Will Deglobalization Lead To Decoupling?

``The most recent evidence shows that growth in emerging economies has started to moderate—partly in response to lower U.S. demand for their exports, and partly in response to the 2008 second-quarter tightening in monetary policy, designed to offset higher inflation pressures. This slowing has served to crystallize what, to date, has been an oversimplification of the debate about the evolving relationship between emerging and industrial economies. The debate should be framed not in terms of decoupling versus recoupling, but whether the decoupling is "strong" or "weak."- Mohamed A. El-Erian, A Crisis to Remember

In 2008, it became fashionable to debunk the so called “decoupling” theme. The kernel of the argument was that since world economies revolved around the US, which functioned as the only major source for “aggregate demand”, a slumping US economy would synchronize the slowdown everywhere. This phenomenon would naturally reflect on global financial markets. Of course, from the single dimensional perspective, they were right.

The salad days of the US debt driven consumption boom was buttressed by globalization, a trend which integrated trade, finance, investments to even labor-migration flows. This occurred because of concerted policies to “open” the national economies, although at varying scale.

Importantly, the boom conditions had been powered by the US Federal Reserve’s monetary policies which was transmitted to the rest of the world via the currency mechanism-dollar links, pegs, and “dollarized” economies and through its current account deficits, which allowed the US to export financial products in exchange for goods and services from the rest of the world.

Moreover, the plethora of credit, from the US and other advance economies, resulted to a diffusion of easy credit in the emerging markets. And because of the profusion of liquidity, capital flowed to rest of the world in search of higher yields (see Figure 1).

Figure 1: Institute of International Finance (IIF): Private Capital Flows

According to the IIF, the world's only global association of financial institutions with 375 members from 70 countries, ``In the previous two expansion phases (1978-81 and 1990-96) there was a dominant region that attracted more flows than other regions. In the early 1980s, the dominant region was Latin America. In the early 1990s, lending to Latin America surged once again, although this was tempered by the Mexican crisis in 1994-95 and its aftermath. Following that, lending surged to Emerging Asia, setting the stage for the Asian crisis in 1997-98. This time around, lending surged to all regions in 2007, before contracting sharply to all regions in 2008 and, most likely, in 2009.” (bold highlight mine). Thus financial markets across the globe and across diverse asset classes simultaneously zoomed.

So the operating framework of the recent globalization boom essentially encompassed liberalized trade and investment policies and fueled by an easy money “inflationary” environment emanating from the US.

From Globalization to Deglobalization

Now that the debt driven consumption bubble is unwinding, some of these trends are being reversed. Here are some of the contributing variables:

One, Forcible liquidations from Debt deflation. Since the center of capital flows came mostly from the US and advanced economies, a global ‘margin call’ from the debt deflation dynamics prompted the simultaneous forcible liquidations across asset classes.

Two, temporary scarcity of the US dollar. The imploding debt markets had been mostly denominated in the US currency, hence payment or settlement of these closed positions increased the demand for US dollars.

Besides, the severe losses in the in the US banking system accounted for as a financial “black hole”. This vacuumed out the US dollars in the system at a greater intensity than had been replaced by the US Federal Reserve.

Hence, the shortages of the US dollars exposed the internal deficiencies of many emerging markets (Korea, Russia, Pakistan etc.) and exacerbated the deteriorating economic outlook. To allay this predicament, the US Federal Reserve entered into currency swaps with most of the world’s major central banks [see How Does Swap Lines Work? Possible Implications to Asia and Emerging Markets]

Three, dysfunctional US banking system. As mentioned in last week’s What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis, like the traumatic 9/11 tragedy, the world basically was rendered dumbfounded or “shocked and awed” as the US banking system froze late last year. Trade and production fell from the cliff as credit windows were shut.

Four, dislocation of trade channels. The emergence of barter as a form of trade signified both the ongoing disorder in the operations of the global banking system and incipient signs of distrust over the present financial architecture.

In the recent tour of Europe, China’s Premier Wen Jiabao ``urged the international community to set up a new global economic system (bold emphasis mine)” (China Economic Net)

Five, national financing seems likely to turn inward.

Current account imbalances are likely to improve as deficits narrows in a LOW oil price global recessionary environment. In a HIGH oil price recessionary environment deficits might not materially improve. And deficit economies as the US will have to increasingly secure financing from its taxpayers than from previous vendor-financing scheme.

From Richard M. Ebeling of the American Institute for Economic Research, ``…the Chinese are becoming increasing leery of lending to the American markets. At the recent international meeting of bankers, businessmen, and bureaucrats in Davos, Switzerland, Chinese officials made clear their dissatisfaction with the American market, where they have suffered significant losses in banks and other financial institutions into which they had invested. In the last five months of 2008, the Chinese sold off almost half of the $46 billion is Fannie Mae and Freddie Mac bonds that they had purchased in the earlier part of the year.

``If foreign lenders do not come to the rescue, Uncle Sam will have to rely far more than in the recent past on the financial markets at home to finance its deficit spending dollars. A lot of new bank lending--with perhaps some of the billions already given by Washington to bailout many of these banks--will have to end up covering the federal government’s expenditures, rather than being available for private sector investment and employment creation.”

Meanwhile, current account surplus economies with huge forex surpluses will likely be used to defend national (e.g. Russia) or regional economies (China, Japan, and South Korea extend currency swaps to Indonesia-Bloomberg) than recycled to the US.

Another important noteworthy development is that China will be providing the currency swap arrangement with Indonesia with its own currency the remimbi, instead of the US dollar (WSJ). Combined with the recent attempt to use its currency as medium of exchange for the settlement of trade with ASEAN nations, China seems to be flexing its economic and financial muscles, which eventually may turn out to be the region’s currency standard.

