Unwinding asset and credit bubbles

Asset values will decline substantially. Share prices have already taken big hits, but there are more to come. Commodity prices have been booming but these will be replaced by falls. House prices are already falling in the US economy but this will spread globally.

"Mortgage stress" will decline as average house prices fall faster than average incomes decline. Mortgage stress will be acute for those people who geared up to buy expensive houses only to lose their jobs and remain unemployed, or are re-employed only at vastly lower salaries.

Vast fortunes will be lost, or at least substantially dented.

Vast fortunes will be made by those lucky enough or shrewd enough to buy at firesale prices. The patience to wait will be a vital ingredient of what comes to be seen as shrewdness or luck.

Goods and services (CPI) inflation is likely to rise as a consequence of financial bailout, and this will be one of the factors eroding asset values and the real value of outstanding credit.

As to severity:

The great depression of the 1930s was studied by Ben Bernanke, who is therefore well placed to avoid the mistakes of the late 1920s and early 1930s. But Bernanke's balance sheet is limited. Is Hank Paulson smart enough to embrace the bail-out that is needed, however unpalatable this is to old-fashioned fire and brimstone managers?

The US economy is already in recession. The Japanese economy remained in recession for the best part of two decades when its great asset and credit bubble burst. The US economy is far more flexible than the Japanese economy, so recovery should be quicker.

Can China, India and the fast growing economies of Asia weather the storm? This will determine the severity of the global adjustment and how the global adjustment effects the Australian economy. China is already suffering inflation (a marked turn-around from recent deflation), substantial environmental damage and a restive population seeking greater political freedom.

Australia is well placed to avoid the worst of the adjustment process. We will do better the faster we embrace restraint. Restraint of wage and price inflation, restraint in growth of government generally and restraint in growth of credit.