like in October 2007.

We’re in the middle of an historic bear market.

With the market all the way back to a long term trend it left 17 years ago, but not yet below. There is a reason the trend is where it is. That reason is that the market spends half of its time below it…

There are very few average years, or decades, however. The running 10 year return on the S&P 500 fell almost to -6% in March.

So is the market cheap? Should this be one of those above-trend times? PE’s – how much investors are willing to pay for current earnings – are certainly at the lower end of historic ranges, especially relative to interest rates.

But it also depends a bit on what is going on around the US and world.

Household Debt

I suppose it all began, and will all end, with debt, but it’s a tangled story I’ll try and draw out.

People just stopped paying for current expenses with current income.

Luckily, the international financial industry was there to help out (for a fee) and the home became the new ATM as mortgage equity withdrawal (MEW) added to disposable income.

House Prices

As the credit dried up, prices fell in step.

And have come back a lot.

So, how cheap are they now? Inflation adjusted, over the longer term they are still expensive.

And even worse in Australia.

Close to fair value relative to income.

Trouble is, because so many were built in the day…

…there are now an awful lot of them ready to be sold.

And so new homes are not selling, at any price.

Though there is a slight uptick in existing home sales due to record foreclosure activity – what Calculated Risk calls the “distressing” gap.

Banks

Which brings us to the banks, who enabled all this borrowing and by consolidating mortgages into securities which investors around the world bought.

I’ve been looking at this chart since July 2007. It shows us where we are in working through the fancy new mortgages underlying those mortgage backed securities. Not surprisingly, prime foreclosures now exceed sub-prime. But the storm she’s a comin’ for option teaser rate resets and Alt-A. Almost ALL the new issuance in the last year and a half are Fanny/Freddie (Agency), an arm of the US government.

Most of the liquidity of the boom years was created off-balance-sheet by non-bank actors leveraging up. This now must unwind.

The banks themselves were perhaps the first to realise the music had stopped, and ceased lending to each other.

The government flooded the markets with short-term money.

And took every bank’s deposits on to their own balance sheet with guarantees in an effort to stop the entire financial system collapsing.

The “stressing” tests assume an early recovery, and as with global warming the “worst case” is tracking actuals.

European banks not only bought US mortgage securities, but borrowed and loaned on US dollars into speculative property in Eastern Europe.

In short, the largest international banks are insolvent; not just “technically” but fundamentally as their balance sheets (and accounts) no longer reflect valuations at which their assets actively trade. 50:1 leverage is not going to get you far in this environment.

So they’ve all stopped lending as they milk their governments for credit and spreads at the cost of industry and consumers. Unfortunately, it is those customers that they’ve lent money to, and the result of cutting off credit is not looking good – particularly for jobs and world trade.

Jobs

Just when, also because, consumers decided they needed to save more, jobs have fallen badly.

Relative to other post-war episodes, this one is worse.

What jobs there are have become much shorter term, as the number of unwillingly part-time workers has risen.

Total unemployment (lhs) and weekly new claims (rhs) are both breaking new ground.

In the last month or so the rate of new unemployed has plateaued, but that rate is still very high – more than a million more lost jobs per month.

All of this has a fairly reliable effect on the market.

World Trade

Consumers in developed countries, particularly in the US, account for a large share of the economy.

When house prices stopped rising so home equity withdrawal ceased to provide spending money, and mortgage resets increased payments, and jobs began to disappear, and credit cards became harder to get, the US consumer decided to stop spending so much.

On top of this, banks stopped providing credit to facilitate trade so exporters couldn’t ship and importers couldn’t receive goods.

Trade flows took a nose dive.

Even hotels can’t sell rooms.

World trade fell dramatically, particularly for Japan, Germany and China…

Global growth is negative for the first time in decades.

Industrial production is still on a downward trend more dramatic than the previous post-war worst case.

Much productive capacity is idle, hence the idea of having the government borrow more to put it to use.

Inflation is unlikely to be a worry while so much excess capacity exists.

Commodities

Bad news is the US still has a big oil habit. Good news is that its suppliers are still accepting US dollars.

Good news is that US drivers are driving a lot less.

Bad news is that oil exports peaked in 2005, despite the rocketing prices since then.

Good news is the oil and gas prices have fallen right back with the slower economy.

Bad news is that commodity prices jump at the first sniff of growth, helping to choke it off.