Sixth, economic structures built upon unsustainable debt are being cleared. This will be reflected on reduced global trade which is expected to decline by 2.1% in 2009.

Lastly, there are budding signs of protectionism or the reversal of trade liberalization. See figure 2.

Figure 2: WSJ: Putting Up Walls

According to the Wall Street Journal, ``Countries grappling with global recession have enacted a wave of barriers to world commerce since early last month, scrambling to safeguard their key industries -- often by damaging those of their neighbors.

``The World Trade Organization is gathering nations in a special meeting Monday to try to stem the rising tide, just two weeks after saying protectionism was largely under control.”

In short, globalization seems being deglobalized.

Of course, deglobalization as a trend is likely to increase or intensify economic risks or worsen the current dilemma. The trade protectionism from the Smoot-Hawley Tariff Act in the US during 1930s was a major contributing factor which transitioned a recession to the Great Depression.

But unlike the Great Depression era, governments today seem likely to be aware of the negative consequences of such policies. The recent actions seem to signify knee jerk reactions out of domestic political exigencies. Hopefully, the actions undertaken by the WTO to mediate could help avoid the aggravation of such trends that risks a reprise of the 30s.

Structural Difference In A Deglobalized World

Nonetheless the collective government policies aimed to address today’s recession is to throw money at the economy. In other words, inflationary actions by governments will remain a pivotal force in driving asset markets and economic outcome.

Now if the essence of deglobalization is centered mainly on the market clearing of global credit bubble economic structure (and not on increasing trends of protectionist barriers) then once the portfolio outflows from forcible liquidations subside, excess capacities directed at the bubble demand are closed or bankrupted and surplus inventory are reduced, the likelihood is that all the convergent inflationary pressures applied by governments could have a distinct impact based on the nation’s capital or production structure.

Take for example the credit structure of major world economies, see figure 3.

Figure 3: US Global Investors: Credit as % of GDP

Credit as percentage of GDP is seen dissimilarly distributed across economies. For instance the UK and US has the highest household credit exposure, brought about by the recent boom in the securitization financed real estate bubble.

And the present financial crisis is forcing a market based “deflation” adjustment to such disproportionate levels of debt. Hence, under current conditions UK and US household debt levels will have to contract during the life of this crisis. Paradoxically, this unsustainable debt structure is what their governments have vigorously been trying prop up.

So unless the US and UK succeeds in destroying its currency to reduce the real value of debt, we can’t see material credit growth to produce the expected inflation based economic growth.

Now since global interest rates are being forced to approach to zero levels, which of these economies are likely to assume more debt?

The answer is that debt take up is likely to occur in emerging markets and Asia than on advanced economies, because of their low levels of exposure.

Plainly put, Asia and emerging has the capacity to absorb more debt than its contemporaries in the advance economies. Hence any bubble that could surface under the present negative interest rate regime will probably be in emerging markets and in Asia. Such assumes that the pangs of the adjustments (production and inventory) from the recent bubble structures have culminated.

Nonetheless to buttress our argument that Asian economies have the capacity to absorb more debt, the recent data on writedowns on bank losses and capital raised should illustrate the ongoing divergence in the underlying strength of global financial institutions (see figure 4).

Figure 4: ADB Bond: 3^rd Quarter writedowns and Capital Buildup

Asia’s hasn’t been immune from the crisis as shown by the chart from Asian Development Bank.

But the message is very clear, Asia’s losses is a speck compared to both Europe and America. This means Asia’s banking system is hardly impaired by the recent crisis and could function normally relative to its peers across the globe once the recession fears subside.

So seen from the demand side, there seems to be a huge room for growth as the household and corporate sector have low credit coverage. From the supply side, the well capitalized, apparently healthier banking system in Asia, may oblige to fulfill such potentials.

Overall, the prevailing policies seem to present itself as an auspicious condition for the next bubble-here in Asia and or in emerging markets.

Government Financial Bubble=Banana Republic?

However, in contrast, the bubble taking place today is progressing under government finance, especially in the US, UK and the Euro zone, where governments have been absorbing the private sector losses in a seemingly futile attempt to support an indefensible bubble structure.

Yet oblivious to the proponents of the “inflation driven” economic growth model, for this to paradigm to successfully operate requires a vicious expansion of the leverage feedback loop cycle-leverage which will require further or larger leverage to support a reverse pyramid shaped bubble framework. We will need to bring back 20:1, 30:1, 40:1 and so forth leverage in the system.

Instead of allowing for debt to fall to the levels where the economy can sustain them, the popular underlying belief is to print money away to contain a deflating bubble. Yet sustained operations of the printing press are likely to cause even greater problems.

So we can expect more bailouts or stimulus to come on stream as earlier efforts fail to achieve the goals. The end result will be an untenable government financial bubble. And a reality check means ultimately, all bubbles meet their comeuppance.

London School of Economics Professor Willem Buiter has a better narrative (bold highlight mine), ``In a world where all securities, private and public, are mistrusted, the US sovereign debt is, for the moment, mistrusted less than almost all other financial instruments (Bunds are a possible exception). But as the recession deepens, and as discretionary fiscal measures in the US produce 12% to 14% of GDP general government financial deficits – figures associated historically not even with most emerging markets, but just with the basket cases among them, and with banana republics – I expect that US sovereign bond yields will begin to reflect expeted inflation premia (if the markets believe that the Fed will be forced to inflate the sovereign’s way out of an unsustainable debt burden) or default risk premia.”

