This Is Not 1929

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Lousy economics destroyed Asian and Russian financial markets. Now imploding financial markets will kill world economic growth. Next year, the world economy will shrink. Only Europe will have moderate growth. Wealth destruction will produce a growth recession in the U.S. (that's low growth with rising unemployment and excess industrial capacity). Japan will continue to emulate an economic black hole in the middle of a time warp. Emerging economies will shrink.

The recent yen boom is a thermometer of how sick the patient is and is an accurate measure of the stress in the global financial system. Japanese banks are fire-selling U.S. bonds and scrambling to bring money home as survival finance. Leveraged investors have left the field in droves. As the treasurer of one of the world's really big banks said to me recently: "The word is out--lend for leveraged investment and you're a dead man walking." And non-performing loans on emerging market debt will add to the misery by gobbling up a massive chunk of the capital of international banks. Losses in the U.S. and Japan will be less than in Europe, but in total they could potentially cause a $4 trillion contraction in lending--the equivalent of the GDP of Japan. Sure, about three to five years down the road nearly half of these bad debts may well be clawed back as banks liquidate the collateral behind them. But even so, don't think I'm underestimating the pain.

Everybody from proprietary traders in banks and investment houses to the guy with a phone in his study has imagined himself a George Soros over these last few years. They all, in one way or another, were able to leverage their investments. There's more than $1 trillion out there with investors who--let's be conservative--had "only" leveraged their bets by four to five times (not everyone can muster the collective stupidity of Long-Term Capital Management). That's two to three times the size of the U.S. equity mutual fund industry. The triple blades of capital losses, redemptions and a lenders' strike will amputate the weakest from the strong in the financial services industry.

This is a global crisis of capitalism that's pretty close to becoming a global capital crisis. Whichever way you roll the dice, one side always comes up--and it's got credit crunch written all over it. With up to 40% of the world's bank capital going up in smoke, there must be massive shrinkage of the credit in the global financial system. There is a crackpot idea germinating among certain G7 leaders that a safer world is one with capital and market controls. But capital controls would only make the capital that emerging markets need in order to grow even more scarce. So controls have the potential to tip the world into deflation, because they would quickly evolve into other forms of protectionism.

But all is not lost. This is not going to be another 1929. First, the U.S. will kill off any international attempts to introduce capital controls. And second, hefty interest rate cuts across the globe are imminent. That will save the financial system. Central bankers have now, belatedly, woken up. The recent minimal interest rate cut by the Fed was designed to help out the likes of Brazil with the intention of putting a full stop to the emerging market crisis. Now the central bankers know they must act to bail out their own banking systems. And they get paid to do something about it. Global interest rates are about to fall--and fall dramatically.

Central banks may succeed in saving the financial system. But they won't stop the global economy from going into recession. That's because, instead of Japan becoming like the rest of us, the world has now become Japan. Cheap money will not become new lending. It will find its way into nice government bonds instead. The consumer, hit by falling asset prices, won't be borrowing to spend either. On the contrary, he'll be saving. So easy money will not equal higher growth.

The U.S. will bail out the world by printing the dollars it needs to survive and pricing them low. The result is that the U.S. dollar will swim against the twin powerful currents of trade deficits and capital outflows. That spells the end of the strong dollar. Emerging markets will like a weaker, cheaper dollar. From Brasilia to Beijing it will mean a God-given monetary easing, as all these emerging market currencies usually ride with the greenback. And it's easier to climb aboard when the dollar is behaving more like a slow freight train than an express.

But the rejoicing in emerging markets won't last long. Demand for their exports in rich countries will be ghastly. And there will be no rich foreign banks knocking on the door to buy their defunct ones. They will suffer a dearth of capital which will drive a wedge between rich and poor countries again--like in the 1960s. And it will prove pretty deflationary for O.E.C.D. economies too.

It may not be 1929. But it ain't going to be pretty.