By Andy Xie, board member of Rosetta Stone Advisors Limited

A historical election has taken place in America. An African American was just elected into the White House in a landslide. The slavery of Africans was an integral part of the U.S.’s founding. Racism remains a potent force in the U.S. society.  This election is undoubtedly a milestone in the country’s progress towards a just society. Indeed, it is unimaginable that such an event could have taken place in any other nation on earth. The U.S. is mired in a financial and economic crisis and appears weak. However, we shouldn’t underestimate its capacity for renewal, as this election demonstrates.

The world is facing a leadership crisis. Government leaders around the world have performed poorly in handling the financial crisis and preventing it from becoming an economic crisis. The U.S. government has stumbled badly in dealing with the financial crisis, swinging from one extreme to another. The chaotic unwinding of Lehman Brothers amidst a huge financial crisis was tantamount to stupidity. It sparked a massive confidence crisis in the financial system that has accelerated the process of turning the financial crisis into an economic one. Despite ample warnings, European governments took too long to stabilize their banks.

Evidences of a global hard landing are piling up. It appears that the minor contractions in the third quarter turned into massive ones in the fourth quarter, possibly five to 10 times the contractions in the third quarter. In the third quarter, the U.S. economy contracted by 0.3 percent, the UK economy by 0.5 percent, and there was probably half as much contraction in the euro zone and Japan. Asian manufacturing economies mostly avoided contraction in the third quarter, probably due to export orders reflecting lagging information. Economic indicators in the fourth quarter point to far bigger contractions. For example, steel price dropped sharply, reflecting sharp drop in global demand. Shipping rates have also collapsed, suggesting contraction in global trade. The Institute for Supply Management index of U.S.’s factory activity fell to 38.9 in October from 43.5 in September. (The level of 50 separates contraction from expansion, and a reading below 40 is exceptionally weak.)

The burden for economic stimulus is on central banks at present. Virtually all the major economies have cut interest rates aggressively in the past few weeks. But the rate cuts cannot reverse the rapid economic contraction. Most analysts blame credit contraction as the cause for the economic contraction. Hence, governments around the world are trying to pressure banks to lend. Lowering rates is supposed to increase incentives for financial institutions to lend and for businesses and individuals to borrow. However, such marginal incentives cannot offset the impact of asset deflation. Property and stock markets have fallen by US$ 50 trillion worldwide. It decreases the collaterals that borrowers can pledge to banks. Hence, banks must cut lending to borrowers whose equity capital has declined so much. The negative wealth effect cuts household demand for loans; their savings preference must go up with so much wealth destruction. The economic deterioration decreases loan demand from healthy businesses that find no need for expansion. Hence, credit contraction, when a giant asset bubble deflates, is due to rational responses of both borrowers and lenders. Rate cuts cannot reverse it.

The solution is massive fiscal stimulus. Financial institutions don’t want to lend to their usual customers, as they are not credit worthy. They want to lend to governments who still are credit worthy. Households, on the hand, want to save more, reflecting the negative wealth effect. Hence, the logical solution is for governments to borrow to fund tax cuts and spending. If the wealth effect from the loss of US$ 50 trillion paper wealth is US$ 2.5 trillion, governments around the world probably need to implement stimulus of a similar magnitude.

Moreover, Asia and Europe should shoulder more burdens for fiscal stimulus. The Anglo-Saxon economies should contract their consumption to end the borrow-and-spend habit that got them into trouble in the first place. If they introduce stimulus, it should be aimed at increasing investment – e.g., infrastructure – that would expand production and, hence, income in the future.  However, fiscal stimulus wouldn’t stop their trade deficits halving or more, as rising savings and falling consumption decrease imports. That means that the surplus countries in Asia and Europe will see exports cut by US$ 500 to 1,000 billion. Unless they stimulate sufficiently to offset this reduction in external demand, they would obviously face a recession.

As argued before, lowering interest rates wouldn’t have the same effect on demand when a major asset bubble is bursting; there isn’t enough equity capital to support the existing debt level, resulting in pressure for deleveraging.  Lowering rates does enhance financial stability, as it decreases funding cost for financial institutions that carry massive problematic and illiquid assets. That’s what happened in Japan.  Its banks held vast amounts of non-performing loans for years. Low interest rate did help financial stability but also lessened incentives to clean up the balance sheets, prolonging economic stagnation.

While lower rates help financial stability, they stoke inflation. This may sound farfetched as the world is worrying about deflation again. Demand contraction undoubtedly cools inflation in the short term. However, it is temporary. Collapsing profitability causes the supply side to contract. Inflation can persist into a sluggish economy as we have seen so many times before. Sharp decreases in commodity prices, especially oil, has made people more optimistic on inflation. This view is not sound. Oil price remains close to US$ 70 per barrel in a rapidly contracting global economy. In 1998, when emerging markets went into recession but Europe and the U.S. were still growing, oil price dropped to US$ 8 per barrel. The potential is huge for oil price to rise. Labor union is another path to inflation. Inflation has eroded real wages in all OECD economies. A unionist backlash is quite possible despite rising unemployment rates. Hence, cutting interest rates carries significant inflation risk. Steepening yield curves – the gap between the yields of long term and short-term bonds – in many government bond markets suggest that markets are expecting inflation to remain high. Let it be said that there is cost to cutting interest rates.  It should be used carefully and sparingly.

