I wrote in two previous articles about the destruction of the global financial system (In gold we trust, Asia Times Online, December 8, 2007) and the vast value destruction in G7 countries Dear dinosaurs, Asia Times Online, October 20, 2007). The plant that grows out of the soil is from the seed that was thrown in, and thus we should see all of G7’s grand errors come back and bite them in the posterior regions.

The behavior of Wall Street analysts and economists almost never ceases to amaze me. After first holding on for years to a charlatan-like view of “this time it’s different” as a means to explaining the apparent miracle of uninterrupted growth for a very long time and inflation of asset prices ad nauseum, the group has now shifted its focus on what shape the ensuing recovery would take. Yes, I shook my head too when I realized these imbeciles had never acknowledged the errors in their forecasts nor do they still recognize the perils being imposed on the global economy by idiot central banks (see The Rogue and the pogue, Asia Times Online, January 26, 2008).

As always, this group oversimplifies the task at hand, using some short-forms such as “V” or “U”. One or two have gone to the extent of using an “L”. Those fancy alphabet soups mean precisely nothing by themselves; all that market observers are trying to tell you is that the global economy will rebound quickly after hitting a bottom (V), linger in the bottom like a sea slug for a while and then miraculously rise up like a submarine-fired rocket (U), or most candidly among the three options, simply plunge and stay at the bottom for a while (L).

In the parlance of this group of market strategists and economists who between them couldn’t muster up the collective skills required to run a fast food franchise outlet, those three letters mean: “Please give me a bonus for 2008” (V), “Please let me keep my job for 2008” (U), and “Please don’t hurt me” (L). Put differently, these are the optimists, realists and pessimists respectively. And all three groups are wrong.

Revenge of the Y

I propose to add another letter of the alphabet into their web of misunderstanding; this may confuse some of the quacks among them, but at least a few should be able to paraphrase this article and publish it as their original thinking soon enough. The letter I have in mind is Y.

A Y-shaped recovery is much the same as a V, except there is an additional tangent from the bottom. What this means in practice is that while a few economies will recover quickly from the current mess, many others will fall by the wayside and slowly (or quickly, it doesn’t really matter) achieve irrelevance to global markets.

It may come as no surprise to readers that I expect Asia to form the upward trajectory in this scenario while much of G7 falls into the steep downward tangent envisaged by the tangent below the “V”. Before anyone starts muttering stuff about how unprecedented all this would be, perhaps they should spend some time thinking about the world economy of barely three hundred years ago. At the time, two economies between them had 50% of global GDP – these two were China and India. What happens for the next couple of decades will simply represent a return of the pendulum to produce the same outcome.

Getting into the details would require readers to understand first the question of “why a Y” and secondly, “how”.

First the question of why a Y. The Achilles’ heel of G7 economies is the financial system, which has now gone into a full-fledged deleveraging mode. Consider the following news items from the last week or so:

1. The failure of the US market for cities and townships to raise money used to pay for things like schools and hospitals (through auction rate securities, see Wealth destruction gathers pace, Asia Times Online, February 20, 2008), because US banks couldn’t find the measly few billion in capital required to support that system. This brings back memories of the aftermath of Hurricane Katrina – when a somnolent US Federal government failed to provide basic necessities to its afflicted citizens, only multiplied by a few hundred times. What this also showed is that the shortage of capital has become the chief constraint in the US financial system, and it is unfortunately not something that either the government or the Fed can do anything about.

2. Great Britain nationalized its failed lender Northern Rock after evaluating all alternatives (see Rocking the land of Poppins, Asia Times Online, September 22, 2007) and finding them overly expensive for taxpayers. In the process, the country has breached fiscal constraints and will now have to tax its citizens in an attempt to recover its financial footing; this will come at the significant cost of economic growth for years if not decades to come.

3. Market reports have cited the impending demise of a large US investment bank that has frozen part of the global derivative market as all banks attempt to quantify their exposures to the “weakest link” in their individual chains. Surprising losses reported this week by two European banks – Credit Suisse and BNP Paribas – that had previously been seen to avoid a bulk of the US problems only accentuated market fears of further write-offs.

4. Two high-profile failures in Germany – IKB and Sachsen LB – continue to haunt the European financial system as Germany has failed to find a buyer and also set the stage for other potential embarrassments such as bigger Landesbanks and commercial bank losses in the near future.

5. I really could go on and on.

To put things in perspective, all of these incidents above, with the exception of Northern Rock, are among the world’s top 100 banks. Readers may respond with – alright, we know that the global financial system is broken, but so what. The banks take losses and move on.

Well, not really. Any recovery is contingent on the emergence of alternative economic uses for assets that were previously mispriced. Think about that – when the dotcom bubble ended, the world still had Internet technology and millions of miles of optic fiber cable. That in turn created the boom in outsourcing, as well as the acceleration of price competition that sparked a global search for cheaper manufacturers that benefited Asia.

Meanwhile, what G7 had left behind was the lifestyle afforded by decades of wealth accretion from the rest of the world, even as their unit labor inputs declined sharply. The US is merely the most obvious example of this malaise, but similar trends can be seen in other countries such as the UK and Italy as well. In essence, the production systems of G7 have become extremely dependent on capital intensive processes, which are in turn dependent on the flow of financing.

This is what kills Achilles – hurting the heel (ie the weakest link in global financing leverage, in this case the US subprime sector) opens up the gush of blood straight from the heart (ie the massive storm of losses engulfing banks). The assets that caused the loss are houses in various suburban locations across various American cities. There is no productive value for these houses, and having cheap houses without any jobs around the region won’t help change population dynamics. Unable to offload these dead assets, banks cannot lend any more to companies, and without those borrowings, G7 factories will simply wilt away and die.

After the question of “Why a Y”, the question of “how” is relatively easy and has been answered above – just reverse the course for Asia and you can see the makings of a recovery. As noted above, the beneficiaries of recent real technology transfers – factories, call centers and the like – were all in emerging markets and particularly Asian countries such as China and India.

These two countries have leveraged growth into building infrastructure that can eventually support self-sustaining economies. While many other Asian countries have also benefited from these trends in the last few years, they lack the strategic depth required to make it on their own domestic consumption. This is why I believe that differentiation would become a key factor in Asian markets this year (see Storm warning for Asia, Asia Times Online, January 4, 2008).

Between them, China and India have vast ability to increase consumption and improve their living standards to what prevails in the rest of the world. One of the first things to do would be to acquire the resources required for further growth but otherwise desist from investments in the US and European financial systems, allowing banks in these countries to crumble under the weight of their own bad loans.

There are those who point out that at US$3.5 trillion between them, China and India are too small to matter against economic colossus like the US at US$11 trillion and Europe at a similar level. That view is wrong because it uses historical currency values that over-estimate the intrinsic worth of G7 economies, or more to the point diminish the GDP sizes of Asian countries.

Much like the US dollar’s bluff has been called, other “reserve” currencies such as the euro and pound sterling will fall by the wayside. The Swiss franc will survive, if only because the need for a country with a secretive banking system that helps finance one’s mistresses will never disappear, but I digress.

To achieve this separation from the continuing economic decline of the US and Europe though, China and India must cut the umbilical cord of currency pegs to the rest of the world. They must float their currencies, take the bite off the export apple but allow domestic consumption to take over as the primary driving force. Without that happening, we are going to end up looking at another letter altogether: a prolonged decline in global GDP size, or an I.