So like Iceland, maybe the US and UK will unwittingly enlist itself in the membership roster of the third world economies or disparagingly, the Banana Republics. Or how about the Philippinization of America and England since the Philippines seems to be a Keynesian paradise?

P.S. there has been much chatter about the merits/demerits of adapting the bank nationalization model of Sweden, including some of our so called local experts.

One caveat everyone seems to miss, Swede banks dealt with traditional mortgages while US banks are stuffed with securitized or structured finance instruments. Put differently, the former has recoverable or redeemable future value while the latter’s future value could be permanently ZERO.

Shanghai Index’s Rally- Impact of Inflation or Indications of Economic Recovery?

``Any market where the Federal Reserve has engaged in purchases – agency securities, mortgage backed securities, providing funding for consumer loans, the commercial paper market, to name a few - the Fed is replacing rational buyers rather than jumpstarting the private sector. Why would a rational person buy securities that are artificially inflated in price? If the Chinese dare to buy these securities anyway, then they must be as guilty as the U.S. of currency manipulation. Indeed, that’s what it comes down to: the U.S. wants to have a weaker dollar and China wants to be in control of when to allow the yuan to appreciate. Insulting China is not the right way to go about it. China has to recognize that a stronger yuan is in its national interest. While the U.S. is accelerating its market interventions with implications for the dollar, China is working hard to allow for more exchange rate flexibility.”- Axel Merk China and the U.S. Play Chicken: Currency Manipulation

Are there signs of financial market divergence or decoupling out there? Probably.

That’s if we read into the performance of China’s Shanghai index as a possible indicator of a potential market reversal (see figure 5).

Figure 5: Stockcharts.com: Does the breakout in the Shanghai Index presage financial market recovery or inflation?

The Shanghai index (SSEC) appears to have been in a bottoming formation since it reached its most recent lows early November.

The SSEC broke through its major bear market trend last December [see December’s China’s “Healing” Equity Markets: The New World Market Leader?]. This despite the downside pressures in most of the world’s major bourses, most especially the US markets.

At Friday’s close, amidst all the gloom and doom, the Shanghai index significantly broke to the upside (red arrow) and way above its resistance levels (horizontal blue line). Since the SSEC is up 25% from its November lows, technically this suggests a transition into the advance phase of the market cycle.

And the SSEC’s pretty impressive breakout comes even amidst predominant consolidation in most of the global markets. Seen at the chart above: the S&P 500 pane below main window, the Emerging Market index-mid pane, and the Asia Ex-Japan index lowest pane.

A Head Fake Shanghai Index Rally?

Some skeptics hastily retorted that the recent recovery in credit growth, (as discussed in Will “Divergences” Be A Theme for 2009?) which may have possibly aided the mighty lift in China’s major index, could have been a function of either “bills discounting” (see figure 6, left window) or maneuvers to please policy makers. In other words, government manipulations aimed at juicing up the market.

Perhaps.

But the same argument has been made before suggesting that China’s government will support “so-and-so levels” as the bear market unfolded. This apparently hadn’t been successful as the Shanghai Index lost 71% from peak-to-trough.

So if the Chinese government failed to prevent its bear market from blossoming why should they succeed today?

Figure 6: US Global Investor: Bills Discounting and Composition of Baltic Dry Index

Anyway going back to the rationalization of “Bills discounting” as driving the markets, according to US Global Investors, ``A recent surge in China’s bank credit growth may have captured, at least partly, an artificial demand spike for short term discounted bills as companies took advantage of borrowing at the lower bills rate to earn the higher bank deposit rate. Commercial banks could have also moved off-balance sheet loans back onto their balance sheets to demonstrate compliance with government mandates.”

Next, we read objections about how short term credit growth will only boost economic growth over the interim, which subsequently could translate to the risks of rising bad loans. In addition, we read that the prospective deterioration of corporate profits amidst an intimidating environment should further weigh on China’s stock prices.

It’s odd to hear such objections when the same parties seem to be in favor of massive government interventions in the marketplace.

The difference is that there seems to be a preference over seeing credit growth happening in the US and NOT in China. This stems from the assumption that the US is the world’s irreplaceable ‘aggregate demand’. For me, such observation reflects a smack of prejudice, linear thinking and denial.

Moreover, the idea that short term credit growth will lead to future bad loans is absolutely correct. But that is the underlying principle behind all these government interventions, because excessive credit growth, whether undertaken by the private sector or the government, eventually becomes a bubble. And as much as it applies to the US, it should apply to China too.

Lastly the toll from bear market in the Shanghai index was a substantial 71% decline on a peak-to-trough basis. This means that the market could have already discounted such profit deterioration.

Shanghai’s Rally A Function Of Home Stimulus?

So instead of looking at the markets burdened with biases or reading today’s grim economic outlook as tomorrow’s outcome, our preference is to try to view markets objectively based on the political setting.

We would like to add that the rise in the Baltic Index which we mentioned last week in What Posttraumatic Stress Disorder (PTSD) Have To Do With Today’s Financial Crisis, appears to have been corroborated (see figure 6, right window). Iron ore shipments from Brazil to China has been surging from the start of the year while the same shipments from Australia to China appears be picking up too.

And since today’s marketplace has been heavily distorted by the massive government “inflationary” interventions, the surge in Baltic Index could likely be a function of the activation of China’s $586 billion stimulus (see figure 7).

Figure 7: US Global Investors: China’s $580 billion Stimulus

Based on the above distribution, China’s stimulus program appears heavily tilted (about 85%) towards infrastructure spending. Thus, the jump in Baltic Index could be deduced as China’s thrust to realize the “pump priming” of its economy.

