The Credit Crisis Exposes a Dysfunctional Global Economic Model

by: Mohammad Farooque

As I predicted in my previous article, a paradigm shift is unfolding. The credit crisis, which started with the deflation of the housing bubble in the USA, is now spreading all over the world. Even countries that were doing relatively well are now in big trouble, except China, which compared to others, is in relatively less trouble. Is it a recession or a recession heading towards a depression? I will argue that the events unfolding now are pointing towards something which has never been seen before.

The whole international business cycle is clogged at several points. Although people mostly talk about mortgage backed securities (MBS) and credit default swaps (CDS) the whole global business model is in trouble. The whole business model, in my opinion, was flawed where the American consumer (and also the Western consumer) was the target population to be provided with goods and services. Whether it is the Chinese producing cheap goods or off shoring office work to Indians working in back offices, the end point of whole business model was to provide for mainly the needs of Western consumers, who were addicted to cheap credit.

Easy access to credit got the consumer going for some time. The US (government and public) has been used to the idea of "credit or financing" for everything from the birth of a baby, to going to college, buying a house (or car), buying Chinese goods, paying back-office workers in India or financing wars in Iraq and Afghanistan. It worked well for several years because there was strong overseas demand for dollars since everybody was doing business in the dollar.

Technically this could have worked well indefinitely as long as the markets kept going up. However, extremes of everything bring a system where anything could be the last straw to break the camel' back, and in this case it was mortgage backed securities (MBS). I must point out that credit balloon was doomed to be deflated sooner or later at some weak point, and had it not been MBS, it would have been something else. Everybody knew that this will not go on forever, both in emerging markets and submerging markets. In case of emerging markets, it was a source of easy money for developing economies. None of the developing countries bothered to seriously develop their own consumer base fast enough to replace Western consumers for rainy days.

Now mortgage backed securities, credit default swaps and many other such investments are frozen. These lethal investment vehicles are showing their aftershocks in the least expected remote corners of the world, from the panicked selling of local currencies to dollars in many developing courtiers to fast growing companies in those countries facing default danger on their debt. Even the shipping traffic between manufacturing and consumer countries is showing a free fall. Even emerging markets could be in trouble because of regional tensions as well as fallout from the credit crisis. Demonstrations in Thailand, regional tensions between Pakistan and India (Pakistan has started mobilizing its troops to Indian border) and other happenings are having real potential to de-track any financial recovery in emerging markets for an unforeseen time.

In the USA, frantic efforts to thaw the credit market are not showing much success. There are mountains of toxic debt in the way of economic recovery, and even if these mountains of debt are moved somewhere, the US consumer is fatigued.

In dealing with the crisis, the government appears to be confused and clueless. There appears to be an obvious paradox in managing the current crisis. On one hand, government is trying to lend money to whoever wants it, but on the other hand, lending standards are being made stricter and there are not so many people who qualify for the loans.

President- elect Obama team wants to spend more money on infrastructure. If the USA was a developing country, then spending on infrastructure could have a good effect on the economy. In my opinion, infrastructure spending will not have a big impact or could even be counterproductive, since the USA already has a decent infrastructure and needs to take advantage of this good infrastructure, by putting up some manufacturing units so people can get jobs. There is too much hope placed on Barak Obama and when it is not fulfilled, people will be very disappointed. President-elect Obama is not a superhuman who can perform miracles.

To solving the current financial problems, in my opinion, there are only two courses. First is to let the economy run the whole cycle and let the risk takers, inefficient businesses, and unsustainable business models go under. The economy will be reborn after the cycle. I would prefer this solution but it needs guts, and I do not think any democratic government can afford to take this path because of the fear of backlash.

The other option is to re-inflate the economy by printing and pumping in so much money that the credit starts flowing out of every orifice of the economy. The trick is that the stimulus needs to be big enough to match the magnitude of debt. A 700 billion dollar stimulus is too little in a world where the debt is approaching trillions of dollars (depending upon how you calculate it could be several trillion to several hundred trillion). However, all this re-inflating will certainly lead to another bubble which could collapse with bigger bang.

I believe that in order for credit to start flowing again, the government has to create a significant gradient so that credit will flow smoothly from the state to the public. The current consumer with poor ratings on his or her credit score, mortgage debt far above than the current value of his or her home and almost no savings will not be able to absorb the new credit even if it is generated by printing more money.

In my opinion, radical steps are needed to salvage the economy, so that consumers can revive their buying capacity. How about instead of rescuing the big banks, we reduce the debt across board on all home owners, on their primary residence, to 30% or 70% or whatever? Or I have an even better suggestion, how about bringing 5 million new immigrants in a short period of time? Since they will not have any past bad credit history they will be eligible to get credit and buy houses, and new furniture, etc. This will move the economy, first local and then global, and the Chinese will start manufacturing goods and Indians will start working in back offices and everybody will live happily for few years before the next bust.

Caution is warranted in utilizing all these mega bailouts. Are we going to gamble on the financial future of 300 million Americans in order to save the current world financial system, which may not be salvageable anyway? In my opinion, the whole business model of goods and services being produced at one point on the globe and consumed by another chosen few is deeply flawed and unsustainable and should be revisited. How about a global system where local communities produce goods and services for local use. In that system, only in exceptional cases will goods and services be transported from destination A to destination B in case B is unable to produce it.

Patience and time will be needed to go through current downturn. It could be a very long and painful one lasting months or years. Avoid the temptations of false rallies or, as they are called, sucker rallies. Keep most of your cash if you have any, or put it in safe fixed investments. Control spending, and keep expenditures to minimum, and save money so that when the economic train starts moving again you have money to buy tickets (stocks) for the next station of prosperity.

Stocks moved up 50% during first the 6 months and 200% from the bottom two years after the Great Depression, and this could be repeated in the next recovery. When this downturn is over, I prefer to buy emerging market stocks if the next government does not have too many protectionist policies. If the next government has too many protectionist policies then I will stay away from international stocks since other countries could take reciprocal actions and impede the flow of capital.

Stock position: None.