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Wednesday, December 5, 2007

The Global Economy - Compass and Charts Needed

By Claus Vistesen Copenhagen

As the Bank of Canada chose yesterday, quite unexpectedly, to lower interest rates to 4.25% from the previous level of 4.50% it should, as merely one of many hints, be readily clear to everybody that global markets (and indeed the global economy) are now fairing in the midst of waters containing many a skerry and pointy rock. In these situations, traditional and well proven sea mastery holds that such obstacles are best dispensed with by having a cool and steady hand on the rudder, a well calibrated compass, and a precisely drawn and up to date chart of the waters you are navigating. As for the steady and cool hand on the rudder this is a characteristic bound to vary from captain to captain, but when it comes to the well calibrated compass and that ever so important chart of the waters then one should expect that this would be a sure asset at our disposal at this point in time. Well, I am not so sure, and in fact when I look at the global economy at the moment it seems very much as if the compass is significantly out of tune and that those watery charts could do with a hefty revision. There are several reasons for this and I have not made up my mind yet on all the issues involved, but I do think especially three overall points stand out.

The cycle is turning ... First of all, I think that the current bout of uncertainty is quite natural in a situation where it seems evident that the cycle is turning. Especially, since the current cycle has been sustained for so long as is presently the case. However, there are some very important exceptions to your traditional bread and butter cyclical downturn. First of all, the cyclical downturn which I hold would have come regardless of the subprime debacle is now of course clouded by that exact financial crisis taking on a profile which quite frankly is unique with respect to financial disruptions. For that reason especially and almost exclusively the road ahead looks very shaky. Secondly would then be, and this I fully recognize, the interaction between the cyclical downturn and the financial crisis. Quite simply, the very sectors (construction and housing) which for many countries have driven the recent expansion are now the very ones suffering under the liquidity and credit crunch. These two points above represent the most basic state of play in global markets and the global economy as it has evolved in 2007.

A new global engine room and the end of BWII ... Yet and despite the fact that the cycle now seems to be turning another point needs to be taken into account. In short, the global economy is now, in these very months, quarters and years, undergoing a change of rather historic proportions as the locus of the global economy is changing away from the US. Edward has had some very interesting remarks on this in the past weeks which I highly recommend you to check up on. In his recent remarks, at this space, he especially makes the following point about the United States which is very interesting I feel ...

Now demography isn't everything, as we well know, but given that the US has such solid and stable demography, just what else is it they are supposed to be doing wrong, I wish someone would please tell me? They have deep capital markets, lots of innovative ideas, patents etc, a well functioning job market, a machine to generate new companies on demand etc etc, and a proven ability to correct when they get into difficulty (which they have done, and which they are now correcting). Who are they supposed to learn from, Italy, or Japan perhaps?

So, we can all see the impetus for the steady erosion of the Bretton Woods II in its current form and but this also carries with it two very important side issues. Firstly, is this the end of the US economy as we know it? Most emphatically not and while the US almost certainly is set to see its role as number one drift steadily away it is in no way toast and headed for perpetual decline which I am afraid might end up being the result for other economies. Rather the US economy will adapt to its new position and this ultimately should be the real lesson for the global economy; watch out export dependant Japan and Germany! This would then bring us to the second point which centers on what happens in the interim. One thing which of course has struck me is the extent to which global liquidity has moved in favor of Japan and the Eurozone as the new shoulders of the Bretton Woods II system. Clearly, I think this is quite unsustainable but until we get to whatever kind of 'equilibrium' we have in store it could be a bumpy road indeed.

The great disconnect in global liquidity conditions ... The third point I want to note relates to overall situation of global liquidity. In this way, it seems to me that what we have is a great disconnect in the global liquidity channels. On the one side the subprime turmoil has had, as one of many, the nasty side effect that the interbank market has dried almost entirely up. This might to many seem a technical issue but quite simply the modern financial system needs a certain amount of liquidity to work smoothly and in the present situation the liquidity is just not there. As such and far from being a mere technical issue of LIBOR rates it now poses a very real risk that this can and will spread to the real economy through a general tightening of credit conditions to business and consumers alike. So, credit conditions might be somewhat more tight than the general level of short term interest rates suggest. This situation which has gripped the fear by central bankers across the globe stands in stark contrast to what you could call the general liquidity situation in the global economy. As such, I want to remind my readers that it was only back in the early Spring of 2006 that the talk of the town was excess global liquidity as the three major central banks G3 (BOJ, ECB and the FED) embarked on what was widely seen a mutual crusade to mop up the excess global liquidity or as it was noted to begin the process of interest rate normalisation. Of course, a lot of water has gone under the bridge at this point and we shall not dwell extensively by it in this entry. However, what remains is then, as I noted, somewhat of a disconnect since if you look at the current trends in inflation as well as general liquidity conditions in some parts of the global system it could indeed seem as if, as Edward so aptly put it in recent in the context of Russia, that too much money is chasing too few people. At least, with Citigroup recently securing a $7.5 billion cash infusion from Abu Dhabi coming at a rather comfortable time in the wake of yet another publication of hefty losses on the back of the subprime turmoil and as people are now contemplating whether China should buy the US mortgage lender and provider Countrywide (now, it seems would be a good time to secure a decent price) the global liquidity conditions have a flip side and it has Sovereign Wealth Fund and (in general) export nations written all over it.

Finally, all this of course begs the question as to what in fact is to be done, and most prominently what to do in the engine rooms of the global central banks? Well, as I hinted above, this is not an easy question to answer and by consulting the traditional punditry you are not guaranteed to get any smarter. In this context, and although I by no means intend to start a brawl, the dichotomy between Wolfgang Munchau's recent column and Nouriel Roubini's ditto still strikes me as a nice example of just how sorely we are in need of those updated charts. Where I stand personally will wait for another day I think. Yet, I will leave you as so often before with a simple yet very important paraphrase; demography matters and although we can't explain everything through this lens I do sincerely think that once we get down to re-sketching those charts and re-calibrating that compass we need to pencil in demographics as an important explanatory variable. Otherwise I am afraid we are running the risk of hitting one of those nasty skerries.