Headwinds

So, is this all just a cycle, perhaps caused by the fluctuations in birth rates echoing down the years from the boomers? Who will buy the boomers’ homes (and vacation homes, and investment homes…)?

There is also a secular trend towards ageing populations world-wide. Who will buy their homes (and stocks) and pay out their pensions and healthcare?

Interesting times.

First up, the most recent; looking at the state of play in funneling taxpayer dollars (and IOU’s) to banks and other powerful interests.

A simple example tracking the mortgages themselves.

The AIG bailout in particular.

The NYT looks at bailouts relative to other government spending.

Washington Post with the whole ball of wax.

Here’s an accompanying one, in color. The green arrow is “You are Here”. This chart is particularly remarkable because for the first twelve months of the green line many weren’t sure if the US was in recession or not. In Great Depression like-for-like terms, US unemployment is now at 17.5%.

This one is ’synchronized’ as well.

A similar pattern in vehicle sales – unprecedented weakness.

Guess what? Property prices have still not inflected. “Home prices in 20 U.S. cities declined 18.2 percent in November from a year earlier, the fastest drop on record.” The 20-city index is down 25 percent from its 2006 peak.

A worrying drop in shipping activity, particularly in the last three months of 2008, though the trend was clearly broken in mid 2007.

Can’t say the authorities aren’t trying. The money supply is exploding.

Bank guarantees are multiples of GDP.

There doesn’t seem to be an asset or counterparty the US Fed doesn’t like.

Long Term

At times like these one needs perspective. Similar events have happened before, though in the long term the historical evidence indicates that we are all deceased. Debt levels as a percentage of GDP.

Real returns on various asset classes.

Without a major economic stimulus plan, “the shortfall in the nation’s output relative to its potential would be the largest — in terms of both length and depth — since the Depression of the 1930s,” said new CBO Director Douglas Elmendorf in testimony prepared for the House Budget Committee.

“Very simplistically, it is a choice between Zimbabwe and Japan.” – Niels Jensen, Absolute Return Partners

I don’t think I’ve ever had so many people ask me which way I thought the economy was going as in the last week. The simple answer is: first deflation, then inflation. But as to when and how much? At this point, no one has the answers; but at least Cassandra and her eclectic group of readers are exploring the questions. The discussion is US-centric, but all developed countries are confronted with the same problem to some degree.

• Do the US Fed and Treasury (and central banks and governments world-wide) really have the fire power (and political will) to stave off a de-leveraging driven deflation with whatever it takes?
• Would they attempt to, and have the practical and political capacity to, withdraw this quantitative stimulus (ie. newly printed money) at the first hint of growth (and a resumption in inflation)?
• Will they instead inflate the debt away at the great expense of creditors, liquidating a long-term reputation that has provided the benefit of a strong currency and low rates since the last US treasury default in 1933?
• Can real growth resume before the residual over-capacity and over-indebtedness is removed?
• Can the US government even finance its existing expenditure and debt committments long term?

This is inherently a political-economy battle, which leaves the pure economist’s talking at cross-purposes – about what is in theory possible or ideal rather than what is politically likely. The empirical economists are at even more of loss, with a single data point and nothing else equal.

On the deflation/liquidation (do nothing) side are ranged the creditors (China, Japan, Saudi…) and the mega-wealthy (which, last time I checked includes just about everyone in the US Senate). On the reflation/inflation (do SOMETHING) side are leveraged intermediaries, corporates and the poor US taxpayer who will end up with the debt service.

The US treasury bill appears to have become the most credible financial instrument, and the US taxpayer backing this appears to have become the guarantor of last resort. But the Bush years have cost future US taxpayers about $10 trillion (estimates Stiglitz) and in the near-term Obama will write some very large checks as well. Who will these future US taxpayers be? If spread across the upper 25% of income earners (as it must inevitably be) the burden will be on the order of $200k each plus interest. Want to step up? The super-rich may just write a check (or walk if they’re chased for more than a nominal share), but for what would have been the middle class this tax burden is the difference between remaining high-income poor and retiring with some personal capital.

Any delay at this point is a win for deflation, at least until supply cut-backs begin to bite (as Moldbug says “The prices we see now are the interaction of 2009 demand with 2007’s plans for 2009 supply.”). When US rates rise and/or the dollar drops the creditors are abandoning the field, but where will they go?

