We are living through history breezing past us without speed-limits. A nation that was heralded as the undisputed and sole super power till about a few weeks ago is now on the verge of an unprecedented economic collapse. So much so that even US President George W Bush, who routinely assured "our economy is fundamentally strong,” has now, stopped using such phrases and is busy planning mega-bailouts and now talks about a recession. Comrades-in-bazookas, Bernanke and Paulson, who have both been stating under oath for the last two years about the housing market, banking institutions and the economy being on strong foundations, are now talking about a ‘financial meltdown!’

It must indeed be astonishing to most observers of such frenetic pace of events unfolding as to how fundamentals can change so dramatically over such a short period of time. I would, however, say that it hasn't changed at all; the fundamentals of the US economy are terrible and have been terrible for almost a couple of decades now. The housing debacle is just the proverbial straw that broke the camel's back. Subprime was the pin that pricked the US bubble economy.

Spending one’s way to prosperity...

What makes an economy strong is the ability to save, invest and produce. It is the productive capacity of an economy that gives the purchasing power to a nation's citizens lifting their standards of living. Consequently, the way to achieve prosperity should be obvious - greater savings, investments and production.

But US has had neither savings (negative savings rate for the last two decades), nor adequate production (increasing trade deficits for the last three decades). So how is it that the US has seemingly increased its prosperity over the same period? The answer lies in the status of the US dollar as the world's reserve currency that allowed its citizens to borrow and consume with impunity at least till now. In some sense, this is not different from the concept of vendor financing where a company lends money to its customers for purchasing its products. It never works in the long run.

The US borrows not to build but to consume...

Most economists would tell you that US has continued to run current account deficits for the last two hundred years and hence such deficits can exist indefinitely. The argument misses a crucial difference between borrowing to invest (resulting in trade surpluses) and borrowing to consume (leading to trade deficits). When America as a developing nation borrowed, it did so to build infrastructure and capital equipment. These actions ultimately enabled the production of consumer goods and thus retire the debt through exports to creditors. In stark contrast, America today borrows to consume. Lenders should be worried about even the return of capital, let alone return on capital.

Free fall of the dollar...

It is not that the symptoms of the above disease were not obvious - we just chose to ignore the same. Due to the continuing trade deficits that now are close to $800 billion per year, the US dollar has substantially weakened against most currencies and, even more dramatically against commodities, over the last few years. But why did the currency depreciation not result in reduced trade deficits as one would usually expect under such a scenario?

The US government, through the Federal Reserve, encouraged the practice of borrowing to spend by keeping the interest rates well below the rates of inflation that destroyed any incentives to save. All the while foreigners were happy to absorb all the inflation created by the US Fed due to benign commodity prices. Today however, not only are these creditors feeling the pinch of supporting the US dollar due to rising commodity prices, but with the collapse of the housing bubble, the principal itself seems to be at risk. The fact that the US consumers can no longer borrow to support their lifestyle is the change that has now happened. Or in other words, the problems faced by Wall Street are merely reflective of the problems in Main Street. The famed American consumer is broke and thus it is only a matter of time before the problem spreads to other sectors of the US economy such as retailing, autos, airlines...

What happens to the rest of the world?

Very much unlike the problems of Wall Street, the problems faced by financial institutions outside of US are because they lent money to US and not because their own economies are in bad shape. While these bad debts have to be written off, it is a one-time event and not a structural problem as is the case for US banks. While this does not preclude any of the non-US banks from going bankrupt, the other economies are fundamentally sound and it's only a matter of time before the required adjustments happen. The financial decoupling will happen sooner rather than later, perhaps with a few bumps along the way.

A much bigger bogey, but in reality a non-event , is the issue of US consumption. It is commonly believed that it is the US consumption which is the driver of global growth and hence a recession in the US would cripple the rest of the world as well. Nothing could be farther from the truth: the very driver of economic growth is production and not consumption. There is no reason that the billion plus Chinese cannot consume the toys, candles and apparel that are exported to the US today. It is just that the purchasing power of these deserving consumers have been suppressed by the government trying to prop up the US dollar. As soon as these currencies are allowed to appreciate at much faster rates as compared to the last few years, consumption can easily be transferred across to the legitimate owners ie. the producers. So the economic decoupling can and will happen much faster.

When that happens the world (and perhaps more importantly, the Central bankers who have as a community propped up the US dollar to the detriment of their own citizens) would realize that as far as global growth is concerned, the US is not the engine, but the caboose.

The road ahead for US...

Not exactly the auto bahn. The US has to transform itself from a nation that borrows for consumption to one that saves for production. Given that consumption accounts for nearly 72 per cent of the US GDP, the immediate implication is a very deep recession. A recession is thus a market way of cleansing the excesses built in an economy during the boom period so that the subsequent growth can start from a more solid foundation. The recession in our particular scenario is thus the medicine to the disease of overconsumption.

