Bubbling

With the two-year anniversary of the Lehman collapse moving into the background, policymakers are coming to grips with the reality that the measures taken during the past two years amounted to nothing more than an enormous transfer of wealth to the financial sector. However, the fundamental economic problems persist across most of the developed world, and there is not much more that can be done other than to embark on a lengthy period of gradual restructuring, depreciation and deflation. In other words, the medium to long-term outlook for the core developed economies is extremely weak. The question is whether the developing world can successfully decouple? So far, they navigated the crisis with flying colors. Most emerging countries had floating exchange rate regimes and high levels of international reserves that could absorb the shocks that were emanating from the U.S. and Europe. Many of the emerging market countries had current surpluses that reduced their vulnerability to the financial turmoil. However, the massive re-allocation of capital into the developing world is creating bubble-like conditions that could put the emerging markets at risk.

The recent economic data confirmed what most Americans already knew, that the economy was extremely weak. Non-farm payrolls dropped by 95,000 in September, as state governments were forced to trim back their work force in order to meet budgetary requirements. The decline in property prices and tax receipts devastated many municipalities and states. The low level of domestic demand across the U.S. was also highlighted by the drop in the inflation rate. Although the Federal Reserve was targeting an inflation rate of 1.7% to 2%, consumer prices rose by only 1% through August. Given the Fed’s legislated mandate of maintaining price stability and full employment, it had no other recourse but to shift to a policy of quantitative easing. The Federal Reserve is expected to purchase up to $2 trillion of additional securities, which is one of the reasons why the dollar is plummeting. However, few of these funds will find their way back into the economy. Consumers are in the midst of deleveraging, and they don’t want to take on additional debt. Consumer credit in the U.S., for example, dropped $3.3 billion during August as households pared back their credit card balances. Likewise, banks are holding back on issuing new mortgages. With foreclosures on hold, due to serious problems with documentation and the securitization market stalled indefinitely, banks are not going to be pushing the additional funds from the Fed into the domestic retail market. Unfortunately, the picture in Europe is not much better. Social tensions are climbing, as governments are forced to retrench. Labor unrest across France, Spain, Portugal and Greece are becoming commonplace. There was a great deal of anger in Ireland after the government was forced to bail out Anglo Irish Bank. The U.K. is also bracing for a new era of austerity, as it slashes government expenditures. All of this points to a weaker outlook for the eurozone. Therefore, with the U.S. and Europe representing almost half of the world’s output, it is hard to be optimistic about the road that lies ahead.

Interestingly, the atmosphere across the emerging markets is quite different. Latin America is expected to grow 5.8% y/y in 2010. Asia will expand 8.7% y/y, and the Eurasian economies will grow 4.5% y/y. A quick taxi drive through any emerging market city will show a forest of construction sites, fleets of new cars and hordes of shoppers exiting luxury stores. As a result, inflation is on the rise throughout much of the developing world, forcing central banks to tighten monetary policy. Higher interest rates, along with the re-allocation of capital into the emerging markets, are forcing currencies to appreciate, which in turn is triggering a loss of competitiveness. According to the Big Mac index, calculated by The Economist, the currencies of Chile, Peru and Uruguay are approaching parity with the dollar. The Turkish lira is slightly overvalued to the dollar, and the Colombian peso and Brazilian real are among the most expensive currencies in the world. This is why many current account deficits are starting to explode. Unfortunately, most policymakers are nonplussed. Many are starting to believe the BRIC rhetoric and relaxing the prudence that guided their way for the better part of the last decade. Banks and financial companies are easing their lending requirements, often providing better terms than those found in parts of Europe and the U.S. The result is that the emerging market countries are developing the same symptoms that brought down much of the Western World. A new bubble is taking shape, and it will not be pretty when it explodes.

One Response to "Bubbling"

  1. neven strmski   October 24, 2010 at 12:10 pm

    I was researching more today on the Fed.’s probable QE2 policy. I came to wonder why no one has tied together a reasonable scenario for possible positive effects of this quantitative easing. I believe that the focus of QE2 will have several likely effects if and when successful. First of all, there is likely a positive correlation between the timing of the Fed.’s QE2 and: 1. the midterm election in the U.S., 2.the lackluster state of the current domestic economy ( pretty obvious ), 3. the recent foreclosure problems in the US, 4. the USA’s promotion of free-floating global currencies. There is no doubt in my mind that these 4 issues are positively correlated.The Fed plans to use this blunt but powerful instrument known as QE2 to stimulate the domestic economy by effecting all four of these issues at the same time. This policy has the potential to take some of the mortgage-back securities off the books of the US Treasury, help the big banks better deal with the current housing foreclosure issues and slowly help the banks increase their lending. At the same time, QE2 can provide a fresh start ( or a new homeostasis ) for the currency valuations of countries around the world that have pegged their currencies to a benchmark (such as the US dollar ) and not allowed their currencies to float. Realistically, what can other countries do to retaliate? Probably not much. And lastly, just several weeks away from the US midterm elections, this policy may stimulate the financial markets and prove to be a ” shot in the arm ” for Democrats in the coming elections.I believe that in the short to medium term, QE2 will help address 3 or even all 4 of these above mentioned issues. Three out of four ain’t bad, but if all four were addressed, QE2 would be considered one of the US Federal Reserves’ shining moments in history.