Cassandra is a “deflationist overshooter”, as am I for the moment:

[This view] reckons that: the weight of de-flation (de-leveraging, de-risking, precipitously de-clining core asset prices, de-capacitating financial system distress, de-employment shocks, secular de-consumption (savings) ratios, even demographics) trumps any triage, stitching or even bionic limb replacement conjured by central banks and Keynesian stimuli, by a large magnitude. And, this view conjectures, that by the time even the most interventionist authorities comprehend this, it will be too late for the inflationist “V” [referring to MV = PT] to ripen. AFTER that (two years?!? three?!?) when the majority of purging may be complete, and only then (year prior to re-election year 2012?) will the drastic measures be taken, which will be overkill and could very well/will lead to above trend inflation. Not hyperinflation. Above-trend inflation. [This view] understands, as Jeremy Grantham suggested last weekend, that solutions will – like reducing greenhouse gases – likely require multiple types of adjustment including falls and write-downs in asset prices (particularly debt); debt-for-equity swaps, coupled with some rise in nominal incomes and price indices. But like the deflationists, this view is predicated upon tinder being too wet to combust… and authorities – in this new paradigm – having the impetus and fortitude to “do the right thing” in the heat of the moment…

Perhaps we just need another boondoggle:

Just look around and you will see boondoggles sprouting up everywhere, in every field of endeavor: we have military boondoggles like Iraq, financial boondoggles like the doomed retirement system, medical boondoggles like private health insurance and legal boondoggles like the intellectual property system. At some point, creating another boondoggle becomes the preferred course of action: since the outcome can be predicted with complete accuracy, there is little risk.

At last the Dodo said, ‘everybody has won, and all must have prizes.’
‘But who is to give the prizes?’ quite a chorus of voices asked.
‘Why, she, of course,’ said the Dodo, pointing to Alice with one finger…

Lewis Carroll – Alice’s Adventures in Wonderland [1865]

I’ve taken a step back from the markets for a couple of weeks to try and get a bit of perspective. In the meantime, global economic data have turned very ugly; a surprise to no one with a pulse.

The banks are still insolvent, and we must cover this with a TARP. Businesses cannot sell the goods they produce, so the government must loan them money to continue building these same goods. Consumers are overly indebted, so the government will cut taxes so they can continue to spend. All debts – banking, corporate, consumer – will now be assumed by the government. Who is going to (eventually) pay? Why, the future taxpayers – the descendants of this generation and any immigrants desperate enough to show up legally.

The whole thing seems a redux on the sub-prime bubble, but this time at the sovereign level. The US Treasury is taking out a 30 year mortgage on the US taxpayer at a record low 90 day teaser rate, but the median taxpayer increasingly has no income, no job, no assets. What happens when the rate resets? Can the taxpayers walk away? Do the foreign (and domestic) creditors foreclose? What do they get, other than green paper? Where are Fitch, Moody’s, S&P? What does “full faith and credit” mean exactly? I think we are all going to find out.

Buiter puts the cat among the pigeons by stating the obvious on the FT stage:

There will, before long (my best guess is between two and five years from now) be a global dumping of US dollar assets, including US government assets. Old habits die hard. The US dollar and US Treasury bills and bonds are still viewed as a safe haven by many. But learning takes place. The notion that the US Federal government will be able to generate the primary surpluses required to service its debt without selling much of it to the Fed on a permanent basis, or that the nation as a whole will be able to generate the primary surpluses to service the negative net foreign investment position without the benefit of “dark matter” or “American alpha” is not credible… So two things will have to happen, on average and for the indefinite future, going forward. First, there will have to be some combination of higher taxes as a share of GDP or lower non-interest public spending as a share of GDP. Second, there will have to be a large increase in national saving relative to domestic capital formation… The US government is ill-placed financially and fiscally, to engage in short-term fiscal heroics. All they can really do is pray for a stronger-than-expected revival of global demand, without any major stimulus from the US.

Bill Gross at Pimco opens 2009 with a damning indictment: Western economies always were (and still are) an intertemporal and international Ponzi scheme. His pragmatic recommendation is to buy what the US government will have to buy, but do it first. At this point state and municipal bonds, TIPS, and bona fide corporates. I suppose the flip side of this is to sell what the US government will sell – Treasuries anyone?

