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The World turned upside down
- a changing of the guard?

William R. Thomson
Dec 19, 2008

Revolutionary war history buffs may recall that as Lord Cornwallis surrendered to George Washington at the Battle of Yorktown in 1781 his band - the Buckinghamshire Light Infantry - played "The world turned upside down". Nothing could be a more apt metaphor for the global financial markets in the latter half of 2008. The established economic orthodoxies have been progressively jettisoned as the global markets entered an unprecedented phase of meltdown and fear drove out greed as the overriding driving force.

The early years of this century saw the greatest credit boom in history. Leverage was piled on leverage through opaque derivatives and for some time the world has been sailing on the Titanic unaware of the looming icebergs. That came to an end with the collapse of major US, UK and European financial giants over the summer and autumn of 2008. One after another icons disappeared with dizzying rapidity: Bear Stearns, Fannie Mae, Freddie Mac, Lehman Bros., AIG, Washington Mutual, Citigroup etc., in the US and Northern Rock and Bradford and Bingley in the UK all collapsed, were merged or fell into government ownership. In the space of a few weeks the once proud US investment banking industry ceased to exist as standalone operations, being either merged or converted into commercial banks.

The wealth losses from write downs in property values and stock market capitalisation have been on an almost unimaginable scale, over US$20 trillion in the case of the US as compared with a GDP of under US$14 trillion. Globally, the figures are comparable for stock market losses of at least US$24 trillion worldwide, including the US, and US$16 trillion excluding.  And there is more to come since commercial property losses, prime loans and credit card losses have yet to be recognised. It is the first crisis of the globalised era and as Charlie Bean, the Deputy Governor of the Bank of England said, perhaps the greatest financial crisis in human history. (What happened to the famed British understatement?)

The financial collapse has now morphed into the real economy - especially the automobile industry in the US - requiring systemic approaches on both a national and a global perspective to try and mitigate and shorten a threatened long and debilitating recession/depression. The banking sectors in the US and the UK have been crippled and despite frantic efforts to recapitalise they are hoarding liquidity and showing a great reluctance to lend even to other major institutions. It is likely we will get more directed lending through so-called moral suasion from know-it-all politicians who now have the banks as their play things. Full scale nationalisation into state banks, which have a truly execrable record world-wide, could even be on the cards as a lest worst option.

We are now facing a fundamental crisis of capitalism in its spiritual homeland. The very tenets of the free market have been junked by a panicked, incompetent Bush Administration, the most right wing in over 100 years, as nationalisations, bailouts and new funding initiatives have followed in rapid succession through either the Treasury or the Federal Reserve. On December 16th, the Fed lowered interest rates essentially to zero, we now have the famed ZIRP or zero interest rate policy that the Japanese were forced to introduce in the 1990s and from which they were never able to depart fully. Coupled with a policy of 'quantitative easing', Bernancke is living up to his nickname of Helicopter Ben.

The most recent estimate by Bloomberg was that the Administration had committed USD 8 trillion to the economy since September mostly through the Fed's own balance sheet. The monetary base, which is the fuel for future money supply increases, more than doubled in the six weeks after the collapse of Lehman Brothers in mid September. All pretence about fiscal prudence has been junked and the US deficit is expected to exceed 10 percent GDP, perhaps considerably.

The National Bureau of Economic Research formally announced in December 2008 that the US economy had been in recession since December 2007 - something most of us knew already - and unemployment is increasing rapidly - over 2.5 million will be added to the unemployment rolls in 2008 on the governments low ball estimates. The situation is similar in the UK and much of continental Europe, especially the extremities that had property booms based on low Euro interest rates, such as Ireland, Spain, Portugal and parts of Eastern Europe. Iceland was the reducio ad absurdum case, with its monumentally oversized banking sector collapsing and being forced to turn to the IMF and others for survival. The Russians seem willing to give a little help, in return, of course, for the use of the old NATO Keflavik air base.