Remember China (GDP $4.22 trillion 2008-CIA) is a rapidly developing third world economy in contrast to the US (GDP $14.33 trillion 2008-CIA) which is the largest most advanced economy in the world.

Yet, when compared to the US, it is likely that China’s stimulus policies has greater chances to work simply because its economy is still largely inefficient due to significant State control of important sections of the Chinese economy’s capital and production structure. According to Gavekal, “the state sector accounts for about 35% of output, and it decisively controls all upstream and network sectors of the economy”.

And because significant parts of the economy are under state control the issue of “crowding out of the private sector” isn’t much a concern in the same way as it is in the US.

On the other hand, of the proposed $884 billion stimulus package for US President Obama only $137 billion or 15.5% is said to be allocated to infrastructure spending.

Inflation Spillage Effect; Jigsaw Puzzle Falling Into Place

Yet, we can’t also discount the idea that Shanghai’s Index performance may have accounted for as our expected “spillage” from the inflationary actions undertaken by many global governments.

For instance, Brazil seems to be the indirect beneficiary of the US government’s bailout of General Motors.

This from the Latin American Herald Tribune, ``General Motors plans to invest $1 billion in Brazil to avoid the kind of problems the U.S. automaker is facing in its home market, said the beleaguered car maker.

``According to the president of GM Brazil-Mercosur, Jaime Ardila, the funding will come from the package of financial aid that the manufacturer will receive from the U.S. government and will be used to "complete the renovation of the line of products up to 2012."

While much of the money printed in support of the US economy seem to be sucked into a vortex of losses within its financial sector, some of these appear to be sloshing over to parts of the world as in the case of GM-Brazil.

Eventually as the global forcible liquidation subsides the impact of these spillages will become increasingly evident.

And the next thrust would probably see inflation seeping into the commodity sector, on the backstop of a combined global infrastructure stimulus. This should translate to a vigorous rally in the commodity sector which should likewise lead to the resurgence of equity benchmarks of emerging markets, including the Philippine Phisix.

Remember markets aren’t just about the conventional notion of economic demand and supply but importantly about the demand and supply of money relative to the demand and supply of goods and services.

As a caveat, we are not talking here of real economic recoveries but one of the after effects from inflationary policies in the context of the present political setting.

And as we long argued, we believe that US Federal Ben Bernanke will fervently use its inflationary policies to achieve either of the two goals, one to reignite the economic growth engines abroad in order to support the US economy through the export channel, or two, reduce the real value of debt.

The US, in contrast to mainstream views, won’t lift the world this time around. At best, it would be the other way around-the world lifting the US economy. At worst, it would be a manifest decoupling.

And as far as we are concerned pieces of our jigsaw puzzle seem to be falling into place or events are beginning to shape as we predicted them to be.

Prepare for the next super inflation.

Cartoon of the Day: From Debt To Debt

Another provocative lampoon of today's predicament from KAL of the Economist.
We'd like to add...it is not only from Congress but also from Bernanke to the banks.

Marked Improvements On Some Key Credit Spreads

Despite the recessionary pressures, some credit spreads have markedly eased (all charts from Bloomberg).

TED Spread

LIBOR-OIS

ECB Liquidity Deposit

Euribor 3 month

Hong Kong HIBOR

BBA LIBOR 3 months

3 month LIBOR-OIS spread

Snap Shot of Asian Bourses

So how have Asia's equity benchmarks been performing of late? All charts from Bloomberg.com

For the major ASEAN markets (Malaysia's KLSE-blue, Philippine Phisix-green, Thailand's Seti-yellow, Indonesia's JKSE- orange), we notice some consolidation or possible indications of a "bottom" formation.

For South Asia, only Pakistan's Karachi 100 in green remains visibly weak while the rest seems to be in rangebound. India's BSE 30 (yellow) appears to be drifting at the near lows. On the other hand, Bangladesh's Dhaka in orange and Sri Lanka's Colombo in Blue seem significantly off their lows.

The industrialized export driven economies of Asia seem mostly coasting along the lows (Singapore's STI-blue, Taiwan's Taiex-green and Nikkei-yellow). Only crisis stricken Korea (orange) seems to have improved substantially.

Finally we see contrasting performances in Australia's S&P ASX 200 (green) also wafting near the lows while New Zealand's NZ 50 seems to be testing its resistance level.

Overall, performances have been mixed albeit those with less exposure to global ex-intraregion trade appear to be performing better.

Less Costs and More Freedom Drive Informal Economies

Interesting commentary from World Bank’s East Asia & Pacific Blog on the informal economy (bold highlight mine)…

``Recently my colleague Ryan Hahn of the PSD blog wrote about an interesting story on sweatshops. This refers to an op-ed of Nicholas Kristof, a columnist for the New York Times, titled "Where Sweatshops Are a Dream". On his own blog, he clarifies: "My point is that bad as sweatshops are, the alternatives are worse. They are more dangerous, lower-paying and more degrading."

``This is indeed part of a more general point about the so-called informal economy. Creating strict standards for the formal economy – to improve working conditions and living standards – often acts as a disincentive to become formal. These standards create a barrier that prevents many workers from having a job in the formal sector and leaves them without protection in the informal sector (or even worse, without job). This is something all countries, including developed countries, are struggling with: How to encourage the upgrading of standards without being counterproductive?”

We think the unstated problem is about costs. If the cost of doing business is substantially higher in a regulated ‘formal’ economy, then obviously it becomes a disincentive, especially for low capital intensive businesses. And by costs we see it in the context of both monetary and utility/convenience from “compliance costs”.