Krugman muses: if the 14 point-years of employment lost in the 80’s slump (points of unemployment x years) resulted in pushing core inflation from 10% to 4%, what will the 14 point-years output shortfall the CBO is forecasting for 2008-1012 do when we start with a core inflation rate only 2.5%?

Roubini says:

The United States will certainly experience its worst recession in decades, a deep and protracted contraction lasting about 24 months through the end of 2009. Moreover, the entire global economy will contract. There will be recession in the euro zone, the United Kingdom, Continental Europe, Canada, Japan, and the other advanced economies… equity analysts are still deluding themselves that the economic contraction will be mild and short… The credit crunch will get worse; deleveraging will continue, as hedge funds and other leveraged players are forced to sell assets into illiquid and distressed markets, thus causing more price falls and driving more insolvent financial institutions out of business. A few emerging-market economies will certainly enter a full-blown financial crisis.

The frustrating (and scary) thing is that these are the guys that have been right so far.

Turn of the year background reading (pdf’s):

Reinhart & Rogoff – The Aftermath of Financial Crises; It’s not good news.

Stiglitz on Paulson and Greenspan – “Capitalist Fools”, on GM – “Bridge Loan to Nowhere”

BIS quarterly – The Bank for International Settlements has the (dismal) facts.

BOC review – The Canadian banks have done a good job thus far.

Countries importing capital: US ($697bn), Spain ($166bn), Italy ($71bn), France ($57bn) Australia ($57bn), Greece (53bn), Turkey ($47bn), and Britain ($46bn).

Countries exporting capital: China ($378bn), Germany ($266bn), Japan ($176bn)…

Asia’s central banks are sitting on $4.1 trillion in loans to other countries…

You can look at capital importers as providing the best combination of low risk (US?) or high return (Australia? Turkey?). You can look at the exporters as facing a combination of high risk (China?) or low return (JP? DE?) environments domestically. Lately investors seem to have fled risk to JPY and USD cash at the expense of returns. Those who want that capital back have to build a better (relative) risk/return case domestically.

The ideal investment prospect would have strong and efficient legal and financial institutions, stable and growing domestic demand, a reliable source of export earnings, and a low level of debt relative to GDP.

Seen any countries like that?

Now we’re getting truly historical data points like the following:

Reuters: Commodities in 2008 posted their worst performance in history, despite a good first half. U.S. loan issuance in 2008 tumbled 55 percent to $764 billion, the lowest volume since 1994. U.S. factory activity fell to a 28-year low in December.

Economist: America’s stockmarkets suffered their second-worst year since 1825(!).

Faber: $30 trillion was lost in stock exchanges globally in 2008.

Bloomberg: Banks owned a record $11.5 billion of repossessed homes in the U.S. at the end of the third quarter. Foreclosures accounted for almost half of all U.S. purchases in November.

Telegraph: UK manufacturing activity slumped at its fastest annual pace in 28 years in November. Yields on 10-year US Treasuries have fallen to 2.4pc – a level that was unseen even in the Great Depression and only once since 1790.

Automotive News: GM’s 2008 U.S. sales of 2.95 million light vehicles were its fewest in 49 years, and Ford’s tally sagged to a 47- year low.

FT: Mutual funds recorded a net $320 billion outflow in 2008. But in December, investors put a net $23 billion into equity funds and withdrew only $3.5 billion from bond funds.

NYT: Banks are hoarding cash, with the amount being held by financial institutions at more than $1 trillion, three times the figure only three months ago.

WaPo: The deal volume for mergers and acquisitions in 2008 was down 29% from a record-high in 2007.

OECD: The failure of the U.S. and European governments to remove bad loans from banks before they are recapitalized may prolong the financial crisis.

Gallup: 35 percent of Americans think that a “depression” is very likely, and another 39 percent think it’s at least somewhat likely… And the latest trade at Intrade just put the chances of a depression – a 10 percent decline in GDP over four consecutive quarters – occurring at some point in 2009 at 40 percent.

So my kids, and their kids, will hopefully be saying “the worst since 2008″ for a long, long time.

Whoops, make that 2009:

CBO projects a federal deficit of $1.2 trillion in fiscal 2009, 8.3 percent of gross domestic product, the biggest share of GDP ever with the exception of the periods during the two world wars.

