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“The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version.”- John Kenneth Galbraith, A Short History of Financial Euphoria, 1994

Financial markets finally caught a whiff of economic reality these past two weeks, erasing $4.5 trillion of global wealth in seven short trading days. It was the worst market correction since the onset of the financial crisis in late 2008, and it may just be the beginning. A final bombshell dropped late on Friday evening as Standard & Poor's held true to its word and robbed the United States of its AAA rating for the first time in history. One Wall Street Journal editor reflected just moments after the downgrade: “You know who's AA+? Belgium. But their fries are better.” The timing of the release was strategic. Futures and currency markets had already closed for the weekend and wouldn’t start up again until Asian markets opened for business on Sunday night (ominously, Saudi and Israeli markets plunged more than 5% in brisk Saturday trade). Not surprisingly, America’s economic and political nemesis thought the downgrade was well-deserved. As the country’s largest creditor with nearly $1.2 trillion in Treasury investments, the Chinese responded via state-run news that “The good old days when [the US] could just borrow its way out of messes of its own making are finally gone.” The irony of mutually assured economic destruction seems to have been lost on the emerging world power. Others warned about the potentially catastrophic consequence of punting the world’s most liquid securities from the AAA club - assets that are used every day as “risk-free” collateral in the $600 trillion derivatives industry and represent a substantial share of fixed income investments at pension funds and insurance companies. They fear substantial market panic in the days and weeks ahead that would make even Lehman Brothers blush. In contrast, America’s wealthiest industrial cheerleader told Fox Business News over the weekend that "in Omaha, the U.S. is still triple A. In fact, if there were a quadruple-A rating, I'd give the U.S. that." Despite the Oracle’s unambiguous support, calls have already begun for Treasury Secretary Geithner’s head on a platter - including a leading Republican Presidential candidate and the Indiana State Treasurer. This comes just months after Geithner made bold public statements that there was absolutely “no risk” of a downgrade. With his political credibility on the line, he may be back on Wall Street before the year is out, but that will do little to solve the current macroeconomic mess. As the world holds its breath for a tumultuous week of trading, pundits will opine on what brought the world to the tipping point and where we might be headed from here. Most of that commentary will focus on the downgrade, the debt ceiling standoff, and emergency G7 and G20 conference calls, but few will present the fundamental economic causes of this drama for two reasons: 1) it isn’t the easiest story to tell, and 2) it’s a tragedy, not a comedy. For those who have been tracking the longer-term structural challenges of the global economy, the only surprising news is that the correction didn’t happen sooner.

An Artificial Recovery

The only tangible recovery over the last two years has been the value of global equities, spurred by trillions in support from monetary authorities around the world. After plunging more than 50% in the wake of the simultaneous failures of Lehman Brothers, AIG, Merrill Lynch, and Fannie (OTCQB:FNMA) and Freddie Mac (OTCQB:FMCC), the market more than doubled over the following two years. To put that rise in context, US markets have only doubled that quickly twice before – in 1933 and 1938 during the Great Depression – and both times markets gave back most of their gains. Central banks ought to be proud of their record-setting performance. The trouble is, outside of the rhetoric about the wealth effect supporting consumption and low rates supporting bank recapitalization, the real economy has barely registered a pulse since the housing markets simultaneously collapsed across most industrialized countries in the middle of the last decade. After years of cheap funding and abundant low-cost labor, a debt-fueled bubble in construction imploded, leaving a legacy of high unemployment (particularly among the young and unskilled), depressed real estate prices, and hundreds of billions in toxic securities floating around the global financial system. Worse still, it shattered the system of trust that the banking system requires to remain liquid and solvent. Rather than address the structural issues within these struggling economies, politicians agreed to collectively throw more debt at the problem and hope that Smith’s invisible hand would miraculously allocate the capital where it was needed most. And did they ever. Trillions in fiscal and monetary stimulus were spent to shock the global economy back to health. Whatever their politics, most economists would argue that at the very least the campaign prevented a prolonged collapse in global economic activity. As this money began to flow into the vaults of banks and the pockets of citizens, a funny thing happened. Everyone started drinking the punch. In the depths of the panic, policymakers, business titans, leading academics and common citizens had a once-in-a-generation opportunity to reflect on the past 30 years of financial deregulation and renegotiate the terms of 21st century capitalism. Instead, as markets stabilized and stimulus-fueled “green shoots” began to emerge, hard decisions were traded for conventional politics, and any opportunity to address the long-term structural challenges like infrastructure and education were replaced with short-term programs to get consumers buying. With their stimulus checks freshly cashed and interest rates at all-time lows, virtually everything was on sale. Business wasn’t back to usual but at least the power was on and the phone would occasionally ring, possibly from a new overseas buyer looking to take advantage of the weaker US dollar. As financial markets rebounded, confidence in the recovery picked up speed. With easy year-over-year comparisons and a weakening dollar, American companies posted strong earnings and made ever rosier forecasts about the growth boom ahead. The only problem is: the boom never came. And the recent fiscal reckoning will only make matters worse. If recent evidence from Greece, Ireland, or any number of past IMF interventions are any indication, government austerity programs rarely unleash the growth they promise, since by mathmatical definition they involve withdrawing hundreds of billions in spending from the economy. Thankfully that means fewer unneeded bureaucrats and expensive military aircraft, but it also means fewer infrastructure projects, fewer teachers and social workers, fewer critical IT upgrades, and fewer border guards. That leaves businesses and households to shoulder the burden of economic growth. But businesses are still cautious about the outlook for spending and have trouble getting access to credit, and consumers are still reeling from a collapse of their asset base (mostly real estate) and stagnant wage growth. Unless demand miraculously picks up for US, Italian and Spanish output, the global macroeconomy is likely to relapse into recession.