And it is exactly this recession that the US government is trying to prevent (or in reality, postpone). Every package that is proposed, whether it is the bailing out of Bear Stearns, the nationalisation of Fannie&Freddie or the $700b bailout plan, would result in perpetuating the malinvestments rather than allowing the inflated asset prices to settle down to more reasonable market levels. Even if the US government were to succeed in their attempt to postpone the recession, and chances are very remote that they would, there is a heavy price to be paid today in the form of inflation.

Re-living the 1930s years of the Great Depression

In some sense, we are just re-living the 1930s in which the US Fed blew up the stock market bubble during the 1920s resulting in the subsequent stock market crash of 1929. As a response to the market crash, we witnessed the Hoover administration (and later Roosevelt as well) enact the New Deal interfering in the market wage/price adjustment process and thus managed to convert what ought to have been a short, but severe recession into the prolonged Great Depression. Compared to the 1930s,the economic fundamentals of the US today are much worse. Adjustments required are thus much greater. Monetary policy is in the hands of helicopter Ben now as compared to the quasi-Gold standard during the 1930s and the politicians at the helm promise even greater anti-market policies as compared to what Hoover did. What else other than a Greater Depression could be the outcome?

What exactly are the timeframes that we are talking about for the setting in of the Greater Depression? In the previous scenario, though the stock market crash happened in 1929, it took another four years for the Great Depression to set in. This time around, given that the fundamentals are much worse and the political/monetary responses are likely to be even worse, we may not require four years. Perhaps, a year or two into the new Presidency is all that would be required!

RBI - stop playing Santa Claus!

Our Central Bank, the RBI, has always played a subservient role to its political masters. This is true not just for the last few years, but for much of the last 60 years. This has allowed the political masters to play the game of redistributing wealth to the various communities and special interest groups in the form of subsidies through deficit spending.

Ofcourse, the RBI has two other stakeholders (though vastly subservient to their main stakeholder ie. political masters) to serve as well: the society at large that suffers directly as a consequence of the above mentioned currency debasement resulting in higher consumer prices and exporters who start clamoring for debasement at the slightest appreciation of the currency.

But it's time that the RBI realized that there is only one true God as far as economics is concerned and that is Mr.Market. So while the RBI can play Santa Claus with its stakeholders in the short run, ultimately the fundamentals come to assert themselves. Given the prognosis for the US dollar, if the RBI continues to debase the Indian rupee to satisfy short-term interests, the consequences are going to be disastrous for the Indian economy over the next few years. The problem of inflation is going to be so daunting over the next few years that it may not even be a bad idea for the RBI to restrict its objective to the sole purpose of achieving monetary integrity.

In terms of the foreign exchange reserves of $300b that the RBI is currently holding, it should be easy for the RBI to recognise that these could easily turn out to be mere pieces of papers in short order (after all the US Fed is playing the same game in the US that the RBI is playing in India). So, the RBI should divest its dollar holdings almost entirely and convert it to a basket of hard currencies-or still better, entirely into the free market currency of gold!

Indian industry - what to do?

The choice here is easy - Indian industry can either pretend that the worst is behind us and watch US follow the route of Weimar Republic or start meaningful action to protect its interests.

While the predominant issue is that of massive inflation in the US dollar, there still exists a similar problem (albeit on a vastly reduced scale) with the other currencies as well. This is going to result in a situation of increasing raw material prices for the next decade or so. Hence, getting into long-term price contracts without providing for the uptrend in commodity prices could prove disastrous. While this concept is extremely important for exporters who price their contracts in US dollars, this is also true for contracts in other currencies or even for entirely domestic industries as well. For example, what about subscriptions to a business magazine that promises delivery at a specified price for the next five years when the cost of their production and distribution sky-rockets?

The vanishing markets angle...

For sure, the US market is set to reduce dramatically in size and even more so in terms of profitability for the Indian companies. I cannot envisage a situation where a company or an industry thrives when their customer is going broke. For a lot of exporters to the US (ie. consumables, building construction materials/services, auto-components, etc.), there may be a replacement market in the Middle-east or in China. Though the business conditions and profitability could be vastly different, the markets for the products and services still exist and so it would be a question of re-orientation of corporate marketing, selling and production strategies.

But for another class of industries (software, BPO,etc.), the existing markets for their services could literally vanish overnight. It would not be very easy for these companies, who have been used to a cushy operating margin (ie. charging $25 an hour for the work of a rookie software engineer who gets paid $250 a month) to change their strategies and start working with markets driven by a different set of dynamics. There would be great consolidation in this industry and ultimately they would get used to working with much less margins as compared to their historical past.

Ironically, the greatest beneficiaries of the inflation created around the world would not be the so-called knowledge-based Industries, but the producers of the basic commodities - especially in the space of energy and food. Maybe, over the next decade we will witness 29-year old farmers driving Maseratis!