First, it’s pretty clear the real economy is now collapsing both due to tight credit as all financial actors deleverage and as a result of a revision in growth expectations such as Keynes wrote so clearly about. Forced liquidity was not enough. An “intact” banking system and zero(!) USD interest rates are not enough. The world’s investors have decided that reduced prospects are in view; and that is a self-fulfilling forecast if held widely. Skidelsky:

The basic question Keynes asked was: How do rational people behave under conditions of uncertainty? The answer he gave was profound and extends far beyond economics. People fall back on “conventions,” which give them the assurance that they are doing the right thing. The chief of these are the assumptions that the future will be like the past… and that current prices correctly sum up “future prospects.” Above all, we run with the crowd. A master of aphorism, Keynes wrote that a “sound banker” is one who, “when he is ruined, is ruined in a conventional and orthodox way.”… But any view of the future based on what Keynes called “so flimsy a foundation” is liable to “sudden and violent changes” when the news changes. Investors do not process new information efficiently because they don’t know which information is relevant. Conventional behavior easily turns into herd behavior. Financial markets are punctuated by alternating currents of euphoria and panic.

In the “new” convention investors are placing a higher value on liquidity, expecting more defaults, and worrying more about what they don’t yet (or cannot) know. (DeLong)

Secondly, increasing numbers of people are pointing out that to the extent that current circumstances resemble the leadup to the Great Depression, and so there might be policy implications for our present predicament, it is China that now has the role of the surplus-generating USA in that prior era, and the USA has the role of an indebted Europe (all of whom defaulted on their WWI debts).

Liberally paraphrasing Yves Smith, Pettis and Setser,

Keynes not only wanted the US to run even bigger budget deficits back then, but he also said it was unreasonable for the US to expect is overconsuming, indebted trade partners such as the UK and Germany to go deeper into debt to support the US. Asian economies simply lack the scale to act as the global locomotive.

Thirdly, there is a vigorous debate this week on the relative dangers of deflation, and inflation; specifically whether it would be better to endure the latter later in order to hold off the former today.

Perhaps perversely, the attack by Willem Buiter on the ECB (and Steinbrueck) for lagging behind in it’s inflationary efforts has me now considering them the most reliable central bank, and the EUR likely to be the safest currency over the medium term.

The independence of the ECB is embedded in the Treaties. A unanimous decision by all member states is required to change the Treaty. Given this operational independence ‘on steroids’ of the ECB, it is unlikely that any Euro Area national government or coalition of governments could bully the ECB into engaging in a burst of public-debt-busting unanticipated inflation.

I’m also with London Banker in his final post, deflation is at least initially in store as investors go on strike. The damage to confidence from bungling governments is at least as severe as the underlying financial issues.

During the reckless boom years, savings collapsed in bubble economies as retail and commercial and financial actors alike chased speculative yields with greater and greater leverage. During the reckless bust years, savings will collapse further as retail and commercial and financial actors chase safety by hoarding their meagre remaining assets from further erosion by refusing to lend at negative returns and refusing to finance failed corporate and investment models that only enrich poltically-connected management and intermediaries… Each bailout further undermines the market discipline which is bedrock to a saver or investor’s decision to part with hard-earned cash by trusting it to the intermediation of the management of a bank or business… It’s this simple: I won’t invest in a country that bails out failure and punishes savers… I will know when it is safe to reinvest when policy interest rates, bank/intermediary oversight and accounting standards give me confidence I am better protected than the corporate or financial elite…

It appears that in aggregate the world is inevitably going to suffer a substantial decline in both production and consumption in 2009 and possibly 2010; and substantial losses on financial assets whose value was premised on higher values for both.

The arguments now are on allocating the pain – who, where and when. (Hint: not me, not here, and not now.)

At least these flights home were on-time, connections connected and luggage brought along. Aerolineas Argentinas is the Fawlty Towers of airlines – a farce that morphed into tragedy outbound as we spent 44 hours en-route, had to buy our own additional last-minute tickets from another airline to get from Buenos Aires to Lima in time, had no luggage for 7 days. Truly remarkable. The children (8 and 6) were heroes, as was my wife. Happily, the Amazon basin, Cuzco and Macchu Picchu were everything we had hoped, and APEC itself was a real eye opener.

I went to Peru to attend the “CEO Summit” stream of the APEC (Asia-Pacific Economic Cooperation) meeting as a business delegate from New Zealand at the kind invitation (and urging) of an old friend and business associate. I’ve long been curious about what really goes on at these sorts of political/business conferences, and APEC seemed a reasonable place to start, though in the meantime I’ve also attended a shorter ASEAN meeting in Manila. I primarily wanted to hear first-hand what the various leaders had to say for themselves in the current crisis and get a feel for investment opportunities; but I also wished to develop additional professional connections — particularly in China — and to contribute my own perspective as a global long/short equity investor to backchannel debates.