And in terms of convenience, informal economies could also signify thefreedom to operate, to quote Stefan Karlsson ``since informal markets are markets where people do not have their freedom restricted by the state this should if anything be counted as something positive. The larger the informal market the greater chance people have to conduct their business without being taxed and regulated by government officials. In countries with a small informal sector it is far more difficult to find other people with whom you can do business and practice division of labor without having your freedom restricted by the state.”

Why Warren Buffett Thinks It is A Buy

One of Warren Buffett’s metric for the buying or selling the stock market is the market value relative to % of GDP.

Carol J. Loomis and Doris Burke of Fortune magazine quotes Warren Buffett as defining the metric, ``If the percentage relationship falls to the 70% to 80% area, buying stocks is likely to work very well for you."

Adds the Ms. Loomis and Ms. Burke, ``Well, that's where stocks were in late January, when the ratio was 75%. Nothing about that reversion to sanity surprises Buffett, who told Fortune that the shift in the ratio reminds him of investor Ben Graham's statement about the stock market: "In the short run it's a voting machine, but in the long run it's a weighing machine."

Of course, this is just one of Mr. Buffett's many valuation metrics. But for purposes of simplification and publicity, he could be suggesting this as it is easily understandable by the public.

Mr. Buffett doesn’t really TIME the markets in terms of momentum, but appears to TIME the market in terms of valuations. And perhaps he could be right despite the colossal economic problems the US maybe facing today. The important difference lies in the time horizon.

Nonetheless while a US bullmarket maybe a distant future, except when the Obama-Bernanke team decides to utterly destroy the US dollar, the likelihood is that stock picking will be the distinguishing mark between Mr. Buffett’s stream of ‘alphas’ and the market’s ‘beta’.

Russia’s Vladimir Putin’s Interesting Davos Speech

Here is the interesting opening ceremony speech of Russia’s Prime Minister Vladimir Putin at the World Economic Forum in Davos, Switzerland which is a suggested read at the WSJ link, click here.

Some excerpts from the speech (bold highlights mine) with our accompanying comment (green font)…

``I just want to remind you that, just a year ago, American delegates speaking from this rostrum emphasised the US economy's fundamental stability and its cloudless prospects. Today, investment banks, the pride of Wall Street, have virtually ceased to exist. In just 12 months, they have posted losses exceeding the profits they made in the last 25 years. This example alone reflects the real situation better than any criticism…

``In our opinion, the crisis was brought about by a combination of several factors.

``The existing financial system has failed. Substandard regulation has contributed to the crisis, failing to duly heed tremendous risks. Add to this colossal disproportions that have accumulated over the last few years. This primarily concerns disproportions between the scale of financial operations and the fundamental value of assets, as well as those between the increased burden on international loans and the sources of their collateral.

``The entire economic growth system, where one regional centre prints money without respite and consumes material wealth, while another regional centre manufactures inexpensive goods and saves money printed by other governments, has suffered a major setback.

``I would like to add that this system has left entire regions, including Europe, on the outskirts of global economic processes and has prevented them from adopting key economic and financial decisions. Moreover, generated prosperity was distributed extremely unevenly among various population strata. This applies to differences between social strata in certain countries, including highly developed ones. And it equally applies to gaps between countries and regions. A considerable share of the world's population still cannot afford comfortable housing, education and quality health care. Even a global recovery posted in the last few years has failed to radically change this situation. And, finally, this crisis was brought about by excessive expectations. Corporate appetites with regard to constantly growing demand swelled unjustifiably. The race between stock market indices and capitalisation began to overshadow rising labour productivity and real-life corporate effectiveness..."

My comment: Mr. Putin simply is weighing against the imperfections and unwarranted distribution of privileges from the US dollar standard

``This is why I would first like to mention specific measures which should be avoided and which will not be implemented by Russia. We must not revert to isolationism and unrestrained economic egotism. The leaders of the world's largest economies agreed during the November 2008 G20 summit not to create barriers hindering global trade and capital flows. Russia shares these principles. Although additional protectionism will prove inevitable during the crisis, all of us must display a sense of proportion. Excessive intervention in economic activity and blind faith in the state's omnipotence is another possible mistake. True, the state's increased role in times of crisis is a natural reaction to market setbacks. Instead of streamlining market mechanisms, some are tempted to expand state economic intervention to the greatest possible extent. The concentration of surplus assets in the hands of the state is a negative aspect of anti-crisis measures in virtually every nation. In the 20th century, the Soviet Union made the state's role absolute. In the long run, this made the Soviet economy totally uncompetitive. This lesson cost us dearly. I am sure nobody wants to see it repeated. Nor should we turn a blind eye to the fact that the spirit of free enterprise, including the principle of personal responsibility of businesspeople, investors and shareholders for their decisions, is being eroded in the last few months. There is no reason to believe that we can achieve better results by shifting responsibility onto the state. And one more point: anti-crisis measures should not escalate into financial populism and a refusal to implement responsible macroeconomic policies. The unjustified swelling of the budgetary deficit and the accumulation of public debts are just as destructive as adventurous stock-jobbing.

My comment: An unexpected trenchant assessment from a cunning politician. However, what is said and what is done are two different airwaves.

``Unfortunately, we have so far failed to comprehend the true scale of the ongoing crisis. But one thing is obvious: the extent of the recession and its scale will largely depend on specific high-precision measures, due to be charted by governments and business communities and on our coordinated and professional efforts. In our opinion, we must first atone for the past and open our cards, so to speak. This means we must assess the real situation and write off all hopeless debts and “bad” assets. True, this will be an extremely painful and unpleasant process. Far from everyone can accept such measures, fearing for their capitalisation, bonuses or reputation. However, we would “conserve” and prolong the crisis, unless we clean up our balance sheets. I believe financial authorities must work out the required mechanism for writing off debts that corresponds to today's needs. Second. Apart from cleaning up our balance sheets, it is high time we got rid of virtual money, exaggerated reports and dubious ratings. We must not harbour any illusions while assessing the state of the global economy and the real corporate standing, even if such assessments are made by major auditors and analysts.

