Emerging Market Chaos shows problems are not just from American mortgages

Go listen to the Giant Pool of Money again.

There has been an excess of leverage in almost every sector of the global economy. Deleveraging will be painful and after an initial deflation risk, central bankers will likely try to inflate the economy out of the crisis. Yes, inflation is coming. Probably not too bad, but three years of inflation at 5-6% in the United States would not surprise me.

Some countries are in trouble because, even though they have accumulated currency reserves, their private sectors borrowed in dollars. They borrowed in dollars because interest rates were low and in recent times, the dollar was weakening. This was very successful in recent times as the dollar was weak and emerging market firms had access to very cheap capital.

Now, the world's risk appetite has collapsed -- so emerging market currencies are crashing and that cheap capital is now extremely expensive in local currencies. The government can try to defend their currencies by selling dollars, but their power to do this is dictated by the amount of reserves they hold. So, China, with about a year's GDP of dollars, can fully defend their currency (yes, I know the RMB does not float, a fact that depends on China's reserves.) Other countries are much less able to.

The difference with 1997 is that these economies cannot export their way out of the mess. The developed economies are in recession. So, emerging economies are going to have to develop local demand. That's going to be hard.