The 21 members of APEC account for 41% of the world’s population, 49% of global trade and 55% of GDP. APEC has lead world growth over the last decades, and will have to form the nucleus of any recovery.

The conference extended over just two days, with three evening functions thrown in; and I have to say the organisation and agenda vastly exceeded my expectations. As in Sydney last year, Lima virtually shut down with official holidays for businesses not involved in the conference; and security was everywhere though there didn’t seem to be any unrest even outside the cordon sanitaire. My interviews throughout Peru showed people hustling to get along, conditions having much improved over the past decade, with vocal but largely intellectual dissatisfaction at the gulf between the rich and poor.

As it happened this was the very weekend that Citi almost went under and the financial crisis continued to dominate the agenda. To cut to the chase, I came away from the conference more depressed and pessimistic than I had been going in. I was looking for clear leadership in decoupling the real economy from the financial carnage, and some sense of cohesion among the emerging country bloc. Instead, leaders seemed largely to be using the forum to complain about other countries (mainly the US), urge business people to continue investing in their particular country (where everything was going just fine, thankyouverymuch), and to forswear competitive protectionism (which I now consider to be much more likely). Herewith the blow-by-blow.

President Alan Garcia of Peru set a high standard at the conference opening, his prerogative as the leader of the host country. He focussed on the need to rebuild trust in international institutions – with thinly veiled criticism of the current US administration – and is clearly putting his hopes in Asia. “China has the trust of the world.” He sees the crisis not as a breakdown, but as inevitable turmoil associated with transition; “a paper crisis” not affecting the real economy. He struck me as a pragmatic Marxist – “Peru is a mining company.”

Prime Minister John Key of New Zealand was also impressive. He was sworn in only 24 hours before his speech, having successfully formed a new government in NZ after the previous week’s elections. He was a successful financier and currency trader and clearly can get things done. In my view as a NZ citizen and resident, NZ could not be luckier than to have someone with business and financial market experience at the helm just now. This is going to be a very tricky period for a very small open economy with an independent currency. He argued for renewed emphasis on re-starting and successfully concluding the Doha round of trade talks which would dramatically help NZ’s agricultural exports; and for the need to regulate global finance without stifling investment.

President Hu Jintao of China was probably the most anticipated speech of the conference, with the large Chinese contingent on pins and needles ready to parse every phrase. I get the impression that the business community in China doesn’t have that much contact with the political leadership. In the event, he didn’t make any significant public announcements, sticking closely to a prepared script. He argued for better representation for BRIC countries in the IMF (a recurring theme), and for “people first, market socialism”. He said fiscal and monetary stimulus within China will boost consumption — but not of resources — with a goal of “scientific development” combined with “harmonius society”. He said corporates have to behave better, and the Asia Pacific should work together.

Prime Minister Kevin Rudd of Australia was certainly the driest speaker, and I had expected more. He barely lifted his eyes from the page as he droned out fairly pessimistic fare. Perhaps he had the flu. He talked about 200m being jobless in 2009, and another 60m thrown into poverty. “We’re all in this together.” AU on the other hand was solid financially – equal best in the OECD? – with positive ‘09 GDP, unemployment below 4% and lots of free trade agreements on the boil. Rudd first mentioned the logjam in trade finance, a problem he estimated at $25bn. He also brought up climate change, saying AU would move ahead with their climate initiatives and try and bring the US and China together.

President Susilo Bambang Yudhoyono of Indonesia pointed out that Indonesia is the 4th largest country in population, has GDP growth of 6.4% and is self-sufficient in rice. He equated poverty with instability, says the US sacrificed community for profit and businesses need to “share the wealth” (an Obama echo?). He’s spending 20% of the federal budget on education, and will spend more in the crisis.

President Michelle Bachelet of Chile spoke over dinner, so I don’t have the benefit of my notes though I remember being impressed. She reminded me very much of Merkel of Germany. She made no bones of her criticism of the current international order, with profits being privatised and costs being socialised.