``In effect, our proposal implies that the audit, accounting and ratings system reform must be based on a reversion to the fundamental asset value concept. In other words, assessments of each individual business must be based on its ability to generate added value, rather than on subjective concepts. In our opinion, the economy of the future must become an economy of real values. How to achieve this is not so clear-cut. Let us think about it together.

``Third. Excessive dependence on a single reserve currency is dangerous for the global economy. Consequently, it would be sensible to encourage the objective process of creating several strong reserve currencies in the future. It is high time we launched a detailed discussion of methods to facilitate a smooth and irreversible switchover to the new model.

``Fourth. Most nations convert their international reserves into foreign currencies and must therefore be convinced that they are reliable. Those issuing reserve and accounting currencies are objectively interested in their use by other states. This highlights mutual interests and interdependence. Consequently, it is important that reserve currency issuers must implement more open monetary policies. Moreover, these nations must pledge to abide by internationally recognised rules of macroeconomic and financial discipline. In our opinion, this demand is not excessive. At the same time, the global financial system is not the only element in need of reforms. We are facing a much broader range of problems. This means that a system based on cooperation between several major centres must replace the obsolete unipolar world concept. We must strengthen the system of global regulators based on international law and a system of multilateral agreements in order to prevent chaos and unpredictability in such a multipolar world. Consequently, it is very important that we reassess the role of leading international organisations and institutions.

``I am convinced that we can build a more equitable and efficient global economic system. But it is impossible to create a detailed plan at this event today…"

My comment:

-Writing off bad debts will be an international issue, as the debt stock is distributed around the world. Besides what’s to distinguish between bad debts incurred from the recent crisis and bad debts from past economic mismanagement. In addition, moral hazard will be an issue to contend with.

-“Time we got rid of virtual money, exaggerated reports and dubious ratings” is a function of unintended effects of inflationary policies, unnecessary government interventions and distortive regulations.

-According to Mr. Putin “Assessments of each individual business must be based on its ability to generate added value, rather than on subjective concepts. In our opinion, the economy of the future must become an economy of real values. How to achieve this is not so clear-cut.”

Why isn’t it clear cut? The reason why the pricing mechanism is subjective is because it is always determined by human psychology. It accounts for the difference in marginal utility (priorities, values) among participants, it is also about the disparate assessment of the fluctuating balance between demand and supply, it signifies the distinct time preferences of individuals and has psychological dimensions (fear or greed and other biases) accompanying the above. Nonetheless pricing based market mechanism still should be the most optimum method of allocation for scarce resources.

Attainment of real values means the application of sound money and free markets.

As for the ``Excessive dependence on a single reserve currency is dangerous for the global economy” is both a geopolitical issue as much as it is a financial issue.

``The global economy could face trite energy-resource shortages and the threat of thwarted future growth while overcoming the crisis. Three years ago, at a summit of the Group of Eight, we raised the issue of global energy security. We called for the shared responsibility of suppliers, consumers and transit countries. I think it is time to launch truly effective mechanisms ensuring such responsibility.

``The only way to ensure truly global energy security is to form interdependence, including a swap of assets, without any discrimination or dual standards. It is such interdependence that generates real mutual responsibility.

``Unfortunately, the existing Energy Charter has failed to become a working instrument able to regulate emerging problems.

``I propose we start laying down a new international legal framework for energy security. Implementation of our initiative could play a political role comparable to the treaty establishing the European Coal and Steel Community. That is to say, consumers and producers would finally be bound into a real single energy partnership based on clear-cut legal foundations.

``Every one of us realises that sharp and unpredictable fluctuations of energy prices are a colossal destabilising factor in the global economy. Today's landslide fall of prices will lead to a growth in the consumption of resources.

``On the one hand, investments in energy saving and alternative sources of energy will be curtailed. On the other, less money will be invested in oil production, which will result in its inevitable downturn. Which, in the final analysis, will escalate into another fit of uncontrolled price growth and a new crisis.

``It is necessary to return to a balanced price based on an equilibrium between supply and demand, to strip pricing of a speculative element generated by many derivative financial instruments.

``To guarantee the transit of energy resources remains a challenge. There are two ways of tackling it, and both must be used. The first is to go over to generally recognised market principles of fixing tariffs on transit services. They can be recorded in international legal documents. The second is to develop and diversify the routes of energy transportation…

``However, unlike many other countries, we have accumulated large reserves. They expand our possibilities for confidently passing through the period of global instability.

The crisis has made the problems we had more evident. They concern the excessive emphasis on raw materials in exports and the economy in general and a weak financial market. The need to develop a number of fundamental market institutions, above all of a competitive environment, has become more acute.

My comment: The Energy market is essentially a government controlled market. Despite all the massive regulations surrounding the industry we see repeated and worsening inefficiencies which has resulted to sharp pricing volatility. And unfortunately, most of this has been unduly blamed on speculators than regulators. Moreover, trying to impose more regulations while attempting to be competitive seems to be an oxymoronic goal.

``We see higher energy efficiency as one of the key factors for energy security and future development.

``We will continue reforms in our energy industry. Adoption of a new system of internal pricing based on economically justified tariffs.

``This is important, including for encouraging energy saving. We will continue our policy of openness to foreign investments.

My comment: Oops! Policy of openness to foreign investments doesn’t seem to square with recent developments.