Handling the current crisis is highly complicated. There are urgent issues regarding financial and economic stability, what would be the right balance between the need for stability and the pace for disposing bad assets. There is the necessity to rebalance the global economy between Anglo-Saxon economies with large trade deficits and rest of the world. There is the important task to create another growth dynamic to replace borrow-and-spend Anglo-Saxon consumption. The performance of global leaders in handling the crisis has been reactive and ad hoc. A financial crisis is a systemic crisis. It is dangerous to treat different aspects of its manifestation separately. The intellectual power of the current global leaders is focused on reforming the global financial system to prevent a future crisis. But this should be the lowest priority. After a crisis of such magnitude, another crisis is at least a decade away. There is plenty of time to focus on financial reforms later. Unfortunately, the global summit in Washington D.C. this month has taken this topic as its centerpiece. It will be a waste of time. Indeed, considering how soon the Bush Administration ends, the world should wait for the Obama Administration to host the summit in January 2009.

Will an Obama Administration improve the situation? First off – it can’t be worse. It is hard to imagine that the new U.S. government could perform worse than the current one. Its regulators pandered to the Wall Street and didn’t focus on risk control. When the crisis began, it tried to make a few deals to make the problem go away. Greenspan is the guiltiest for the current crisis for its liquidity policy. The Bush Administration is the second.

What gives me comfort about Obama is what sort of people he has chosen to surround himself. Paul Volcker and Warren Buffett, whom I respect most in the financial world, are his advisors. They are common-sense people. Too many experts believe in theories without understanding their limitations and can get sucked into believing in a free lunch. That is what makes a bubble. Every bubble is some new object, theory, or phenomenon that promises a free lunch. A person like Warren Buffett or Paul Volcker would never get sucked into one.

Barack Obama has impressed me in his two years of campaigning. The U.S.’s long election process serves the purpose of allowing people to watch how candidates respond to adversities. Obama has shown incredible self control in all circumstances and the ability to optimize at any point of time. He is a sharp contrast to the baby boomers like Clinton and Bush, who are narcissistic and self-righteous, and have a tendency to wallow in self-pity under adversity. The parents of the baby boomers like Bush Senior are considered the greatest generation in the U.S.’s history. They grew up during the Great Depression, won the Second World War, came home to build the economy, and broke the Soviet Union during the Cold War. Their children protested against the Vietnam War in 1960s, became MBA’s or lawyers in the 1970s, climbed the corporate ladder in the 1980s, and came to power after the Cold War in the 1990s. They used their power to make one bubble after another for a good time. Under their reign a shopping trip became the ultimate purpose in life. One thing that American voters did right in this election was to elect someone from the next generation.

Obama’s choice of the Treasury Secretary is so critical to the global economy. Unfortunately, I think he may pick someone from the Clinton Administration who, like Greenspan, believes in liquidity. Financial markets worship liquidity like free money. In reality, liquidity is short-term debt. When a central bank boosts liquidity, it works through encouraging investors to borrow more. When investors borrow more to purchase risk assets, asset prices appreciate. The wealth effect boosts economic activities. The dirty secret is that liquidity works through creating bubbles. When it is used repeatedly, it leads to a huge bubble. The crash would cause catastrophe like what the world is facing now.

After a huge bubble bursts, cutting interest rate or boosting liquidity can stabilize financial system. But, it would be a mistake to use it to boost economy like under normal circumstances. There is no debt appetite or capacity to take on more in the real economy. Excessive monetary expansion could trigger inflation, i.e., money supply would go straight into rising prices. I am afraid that picking a liquidity believer for the Treasury Secretary is dangerous. Hopefully, Warren Buffett and Paul Volcker will always be there to bring common sense to Obama’s economic policies.

As soon as he takes over, he will be facing new crises. The U.S.’s auto sector may finally collapse. It has been in trouble for three decades and has survived on credit. The credit crisis is cutting off its money flow. The economic crisis and high oil price are destroying its sales. The failing automakers are talking about mergers. The purpose is probably to create a behemoth too big to fail. It’s not clear that the U.S. auto sector should be saved. Its managers have not solved their competitiveness problem and have depended on accounting tricks and gas guzzling SUVs to stay alive. If Obama chooses to use taxpayers’ money to keep it alive, it only gives incentive to other industries to beg for money from the government.

The U.S.’s under-funded pension industry could slump into crisis soon. The sharp fall in stock market has exposed the problems in this industry. For too long the U.S. industries have relied on stock market appreciation to shoulder their pension burden. The market collapse forces the issue on them when they are least able to deal with it. The total pension liability is US$ 12.2 trillion. How much of it has been lost in the market crash or the credit crisis? It must be a large number.

Then, there is US$ 2-trillion fiscal deficit to fund in 2009, nearly one fifth of the outstanding amount. The U.S. is dependent on foreign money to fund its treasury issuances. How would the world have the confidence to fund so much? The poor economy guarantees large deficit to last and the treasury supplies to remain high. If there is a confidence crisis among foreigners, the U.S. treasury market could crash like the stock market now.

Barack Obama is facing the biggest challenges since Franklin Roosevelt became President in 1932. In a way, Obama’s job may be tougher. When Roosevelt took over, the U.S. had savings surplus. He could just borrow at low interest rate to boost fiscal spending. Even with the sharp consumption decline the U.S. will likely remain a savings deficit country. Hence, Obama’s fiscal policy must consider foreigners’ confidence.

With all the trillion dollar crises ahead, maybe the only solution is printing money. The Fed can just print enough money to fund everything. Of course, the bond market and the dollar will drop sharply in anticipation of inflation. The U.S. government, businesses, and households could all refinance their debts at short end to benefit from the Fed’s low interest rate. Overtime, the debt is inflated away. It seems that stagflation may be the only way out.

Obama may be smart. But the problems may be too big for him. Printing money may be the only option left. You should sell the U.S. treasuries.