the world is simply too enormous and too complex to be saved with restricted resources.

And the harsh reality is that world will have to undergo an economic restructuring than continue to survive on a farcical political economic landscape dependent on sustained bubble blowing.

Otherwise what may seem like a temporary recovery may even lead to a malevolent nightmare, as Joseph Schumpeter in the The Economics of Recovery Program observed, ``"Depressions are not simply evils, which we might attempt to suppress but-perhaps undesirable-forms of something which has to be done, namely, adjustment to previous economic change. Most of what would be effective in remedying a depression would be equally effective in preventing this adjustment. This is especially true of inflation, which would, if pushed far enough, undoubtedly turn depression into the sham prosperity so familiar from European post war experience, but which, if it be carried to that point, would, in the end, lead to a collapse worse than the one called in to remedy.”

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