Separately, I would like to comment on problems that go beyond the purely economic agenda, but nevertheless are very topical in present-day conditions. Unfortunately, we are increasingly hearing the argument that the build-up of military spending could solve today's social and economic problems. The logic is simple enough. Additional military allocations create new jobs. At a glance, this sounds like a good way of fighting the crisis and unemployment. This policy might even be quite effective in the short term. But in the longer run, militarisation won't solve the problem but will rather quell it temporarily. What it will do is squeeze huge financial and other resources from the economy instead of finding better and wiser uses for them.

``My conviction is that reasonable restraint in military spending, especially coupled with efforts to enhance global stability and security, will certainly bring significant economic dividends. I hope that this viewpoint will eventually dominate globally. On our part, we are geared to intensive work on discussing further disarmament.

My comment: True, military spending isn’t a productive endeavor. But action should match rhetoric. According to Al Jazeera in 2007, ``Regionally Eastern Europe saw the biggest growth in military spending mainly because Russia's spending grew 86 per cent, or $35.4bn.”

Updated: Democratizing Knowledge Revolution Via $10 Laptops (Still A Dream)

India recently announced that it would be introducing $10 (Php 500) laptop computers soon.

Although it is still unclear as to the real offering price as reports vary, BBC says ``Early reports of the cheap laptop suggested that it would cost only 500 rupees (£7). However, this could be a mistranslation, because transcripts of the speech, in which it was unveiled, mentioned it costing $10 (£7) but this was later corrected to $100 (£70)”.

Albeit the physorg.com says, ``The $10 laptop project is the product of a collaboration among institutions including the Vellore Institute of Technology, the Indian Institute of Science, and IIT-Madras. The project began about three years ago in response to the proposed $100 laptop (the "One Laptop Per Child" project), an idea from MIT's Nicholas Negroponte, which was going to cost $200. Currently, the $10 laptop is projected to cost $20, but India's secretary of higher education R. P. Agarwal hopes that price will come down with mass production. The $10 laptop will be equipped with 2 GB of memory, WiFi, fixed Ethernet, expandable memory, and consume just 2 watts of power.”

The goal of the $10 laptop is ideally meant to broaden the access of computers for ‘poor’ school children around the world. However, considering the onus from the heavy doses of stimulus being applied today to prop global economies, subsidies from governments to finance its distribution would probably be limited. This means successfully bringing prices to this level can only be achieved if it will be driven by the markets.

Nonetheless, the positive outcome from a market based distribution of these inexpensive “socialized laptops” is likely to have a huge impact on laptop and PC prices and sales globally. Notwithstanding the prospects of exponential growth of web based usage.

To give you an idea of the existing industry penetration levels, according to comScore World Metrix, ``global Internet audience (age 15 and older from home and work computers) has surpassed 1 billion visitors in December 2008”.

The breakdown of global audience by region as follows:

Again from comScore World Metrix, ``The Asia-Pacific region accounted for the highest share of global Internet users at 41 percent, followed by Europe (28 percent share), North America (18 percent share), Latin-America (7 percent share), and the Middle East & Africa (5 percent share).”

So based on geographic distribution, growth is likely to favor Asia.

And which country holds the most users?

According to the Economist, ``THE number of people going online has passed one billion for the first time, according to comScore, an online metrics company. Almost 180m internet users—over one in six of the world's online population—live in China, more than any other country. Until a few months ago America had most web users, but with 163m people online, or over half of its total population, it has reached saturation point. More populous countries such as China, Brazil and India have many more potential users and will eventually overtake those western countries with already high penetration rates. ComScore counts only unique users above the age of 15 and excludes access in internet cafes and via mobile devices.

To quote Forbes Nanotech's brilliant Josh Wolfe in Airbrushing Airwaves & The Adjacent Possible ``The history of technology has been one of displaced labor. New jobs are birthed as old ones die. Talent is embedded in technology. And technology gets further embedded in advanced materials."

The $10 laptop is likely to democratize the knowledge revolution globally.

Update: From hype to dud, the supposed 'laptop' turns out to be another computing device....

This from the Times of India ``The hype surrounding the $10 laptop ``prototype'' with two GB RAM turned out to be a joke when the department of Human Resources Development announced — during its inauguration in the temple town of Tirupati — that it wasn't a laptop at all but a computing device.

While the world eagerly waited for the launch of the $10 laptop — designed by students of Vellore Institute of Technology, scientists in Indian Institute of Science, Bangalore, IIT-Madras, UGC and MHRD — it wasn't a patch on the $100 laptop made by MIT.

The MHRD officials said the price was working out to be $20 but with mass production it was bound to come down to $10 (Rs 500) and thus become affordable for every student in India.

But netizens were disappointed when the ``laptop'' turned out to be nothing more than a computing device along with a hard disk with e-books, e-journals and relevant educative material through the state-art-of-the-art ``Sakshat'' portal.

Learning from Past Crisis; History As Basis For the Future

``When you see that trading is done, not by consent, but by compulsion - when you see that in order to produce, you need to obtain permission from men who produce nothing – when you see money flowing to those who deal, not in goods, but in favors – when you see that men get richer by graft and pull than by work, and your laws don't protect you against them, but protect them against you – when you see corruption being rewarded and honesty becoming a self-sacrifice – you may know that your society is doomed.” Ayn Rand, Atlas Shrugged

Most of us would like to know when this crisis might come to a close. Most of us would also like to know when life might ‘normalize’.

Of course, life, as we know it, won’t likely be the same or “normalize” as it had been during the past decade.