President Lee Myung-Bak of South Korea lead off the second day. He made a point of his being a CEO for 27 years before politics. He cited South Korea’s increase from $100 to $20k per capita income since 1960, and thinks Latin America can do the same with “Asian technology and capital”.

President George W Bush of the USA was everything I had expected and less. He didn’t seem to have any idea what was going on in the world at large, felt himself to be immensely important and popular (having attended every APEC during his term), and was obviously enjoying his visit – the last overseas visit of his presidency (and perhaps for life depending on the international mood about enforcing the Hague Conventions). He didn’t listen to a word of his introduction, winked and chuckled his way through a sort of stump speech arguing for “staying the course”, and in the best Orwellian fashion called for free markets, free trade and free people (depending of course on what you mean by “free”).

Prime Minister Stephen Harper of Canada is an economist turned politician; having studied macro, political economy and economic history. “Canada’s proximity to the USA is our largest current problem.” He said the Canadian banks seem to be in relatively good shape having stuck to commercial finance, and the deficit is under control. Was very positive on free trade and NAFTA, FTA’s with Peru, Colombia. Update: On returning from Lima Harper became the first Canadian PM to suspend Parliament in order to avoid a vote that would have ended his government.

President Felipe Calderon of Mexico got straight to the point, said they were already seeing a lack of export demand and falling prices. He predicted that FDI will drop as well as remittances. He said the world must quickly correct structural imbalances and re-establish trust in institutions. He advocates bottom-up help for debtors and foreclosures, and will spend an additional 2% of GDP on infrastructure.

There were a dozen business VIP’s given a platform as well. Of these the most inspiring was Jack Ma who created Alibaba, the largest B2B network in China. He sees small business leading any recovery – “small is beautiful” – and this as a time for knowledge, passion and dreams. He want’s to use Alibaba – “nobody can stop the internet” – as a channel for SME finance, IT training and human development.

Perhaps the only substantive result of the actual leaders summit will be some action on trade finance, which is no small thing. I arrived home to find that the NZ cattle market has ground to a halt because a ship or two full of chilled beef went to Russia and was turned back due to an inability to pay for it. Thus are the excesses of Wall Street visited upon the real economy.

As I listened to these political leaders it occurred to me that markets are doing exactly what the governments won’t – insisting on transparency and refusing to kick the insolvency can down the road. The price action is thus something to be encouraged, not lamented or prevented.

In short, I’m looking for signs of de-coupling of the real economy from the financial smoke and mirror factories – the ‘zombie’ Wall Street banks. I’m also looking for global triage and think it possible that we’ll see some economies (that’s you Japan, China, Brazil, India and Saudi Arabia) break away from the de-leveraging black hole and via fiscal stimulus sustain each others’ growth and credit needs in a manner similar to Malaysia’s course in the ‘98 crisis. For the time being, I’ve given up on the US (too much debt, too little industry), and Europe looks neutral at best. Iceland, of course, is toast, and the UK is wobbly.

Illargi:

Paulson throws your money at the one sector of the economy that doesn’t do anything useful, money that could have been used to support those sectors that provide your jobs and produce things that are actually useful.

Is it just me, or does the US dollar remind you of frequent flyer points that can only be spent on a rapidly dwindling catalog of increasingly shonky goods? It looks like China may be wishing to cash in some of theirs on parts for a railroad, and they should.

Comstock Partners summarises the situation for the US:

We have a budget deficit of about $455 billion this fiscal year and as we have warned in many of our weekly comments, we expect a deficit of $1 trillion or more in the next fiscal year. The incoming administration is also inheriting a $10 trillion government debt… We don´t expect the current global recession to end until the end of 2009 or beginning of 2010. The record U.S. total debt of over $50 trillion on an economy of almost $15 trillion is what we would call very onerous. For a period of about 20 years from the 1960s through 1970s it took $1.50 of increased debt to generate each additional $1 of GDP, but that ratio has trended up consistently in the last 28 years. In recent years it has taken about $3.50 of increased debt to generate an incremental $1 of GDP… Now that the deleveraging process of debt unwinding is in full swing world-wide, what do you think is going to happen to global economic conditions?

US data last week set more records:

U.S. workers drawing jobless benefits hit a 25-year high this month… Consumer spending fell 1.5 percent last month, after a 2.4 percent drop in September that was the largest since SpendingPulse started the data series in 2003… U.S. imports from China hit a record $33.1 billion in September, but imports from the European Union fell 3.8 percent and imports from the Organization of Petroleum Exporting Countries slumped 27.1 percent as the cost of imported oil fell by a record $12.41 per barrel in September… imports of consumer goods fell nearly 7.9 percent in September… U.S. exports fell at the fastest pace in seven years… U.S. goods exports fell by a record $10.4 billion, with all major categories showing a decline.

