Day of truth for the markets

Today is the day the truth of the global economy has finally come out, and the markets are facing up to it with terror and trembling.

At first, a better than expected U.S. jobs report appeared to be reversing some of the week’s negative market sentiment as the Dow headed north, but that quickly proved to be just a head fake. In the first place, the numbers were only good by comparison with the really horrible ones of last week, and in the second place, the jobs numbers don’t tell you as much about the U.S. economy as the numbers for the long-term unemployed and for the proportion of the working age work force that is actually working. Those numbers are among the worst for the United States since the 1930s.

Perhaps even more important than that has been the dawning recognition that the agonizing last-minute agreement to raise the U.S. debt limit has not resolved and may actually have added to U.S. economic woes. The rush of investors into yen, Swiss francs, Canadian dollars, Israelis shekels (anything but U.S. dollars) over the past two days has been a dramatic signal that investors see the U.S. outlook as bleak and that no one believes U.S. leaders have a clue about how to run the economy or where they want America to go more generally. The debt limit debate demonstrated the rot of government dysfunction to be far more advanced that any had imagined.

Equally dysfunctional have been the leaders of the European Union whose serial announcements of one inadequate bailout agreement after another have only served to exacerbate rather than resolve doubts about the future of the euro and, indeed, of the EU itself.

A third element has been the recognition that Japan is unlikely to become a driver of growth and that a world burdened by slow growth in Japan, the EU, and the United States is unlikely to be a very dynamic place, no matter how rapid the growth in China and India. There may have been some degree of decoupling over the past decade, but not that much.

All of this is forcing a facing of realities. For nearly thirty years, the conventional story has been that the U.S. economy is flexible, dynamic, moving from strength to strength in high-tech and sophisticated global services. But now the truth is dawning that two decades of first the dot.com bubble and then the real estate and financial bubbles were simply a Potemkin village masking the chronic erosion of U.S. industrial and technological leadership and of the standard of living of the middle class. It is now becoming clear that the United States is not going to recover anytime soon and that it is in for a long battle to revitalize its restore its former economic dynamism.

In particular, it is becoming clear that to create jobs and rising wages and living standards, the United States will have to resume producing tradable goods and providing tradable services that will reduce its chronic trade deficits. This, of course, will mean a weaker dollar and a decline of U.S. consumption as a percent of the world’s total consumption. And, this, in turn will mean a wrenching readjustment of the global supply chain and of the long accepted patterns of globalization.

By the same token, Europe has reached a crossroads. If the euro and perhaps the EU as well are to survive, there must be a truly European finance system as well as a central bank. It will no longer work to have the Germans running trade surpluses while everyone else runs trade deficits in the absence of an effective system of funds transfers from surplus to deficit areas. Europe must become truly Europe, or no Europe at all.

It seems that after decades of undervaluing its currency to foster its export-led growth strategy, Japan will now finally be forced to reorient its economy toward domestic consumption by the tightening noose of the ever strengthening yen. Truly, it has been said that "those who live by the sword will die by the sword."

This is a lesson that China might do well to learn now rather than much later as in the case of Japan.