This Time is Not Different

There should be some comfort – and a good dose of embarrassment – that humanity has been in this situation countless times before. Manias and panics have been a part of the financial system since the dawn of modern banking in 14th century Italy. Reinhard and Rogoff’s often-cited report (pdf) – surveying 700 years of financial folly – suggests that when countries experience the type of debt-fueled growth that gripped most industrialized economies over the last 30 years, it typically ends in a prolonged period of sub-par growth and ultimately some form of default. However painful, politicians already have a working script for how to move forward. As the global economy shakes off the effects of its prolonged debt hangover, the theory goes, everyone will simply get used to a new normal of higher taxes and lower spending until deleveraging works its way through the system for governments, businesses, and households alike. Others suggest that modern economics has lost its credibility altogether, and policymakers ought to look to a higher power for advice and support. Whatever guidance politicians seek, they are now faced with a barrage of bad economic data, from slowing global manufacturing indices to recessionary consumer confidence, to embarrassing political leadership in some of the world’s most important economies. Investors and policymakers are fundamentally split on how markets will react. Not surprisingly, they are also split on how to respond. This is now beyond stimulus versus austerity. With little ammunition left in the policy warehouse, it may be time for the radical reorganization that could and should have happened in the depths of the financial crisis.

A New Business Model

Assuming policymakers eventually realize that stimuli and bailouts are only short term measures – even the healthiest patient can only take so much chemotherapy – a longer-term dialogue needs to begin around how to reposition the G7 for prosperity in the new millennium. Of the group, only Germany and Canada have any hope of continued economic growth and political stability, but their fortunes are inexorably connected to the health and well-being of their struggling neighbors. Beyond the G7, the G20 are quickly growing into their own political and economic force, but even the high-performing BRICs have their own troubles and are years if not decades from economic maturity. China acted swiftly and powerfully to stimulate its economy in the wake of the crisis, and chose the wise path of infrastructure investment rather than consumption to prime the economic pump. Unfortunately rampant graft, profligate lending at state-sponsored banks, and a massive real estate bubble threaten to collapse the world’s buyer of last resort. Brazil has done well to shield itself from slumping American demand, but its rockstar status among emerging markets has put considerable pressure on the currency and inflation has become a dangerous reality for the central bank. India has similar challenges with graft and inflation, but is burdened not only with a soaring population but also the governance challenges of the world’s largest democracy. Finally, Russia is just fortunate to have a natural resource bounty or its declining population and oligarchic economic system would likely strangle any potential for growth. Despite these troubles, however, G7 members could learn a thing or two by borrowing some of the pillars of BRIC growth. In particular, these four emerging economic powers have prioritized a robust educational system that churns out graduates with superior capabilities in maths in sciences. They have invested in critical infrastructure to facilitate greater trade and productivity, like next-generation telecommunications and high-speed rail. They have focused on creating policies to stimulate export-oriented industries and nurture innovative growth sectors, like China’s leadership in solar technology and Brazil’s expertise in biofuels. Obviously it is easier for the BRICs and their emerging G20 peers to leapfrog the G7 on many of these initiatives. If you already have 30 year old copper lines connecting virtually every building in the country, why would you invest in the most expensive wireless technology available? But if the US and its peers want to avoid – or at least delay – another changing of the economic guard, policymakers better start thinking in longer cycles than their elections or there is a very real risk of a second Great Contraction gripping industrialized nations for years to come.

As the Harvard economist John Kenneth Galbraith once wrote:

“Built into the speculative episode is the euphoria, the mass escape from reality, that excludes any serious contemplation of the true nature of what is taking place….Contributing to and supporting this euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten…”

One can only hope that history doesn’t repeat itself and policymakers finally learn the right lessons from the past. Unfortunately, even rhyming at this point might be too much for the fragile global economy to bear.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Source: Economy: Staring Into the Abyss