Ecinya doesn’t expect much from the G-20 conference:

The world cannot begin to resolve the systemic and economic problems that have derived from the American fiscal and monetary policy malaise UNTIL George W Bush departs the global stage. This weekend George W is hosting the G20 Summit.

Everyone has advice for the summiteers. VoxEu published a short book (pdf). Dani Rodrik had a good go at pre-drafting the inevitable communiqué as leaders agree to agree, except “The Bush administration opposes any regulatory agency with cross-border authority”. His summary:

There is no coordination in the fiscal arena, the promises made to emerging markets are vague, and even though there is a clear statement on protection and export subsidization, there is no monitoring or enforcement mechanism.

Jean-Claude Trichet (president of the European Central Bank) would like to fix three things: incentives, transparency, and pro-cyclicality.

Modern financial systems have favoured instruments and intermediaries that promise large returns in the short term. Institutions come under pressure to follow the strategies of those able to show high short-term profits. This process tends to lead to herding behaviour, in which risk controls easily become a secondary issue. We need to counter these mechanisms and establish the right incentives for achieving a balance between short-term and long-term investors and intermediaries. Incentives for market participants need to be strengthened in this respect, including through revised internal compensation schemes…

The second point concerns transparency. Despite all regulatory advances and progress in information technology, the financial system has been characterised by a lack of transparency about the ultimate allocation of risks. Two examples are the sheer complexity of structured financial products, which even sophisticated investors are not able to assess properly, and the lack of regulation for certain financial institutions. Regulators therefore need, in particular, to tighten up requirements for markets in which structured financial products are traded and strengthen reporting requirements for formerly unregulated institutions…

Finally, pro-cyclical behaviour is pronounced in financial systems. But in the present global financial system there are mechanisms that intensify fluctuations. The challenge is to preserve an efficient financial system as an engine for economic growth and at the same time ensure its stability. For example, capital regulations and provisioning rules as agreed by the Basel committee on banking supervision, and industry governance structures, especially in the area of risk management, need to restrain excessive risk-taking in upturns and discourage excessive conservatism when credit to companies and households is most needed…

Spiegel surveyed Nobel prize economists…

Lucas: The public needs a conveniently provided medium of exchange that is free of default risk or “bank runs.” The best way to achieve this would be to have a competitive banking system with government-insured deposits.

Stiglitz: To too great extent, there has been a race to the bottom in accordance with the myth that deregulation breeds innovation. Instead, the innovation was greatest when it came to getting around the regulations designed to ensure good information and a safe and sound financial system… Financial market regulators, at both the national and international level, have failed… Even countries which have done everything right — those which have managed their economy with far better regulation and better macro-economic prudence than the US — will suffer as a result of America’s mistakes… The sources of liquid funds are in Asia and the Middle East. But why should they turn their hard earned money over to an institution with a failed track record; one which pushed the deregulatory policies that have gotten the world into the mess where are in now; one which continues to advocate the asymmetric policies which contribute to global instability; and one whose governance structure is so flawed?

Phelps: A good life requires a rewarding workplace — one of change and challenge — and that requires some sort of well-functioning capitalism… That the banks chose to take on ever-greater levels of risk, with no end in sight until the collapse, was an effect of employee compensation: Fortunes could be made for each additional day that the bank could operate. There was no claw-back provision that would pay bonuses only for performance over the long term… Unfortunately, the banks for the most part appear to have lost the expertise to make business loans and investments, which they once had…

Samuelson (age 93!): Based on my observations of economic history, both short run and long run, I believe that there is no satisfactory alternative to market systems as a way of organizing both economically poor and economically rich populations. However, using markets is not the same thing as unregulated capitalism so beloved by libertarians. Such systems cannot regulate themselves, either micro-economically or macro-economically… President George W. Bush will figure in the history books as the worst president in the 234 years of US history…

In a sign that they are prepared to sideline the outgoing US president, Mr Medvedev backed the call from President Sarkozy for a follow-up summit in February once Barack Obama has taken over.

The world simply has to hold its breath for 60… more… days…