Economic turbulence provides opportune time to administer painful remedies

Oil's continued decline appears to have given rise to a false dawn, a hope that somehow the West's insatiable demand and the East's unstoppable growth are going to suffer a significant and lasting decline. This doesn't square with the new optimism the dollar rally has sparked in US assets. What's even odder is how traders are interpreting this as positive for transportation stocks. If demand for oil is falling, it would be because people are travelling less, not returning to the skies. And if they're packing their bags, then oil prices should stop falling and start to rise. The long-term argument for high commodity prices holds. Certainly $150/barrel might be excessively high, but the sudden vacuum in oil seems equally irrational. The market has a short memory; it tends to focus on short-term developments, not the long-term economic shift. If anything, the continued erosion of credit argues for higher inflation and commodities prices as the value of money falls. Defaults continue to spread across different classes of credit products, the latest being securities backed by consumer loans and credit cards. At risk is a truly titanic number of credit derivatives held globally by a wide range of financial institutions. As the damage continues to ripple outward beyond the US, we will see fluctuations in currency values and shifts of money back into the US despite the dim outlook there. But these should not be mistaken for a reversal in the crisis itself. The only reliable indicator that health is being restored to the credit market would be shrinking default swaps and lower volatility. As far as I can tell, that is a long way off. Some economists argue that we are in for a global recession in 2009. But even that gloomy prognosis recognises that the emerging markets will still manage growth of six per cent and better. Economists parsing China's export data say it they are not seeing the much ballyhooed slowdown in the country's output. We may see the decouplers regain confidence by year's end if that's the case. So what's going to happen? As best as I can tell from contending theories, odds are best for emerging markets and the Gulf to suffer significantly slower growth and a painful tightening of credit. But this does not mean they will slip into recession. Rather, the internal dynamism of their economies and the emergence of their middle class will continue to lead them forward at a slower rate of growth into 2010. Just how well they can weather the storm, and how healthy they'll emerge, will depend on using this period as the catalyst to adopt painful and sometimes destabilising reforms, both to their currency regimes, to subsidies and incentives. If done right, this should shake the economic establishment to its core. The risk is that these transformations, and tougher economic conditions overall, heighten political pressure. The risks of event shocks like Russia's attack of Georgia, remain high. @Email:[e-mail]