Bretton Woods II

With the US in meltdown and suffering an interregnum between the Bush and Obama Administrations the first ever meeting of the 20 largest economies (G-20) was called and met in Washington to discuss the way forward. The meeting was labelled Bretton Woods II, after the meetings in 1944 that established the post World War II by founding the IMF and the World Bank and the convertibility of the US dollar into gold as the world's reserve currency. However, whilst Bretton Woods I had been two years in the making and the meetings lasted three weeks, BW II had been three weeks in the making and the meeting lasted a few hours.

Nevertheless, the meeting is potentially significant. In a real sense it marked a changing of the guard: the transition from the US as the sole hyper-power to the first among equals. A few weeks later the National Intelligence Estimates for the incoming President recognised the probable slippage in the US' heretofore impregnable position in the coming years.

The G-20 meeting was not called by the US but by the Europeans and those restive countries holding huge levels of dollar reserves, such as the Chinese and the oil rich Middle Easterners with large sovereign wealth funds. To help the global economy these sovereign wealth funds must be mobilized partly through the IMF and World Bank. Unfortunately, till now the governance of these institutions has reflected the division of global economic power in 1945 not 2008 and, as a result, the rising powers - the BRICs, Asia and the Middle East - are severely underrepresented, whilst the US and Europe, especially, are hugely overrepresented. In contrast to normal banking practice the borrowers have been setting the agenda. (That's the polite way of putting it; one could refer to inmates and asylums.)

Necessity being the mother of invention, there is now a commitment to a substantial and timely reform in IMF voting power favouring the emerging powers; in return for which the IMF would receive greatly increased funding from the Arabs, the Chinese and the Japanese. In addition, there was a general consensus (Germany excepted) that most countries would take fiscal stimulatory measures to mitigate the recession, even though for some, like the US and UK, it is a bit like giving an alcoholic another drink. Further, it was agreed that there needed to be more active regulation of the financial sectors, nationally and globally and the free trade Doha round should be expeditiously concluded.

Outlook for 2009

Since the situation keeps changing that any projections have much greater uncertainty than normal. On the assumption that the financial sector has been stabilized by the emergency actions in October and November - and that is a brave assumption - then the IMF projects, without much confidence, global growth in 2009 to fall to 2.2 percent from the 5 percent levels of 2005-7 with the US, Europe, UK and Japan all in recession throughout 2009. China and India are pencilled in for 8.5 percent and 6.3 percent respectively, both of which estimates are much more likely to be on the high rather than the low side, and Brazil and Russia predicted in the 3 percent range.

It will be a different world with the Government rampant again everywhere in fiscal and monetary policy, regulation and nationalisation, for the first time since the 1970s, with the hope that this activism avoids both the general stagflation of the 1970s as well as Japan's wasted decade of the 1990s. These are long odds and will require enormous luck, since they confound the historical track record, as well as judgement. Activism could easily lead into a slide towards protectionism in Congress, although Obama's economic team is opposed to such slippage. Inflation will not be a problem next year but beyond that timeframe it could well return as a recovery sets in and the velocity of circulation picks up. Historically, it has been seen as the way out of an indebtedness situation. Why should it be different this time?

For the markets, crisis generates great opportunities and they are present today in abundance for those with liquidity and fortitude. 2009 is likely to be the most challenging year economically in six or seven decades but could well be more rewarding for both traders and investors than this year, especially in Asia. Just remember Lord Cornwallis - his world was turned upside down at Yorktown, but he went on to fame and fortune in Asia, more specifically India. There may be a message there for today's investors: Asia remains the growth opportunity in the world and Asia's favourite commodity - gold - remains everyone's insurance policy.

Dec 17, 2008
William R. Thomson
email: wrthomson@btconnect.com

William Thomson is Chairman of Private Capital Ltd. in Hong Kong and an adviser to Axiom Funds and Finavestment Ltd. in London.

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