US economy entered yet another soft patch around July-2011. The soft patch was followed by one of the most unprecedented events in world economic history on August 5, 2011– S&P downgrading US credit rating. After all it was only on Aug 2, 2011 that US Congress revised its debt ceiling upwards and most expected the downgrade will not happen in immediate future.

This downgrade coupled with weak economic data led to complete chaos with bloodbath all around the world markets. The pace of events was unsettling as most felt that markets were better prepared for any crisis after witnessing the Lehman and European debt crisis. However, what markets got was completely a different scenario of collapsing markets and re-emergence of another Lehman moment. From the optimism in early part of the year, another round of doom has set in. This time the situation is even bleaker as in Lehman, government took over the firefighting mode. This time with several major economies facing sovereign debt crisis and having no ammunition, one is wondering who will play the firefighting role?

Given this background, markets are into a highly uncertain territory. The markets are again witnessing a rush for safe haven avenues. Equities and risky assets are out of portfolios and investments in fixed income markets and precious commodities have increased. Gold becomes the natural choice in such a case with prices crossing levels which most thought were unsustainable. Is the case with Silver though the shine is more in Gold as of now. The yields of US Treasuries have eased considerably despite downgrade continuing the preference of US Treasuries as a safe haven investment. This was something seen similar in Japan as well where yields of Japanese bond eased and remain low. Another interesting development was currencies becoming safe haven investments.

Lately, investors have taken large exposures in currencies like Swiss Franc, Yen etc and expect to make returns through its continued appreciation. Investors deem Swiss economy as stable with lower debts and well developed financial system. So much so, the appreciation forced Swiss National Bank to lower its policy rate further from a range of 0-0.75% to 0-0.25% and also intervene in currency markets. Bank of Japan has also been intervening in the currency market to prevent appreciation of Yen. This has again renewed concerns over currency wars as policymakers prefer to keep their currencies undervalued.

Apart from market movements, the bigger worry is how one comes out of this global crisis. It was just one Japan till 2007 with zero rates and persistent weak economy. And now we have multiple Japanese kind of economies like UK, US and even Euroarea. Japanese policymakers once said that best way to come out of such crisis is not to have one at the first place. This option is not available to these economies anymore and now we have an unusual situation of having most major economies in a precarious position.

Ken Rogoff of Harvard University has recently argued that our assessment of this crisis has been wrong all along. He says it is not a typical recession of business cycles and unemployment but also includes issues like credit and debt. Hence the policy solutions of monetary and fiscal policy easing are going to be ineffective. Infact, fiscal policy expansion actually makes things worse as government debt levels rise even more. The crisis would imply economies will have to undertake balance sheet adjustment which is both painful and cumbersome. He suggests other radical options like inflating debt and financial repression. Inflating debt implies countries adopt higher inflation targets so real values of debt declines overtime. Financial repression implies banks are forced to buy government debt and interestingly some countries like UK have already adopted them using different names.

Both these radical solutions are not going to be acceptable leaving painful balance sheet adjustment as the only option. Japan could not adjust in period of high global growth during 1992-07 making it even more difficult for others to adjust in what looks like weak global growth in the future. Till then, we are likely to have few more Lehman moments on the way.

by Amol Agrawal
Amol Agrawal is an economist and blogs at Mostly Economics (http://mostlyeconomics.wordpress.com)