Friday, January 2, 2009

The Debts of a Nation: Looking Forward Into 2009

Markets were already pricing in a mild recession in late August 2008. This was a KNOWN certainty. BUT, they were not pricing in UNKNOWN certainties, e.g. the collapse of the credit markets caused by Lehman's bankruptcy.

Earlier this fall trading systems were (and to my knowledge still are) based on quantitative risk modeling and other bs economic theories invented by ivory tower academics.

That complacency was shattered when Paulson and Bernanke allowed LEH to fail. Their theoreticians had assured them that the damage could be contained. But they were wrong.

Their parameters contained a genteel, orderly world that its participants had navigated successfully for generations. The foundations were established in the virile youth of early 20th century America when the Federal Reserve was founded as America's 3rd Central Bank. It was a system that many assumed was fundamentally sound.

But nothing lasts forever. Successive crises since the Federal Reserve's founding (World War II, Bretton Woods I, Bretton Woods II, Soviet collapse, Asian Flu, and Dot Com implosion) were merely band-aids applied to the festering rot at the core of the world's largest nation.

America had transformed from a net creditor into a net debtor. And in that transformation, America also turned from an idealistic capitalist into a machine continually searching for new ways to refinance its debt. . . .at any cost.

US policymakers rely on the assumption that foreigners in developing nations will continue to lend funds despite lower returns. This assumption is a monetary fiction that severely distorts risk premiums and encourages exchange rate anamolies. The excess liquidity present in the US only accelerates economic problems.

More than a decade ago, when financial crisis spread from Thailand to South Korea to Russia and Brazil, the unifying thread was that these emerging markets had borrowed heavily in dollars. Declines in their own currencies increased the burden of repaying these debts. Severe austerity measures were imposed by their creditors, a cabal of Western bankers that syndicated loan repayments through transnational organizations such as the IMF and World Bank. Developing nations suffered bankruptcies, high taxes, and massive civil unrest. Under the repayment terms, debtor governments were forced to ruthlessly cut essential social entitlement programs and privatize state owned industries (which often employed large segments of the population) at deep discounts to international creditors.

Might we see the tables turned? Perhaps.

2009 will be the year of unknown risks surfacing. The majority of market pundits continue to operate under the assumption that all known risks have been contained. They still believe that the system's parameters can sufficiently contain the world's credit problems. They still continue to believe in the debts of a nation.