Tuesday, July 22, 2008

The real threat to the global economy

Two months ago, this blog was ranting and railing about global inflation. Then a month ago, the focus of my posts shifted to the US banking crisis.

Well, since two months ago, the world, in my opinion, has just about tamed inflation. Fearing the bigger spectre of a wage-price spiral, governments and central bankers in emerging economies the world over have made inflation-fighting their primary objective, as reported in this Bloomberg article.

Their monetary tightening, coupled with the rise in energy and food and materials prices, has already resulted in significant demand destruction in their local economies. Their massive populations, much of whom were just coming out of poverty and starting to demand more consumer goods, will likely stay poor for the meantime. They’ll maybe even start adding to their rolls of the poor, as demand destruction destroys livelihoods, and impacts on the middle class of these countries.

The slowdown in US demand has further dampened growth in these emerging economies. With their largest export market sputtering, their only options were either to find alternative export markets or develop their domestic market. Not everyone will be able to find a domestic market. Not when their people are staying poor.

Still, we forecast that for many firms, survival means finding a substitute local market. With the rise in oil prices increasing transportation costs, we reasoned that businesses will again be local. With the increase in energy and commodity prices increasing all input costs, we also forecast that the biggest competitors in an industry will likely weather this crisis. The resulting carnage of smaller companies will contribute to demand destruction and slowed global growth.

Now that inflation is coming under control in emerging economies, and demand in developed economies, particularly the US, also being crimped by the credit crisis, the destructive price-wage spiral seen during the 1970s hyper-inflation will likely be averted. As pointed out previously in this blog, we're all in this crisis together, and no single country will bear the brunt of inflation or economic stagnation by itself.

My opinion is that the bigger and more complicated problem now facing the global economy is in fact the credit crisis itself, and to a lesser extent, the slowing US economy.

As mentioned, the slowing US demand has already impacted the growth of mainly export-oriented emerging economies. But more than that, I believe the crisis of confidence now wreaking havoc on US financial markets could still spread like a contagion to the global financial markets. Banks, after all, are not only good intermediaries of capital, they are also good intermediaries of risk.

The American credit crisis is now imperilling US financial institutions that are widely acknowledged to be “too big to fail”. Fannie Mae, Freddie Mac, Citigroup, Lehman Brothers……..

If a major US institution falls, whose links with large institutions worldwide are too great, whether it issued a widely-held security worldwide, or is itself a large investor, banker, or counterparty in the global economy, the repercussions of its fall will be enormous. The ripples and after-effects to other economies globally could very well sink the world into a deep recession.

Much rests on the shoulders of Ben Bernanke, the Fed, and the US Treasury.

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