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Time to Face the Facts, Not Turn Inward


America seems unwilling to accept and face conditions as they are, which is the first of many steps to healing the wounds.

Editors Note: This article was written by Andrew Jeffery of the Minyanville Editorial Staff, author of Explaining Decoupling the Markets and Mozilo Misses the Mark.

"We have met the enemy and he is us."
- Walt Kelly

The Wall Street Journal reports that Americans are becoming increasingly anti-global as fears about a weak economy breathe life into a dangerous xenophobia. This protectionist rhetoric threatens not only our leading position in the world economy, but our already tenuous relationship with the very entity currently keeping our economy and financial system afloat: the rest of the world.

The unencumbered flow of capital and goods across borders has led to a widespread increase in the standard of living for much of the developed world. Emerging economies have pumped out goods at an ever-faster rate in an attempt keep up with seemingly endless world demand driven by the American consumer's thirst for stuff. However, a breaking wave of unsustainable debt-induced expansion and a mispricing of risk has crept out of the realm of the esoteric and into the mainstream.

As the U.S. domestic economy has slowed in real terms, a weaker dollar has boosted profits for firms doing business overseas. Central bank intervention, multinationals' earnings growth driven by sales in non-dollar currencies and an underlying foreign bid for U.S. equities have thus far propped up stock market indices, which remain close to all-time highs despite turmoil in the credit markets. The weak dollar has also made U.S. goods more attractive to foreign purchasers as exports have made up for slackening consumer demand and slowing job creation. Until recently a glut of cheap labor in countries like China and India has kept upward price pressure in check, allowing Americans to continue servicing the ballooning debt.

Precisely at the time the United States should be grateful to foreign countries for keeping the floodwaters at bay and welcome economic support in the form of free trade and capital investments, Americans are turning inward. This perpetual state of denial, the refusal to admit that the U.S. is on the brink of something far more serious than most imagine is the single biggest risk facing economic health of the country. America seems unwilling to accept and face conditions as they are, which is the first of many steps to healing wounds. Ignoring this problem will not make it disappear; the wave is already on the way.

Pundits call this a crisis of confidence, claiming that fear has exaggerated concerns over the health of the economy. Fear there is aplenty, and for good reason.

Growth spurred by cheap financing has been the universal enabler of the massive global boom from Buenos Aires to Shanghai, while low nominal interest rates and strong economies kept defaults on borrowing at historically low levels. Hunger for additional yield coupled with creative leverage pushed down risk premiums, meaning investors were less and less compensated for sticking their necks out further and further. Risk was sliced up and spread around the world so no one institution would be left holding the bag when the game was up, with the belief that the system as a whole would be stronger for the effort.

Unfortunately for those who believed the hype, this thesis has been proven a fallacy. Transparency turned opaque this summer, and the fingers of what began as a subprime malaise spread into the most unexpected places. A German bank nearly went bust, teachers in Florida chewed through their nails on payday, and a fast food chain took losses on something called a 'swap.'

That central bankers and Treasury secretaries once called the subprime problem 'contained' is laughable, since the manifestation of a massive debt and derivative bubble was exactly that, a manifestation. Loose underwriting, under-priced risk and overzealous lending were not unique to the world of subprime residential mortgages. Private equity 'bridge' and 'covenant-lite' loans, no-money-down auto lending, unsecured personal lines of credit, and $500 trillion in financial derivatives are evidence that banks are in over their skis, overextended to the point of insolvency.

Lending on a worldwide scale is grinding to a halt as the banking system's collective capital base is eroded by writedowns on no longer obscure structured debt. As capital decreases and balance sheets shrink, the extension of new loans slows while banks scramble to maintain capital ratios both internally and externally mandated.

Growth – dependent on easy money to maintain its frenetic pace – is slowing and with it the demand for goods, now more expensive after years of unsustainable demand. This is stagflation, lower growth and higher prices.

Less demand for more expensive goods leads to fewer purchases, and the purveyors of goods will cut jobs. People without jobs have less money to spend, and those same purveyors will then be forced to cut prices or face bankruptcy. This is deflation. Deflation begets lower prices, not the other way around.

And meanwhile, as the financial crisis unfolds, regulators, politicians, and even banks themselves bury their heads in the sand. For months banks cried "no exposure!" only to write down tens of billions of dollars. The Fed vows action and readiness, meanwhile announcing solutions that fail and fade while behind the scenes the invisible hand doles out periodic doses of meager support to the markets for money, a lifeline to an addicted patient.

These piecemeal solutions simply prolong the pain. Reconstructing the banking system, measures aimed at decreasing rather than stabilizing home prices, and an orderly unwind of the derivative markets may be tough pills to swallow, but such are the drastic steps needed to fix a drastic problem.

So far, acting in their own best interest, China, Singapore and the UAE have come to the rescue of firms like Morgan Stanley (MS), UBS (UBS), and Citigroup (C) to prop up American equity markets.

So far, foreign governments have been reticent to unload their dollar reserves, lest they ignite of a complete meltdown of the world's 'safest' currency.

So far, red-hot economies have kept in inflation in check.

The United States is on the leading edge, the crest of a rogue wave about to break. Some saw it coming on the horizon, but the country acted too late to make it past the impact zone. In an election year, on the verge of recession, with policymakers set to pander to Americans' inclination for pushing off blame to the most convenient scapegoat, we face a choice as a nation: act bravely now, or maintain the status quo of self-interested denial and eventually realize there's no one left to blame.
No positions in stocks mentioned.

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