The Fed and the Treasury know they have limited tools to fight deflation and this is why they always want to err on the side of inflation.  Once the economy slips into deflation, the cycle is difficult to stop.   As prices drop, consumers and corporations postpone spending as they expect prices to drop further and are concerned about the future.  The savings rate goes up, which normally would be a good thing, but it causes the velocity of money to drop, and the money supply shrinks.  Unemployment goes up, the economy slows down even more, corporate and consumer spending declines further – the vicious cycle keeps repeating. 

The Fed and the Treasury know this quite well, Bernanke is an expert on the Great Depression; to fight this they are using every weapon in their arsenal and are inventing new ones every day.  Ben and Hank declared global war on deflation and they’ll likely succeed even if it will cause inflation to go up in the long-run, once credit stabilizes. 

The immediate concern is deflation.  We should not be concerned about inflation at least for awhile.  It is very hard to have inflation when the banks won’t lend money and their capital base is shrinking.  Also, it is unlikely that the $700 billion plan will be inflationary, as the Fed is swapping government for corporate debt. 

But the rest is uncertain.  It is very likely that bad debt will need to be socialized to avoid the Great Recession.  In other words taxpayers will carry the burden of losses in the financial system and of the stimulus packages that will be announced very soon.  This will bring higher taxation and higher interest rates in the future, which will dampen the growth rate of the economy after the financial crisis passes.  A likely price for today’s government intervention is slower economic growth in the future.

In any scenario it will be hard to avoid higher unemployment in the US as, up until today, the US economy was geared for growth.  Increased unemployment will add another level of stress to the issue of bad debt on the government’s books.  In the semi-normal recession scenario, unemployment will be at more acceptable ranges, much lower than in case of the Great Recession.  (Of course, “acceptable” is a very subjective word and it is only “acceptable” if you are not the one losing the job.  Paraphrasing Ronald Reagan – a recession is when your neighbor losses a job, depression when you lose a job.) 

In looking at the external consequences of a global recession, I prefer to divide the world into four broad categories of countries: the US, Europe (and other developed countries), emerging markets, and commodity exporting nations (Russia and the Mideast).

As I mentioned before, the US will fare the best on a relative scale, because we are diversified.  Despite the socialism which has transpired through the various bailout initiatives, we are still a capitalistic economy.  Our capitalistic DNA will be only slightly (and hopefully only temporarily) diluted with socialism. 

Europe is in a very interesting situation, one which will test the stability of the European Union (EU) and the long-term survivability of the euro.  The EU consists of countries with strikingly different histories.  Some have experienced runaway inflation and, for this reason, countries like Germany are very cautious about increasing monetary supply.  To fight today’s financial crisis some countries will want to increase the money supply, and this will pit countries against one another.  This also makes me less bullish on the euro.

Russia and the Middle East benefited from high commodity prices. If you look at Russia, for instance, the return on capital in oil- and commodity-related industries was much higher than in any other industry.  This siphoned capital from other industries, which caused investments in these industries to decline.  To make things worse, the rise of commodity exports drove up the Russian currency, making non-commodity industries even less competitive in the world market.  Once you take high commodity prices away, Russia is worse off than it was before.  On top of this, when Russia did well, it acceded to pressures to increase social programs. (In case of Middle East, they embarked on ambitious construction projects, like building a brand new city with a zero carbon footprint in the United Arab Emirates).   Russia has created a stabilization fund (a super savings account), but I am not sure how long this fund will last.  Russia is strong on a balance sheet basis, but that is a reflection of the past.  The future, as reflected in its future income statements, looks horrible.  To some degree it is almost a mirror image of the US – our balance sheet is weaker but our earnings power is strong.

The Middle East is a very similar story to Russia - with a twist.  It benefited from oil prices and spent a lot on infrastructure, like building out new cities.  My concern is that terrorism came mostly from the Middle East, and I am unsure what will happen when poverty levels go up in these countries.

In the emerging markets, the story begins with China, whose plight I compare to Starbucks. Starbucks grew fast for a long time and got very big.  But in the late stages of that growth, the quality of growth declined.  Instead of opening two stores a day they opened five stores a day.  In the later stages of growth, management could not keep with such a high growth rate - management decision quality deteriorated.  They opened stores on the wrong side of the street, hired the wrong people, and paid too much for leases. 

They realized their mistakes and went back and closed some stores.  The lesson is that when you grow fast, the quality of growth at the late stage is not good. 

Starbucks is providing us an insight of what is going on in China, but on a much greater scale.  China is moving toward capitalism, but they are not there yet.  It has grown at 10% for 10 years and, thus, the quality of growth has very likely suffered.  For instance, they built the biggest shopping mall in the world, yet it is empty.  There is a huge amount of bad debt in the Chinese economy.  It is very difficult to see where bad management decisions will show up, but some are surfacing.  They only show up when growth slows down, both in China and the rest of the world.  Last month, for the first time in 26 years, Japan became a net importer.  This was because the US and European demand declined.  It foretells the fate of China, whose exports will dry up very fast. 

The Chinese economy is geared for much higher growth.  It is like the bus from the movie Speed, which must go at 55mph or else it will explode.  When an economy grows so fast for so long, all decisions are factored into that growth.  Companies build factories sized for five year growth projections. If growth slows down to 5%, China will have 25% over capacity.  Remember that over last 15-25 years, the US had a lot of manufacturing taken over by China.  Now, in the US and the developed markets, factories make up 18-25% of the economy, but in China it is close to 50%.  A global slowdown has a much greater impact in China. 

China has higher operational leverage and financial leverage.  When sales growth slows down, margins and profits will collapse.  As the global economy slows down to a couple of percentage points, for China it will be the equivalent of negative growth in the developed markets.

If the quality of decisions was poor, their consequences will be even greater.  Overcapacity and leverage will accelerate the impact of a global recession for China.