We are likely to live in a world which will be governed by more regulations, higher interest rates, lower leverage, higher taxes, possibly diminished ‘globalization’ in terms of trade, and capital flows and reduced political freedom especially seen through the lens of the once liberal Anglo-Saxon world, as discussed earlier in 2009: Asian Markets Could OUTPERFORM.

Yet even as they undergo rehabilitation, we can’t discount the reemergence of bubbles through other asset classes and the reorientation of the conduct of the world’s political economy. Remember, bubble cycles are the inherent character of our paper money system.

Historical Roadmap

Moreover, while history may not exactly repeat, the lessons of the past may provide us with some essential clues or may function as some sort of a roadmap to help guide us in navigating our way through the present financial crisis.

As we have discussed in Will Previous Crisis Serve As Deserving Guidepost For Today’s Crisis?, Harvard Professor and former IMF chief economist Kenneth Rogoff and Carmen Reinhart recently updated a study of the previous world crises, see figure 1.

Figure 1 Rogoff-Reinhart: Learning From The World’s Past Real Estate-Banking Crises

In the Rogoff-Reinhart paper, the ‘Aftermath of the Crisis’, we are treated to 18 major post war banking-real estate crises of advanced economies including some of the recent emerging markets crises and its consequent impact to domestic real estate and the equity market in terms of pricing based losses and the periods of agonizing adjustments (peak-to-trough).

We can observe that the typical or average housing cycle (right window) losses of real housing prices have been 35.5% and has lasted an average of 6 years. As you may notice, the Philippines, in the wake of the Asian Crisis in 1997, suffered the second biggest loss of 50% after Hong Kong, and where our painstaking market cleansing cycle culminated after 6 long years. It is also important to note that the longest real estate bear market cycle was recorded in Japan and which registered over 15 years of losses.

Next, equity losses averaged 55.9% which lasted for about 3.4 years.

In addition, a defining characteristic of such crises is that the real public debt exploded as governments suffer from falling tax revenues and increased spending to fight off recession. On the average, real public debts ballooned by 86%.

Applying Past Lessons Today

So where are we today?

Figure 2: US Housing Prices (researchrecap) Japan Housing Prices (J. Quinn: Financial Sense)

If we are to base our analysis on the epicenter of today’s crisis which is the US, then housing prices based on the Case-Shiller index has lost 30% (see figure 2, left window), and is almost near the average loss of 35% during similar crises. Peaking in 2005, the housing bear market is now on its 4th year which is also approaching the average of 6 years.

In terms of the bear market cycle in equities, the major US bellwether as signified by the S&P 500 has lost over 50% and is now 16 months old or 1.3 years. Compared to the average of 3.4 years, the equity bear market cycle suggests of a transition for about two years more.

So simplistically speaking 2011 should be a turning point for the US real estate and US equities…if we are to base it on the average.

But as our earlier caveat, all crises aren’t the same.

Further, the average alludes to the typical. Since today’s landscape is global in scope compared against a regional or national phenomenon in the past, it is likely that the disposition of today’s crisis will be distinct.

Besides, the collective global government response has been unprecedented in scale. Importantly, today’s crisis jolts the foundations of the world’s monetary architecture. Hence, today’s crisis may not be the archetype.

What seems to be relevant is that the US government has been implementing almost similar policy responses as with Japan in the 1990s following its bubble bust.

The Keynesian approach of Zero Interest Rate, government infrastructure spending, tax cuts and rebates and monetary manipulations via the purchase of commercial paper, shares of public companies and provision of bailout funds for bailouts only resulted to a prolonged era of distress from which Japan’s real estate fell by over 15 years (see right window) and whose stock market went nowhere from 1990s until today.

Just recently, Japan’s key benchmark, the Nikkei 225 crashed below its support level shaped during the trough of 2003 to register a NEW low. The Nikkei which presently drifts near the 2003 lows reflects a loss of over 80% from the peak in 1990, nearly 20 years ago!

Of course some may argue that the rapid fire response by the US government may do the magic trick. Well, for us, the fundamental defiance of nature’s economic laws will either bring short term panacea with long lasting torment similar to Japan or precipitate another set of collapse.

Conclusion

Nonetheless, in our opinion, the US won’t probably see a bullmarket for years to come, even if the economy manages to emerge out of the recession. The indemnity from the recent crisis will be scathingly enormous and will contribute heftily to the suboptimal growth outlook. Besides, the intensity of government interventions seems likely to create substantial inefficiencies in the economy that should weigh on its productivity. Moreover, the US will have to deal with its ballooning unfunded entitlement liabilities.

Remember, it took almost 25 years for the Dow Jones Industrial to breach its 1929 peak. In the same vein, US benchmarks haven’t successfully broken through the dot.com pinnacle set in 2000, which makes today’s bear market nearly 10 years old! Hence it is likely that the US could be rangebound or muddle through over the next few years or even in the next decade.

Of course, we’d argue otherwise that if the Obama-Bernanke tandem prints an ocean of money similar to Dr. Gideon Gono’s policy approach in Zimbabwe. While this may boost share prices, not out of earnings, but because people may shun the destruction of its currency and seek sanctuary in hard assets or in stocks as ‘stores of values’, the net effect is that any nominal gains will be offset by currency losses.

Thus, the lesson we can get from the Rogoff-Reinhart study may possibly apply NOT to the US or the credit bubble infected economies. But as possible beacon to the performances of economies or markets untainted by the credit bubble structure but had been affected by the contagion from the implosion of the proximate epicenters of the bubbles.

While 2008 had been a year of convergence as we discussed in Will “Divergences” Be A Theme for 2009?, we’d probably see the resurrection of an unpopular discarded theory.