As the recovery (or at least the first signs of one) confirms, the focus of the attention moved from checking whether the stimulus would be enough to kick-start the economic activity to checking how to pull it “out of the system” without killing the economy in the process.
Andy Xie thus proposes an analysis of the pitfalls of pulling out the stimulus. In essence, his argument runs that the excess liquidity is liable to create inflation, as that is the only acceptable alternative to deleveraging by bankruptcy.
(…)
Financial markets had been chattering about economic stimuli exits for about a month before Canberra’s move. The consensus was that central banks would keep rates extremely low through 2010, and possibly beyond, on grounds that the economic recovery is still shaky.
Central banks also have been discussing the subject. Their messages are, first, that they know how to exit and will exit before inflation becomes a problem and, second, that they don’t see the need to exit anytime soon. They try to assure bond inventors not to worry about their holdings, despite low bond yields, while trying to persuade stock investors they need not worry about high stock prices, as liquidity will remain strong for the foreseeable future. So far, central banks have made both groups happy. But Australia’s action is likely to raise concern among financial investors who hold expensive stocks and bonds.
Each economy will exit at its own pace, according to local conditions. First, the United States and Britain, where property bubbles have burst and could not be revived through low interest rates, will increase rates next year at a pace in line with the speed of inflation expectation. Their goal is to keep real interest rates as low as possible to support financial institutions still sitting on mountains of bad assets. They don’t want to stop inflation, but want to limit the pace of its increase. Through low real interest rates, their economies could decrease debt leverage. I think the Fed would raise interest rate by 100 bps in 2010, 150 bps in 2011, and 200 bps in 2012. The United States could be stuck with an inflation rate of 4 to 5 percent by 2012 – and for years to come.
As Andy Xie stresses, the stimulus exit will be a combined effort of all the central banks and it will not be exempt of risks: one central bank alone could derail the whole process.
My central point is that the global economy is cruising toward mild stagflation with a 2 percent growth rate and 4 percent inflation rate. This scenario is the best that the central banks can hope to achieve; it combines an acceptable combination of financial stability, growth and inflation. But this equilibrium is balanced on a pinhead. It requires central banks to constantly manage expectations. The world could easily fall into hyperinflation or deflation if one major central bank makes a significant mistake.
In modern economics, monetary stimulus is considered an effective tool to soften the economic cycle. While there are many theories about why monetary policy works, the dirty little secret is that it works by inflating asset markets. By inflating risk asset valuation, it leads to more demand for debt that turns into demand growth. In other words, monetary policy works by creating asset bubbles.
It is difficult to reverse this kind of stimulus. A complete reversal requires that household, business and government sectors decrease debts to pre-stimulus levels. This is why national ratios of indebtedness-debt to GDP have been rising over the past three decades while central bankers smoothed economic cycles through monetary policy. It led to a massive debt bubble that burst, leading to the ongoing slump.
Of course, the bailouts have brought in essence to transfer the non-performing debt from private actors (where it could be cleansed through bankruptcy) to government actors and central banks. The issue being here that it would be impossible to call these loans in without bankrupting the originators.
By some estimates, US$ 9 trillion has been spent to shore up failing financial institutions. A big chunk of that money was borrowed against illiquid and problematic assets on bank balance sheets. As the debt market refused to accept that collateral, governments and central banks stepped in. Today, it is impossible for banks to liquidate such assets without huge paper losses. Hence, if central banks call the loans, they are likely to go bankrupt.
Of course, central banks can suck in money from elsewhere to substitute money that’s tied up in non-performing loans. They are unlikely to do so, however, as it would depress a good part of the economy in order to support the bad. And that could easily lead to another recession.
The bottom line is that, regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before — money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough. After a debt bubble bursts, there are two effective options for deleveraging: bankruptcy or inflation. Government actions over the past year show they cannot accept the first option. The second is likely.
What Andy Xie shows is that while the originating issue is the same, the exit strategies will have to be quite different according to each country or zone, each having its own specificity.
Some may argue that Britain is not expensive anymore. The problem is that being less expensive is not good enough. Prices have to be low enough to attract non-financial economic activities despite a rising tax burden. The pound’s value must be very low to achieve that goal. Five years ago, I predicted the pound and euro would reach parity. It seems the day is finally here. But I’m not sure parity would be enough; the pound may have to be cheaper.
Of course, the euro zone is a mess, too. With high unemployment rates, a stagnant economy and imploding property markets in southern Europe, shouldn’t the euro’s value decline, too? Yes, it should. But it won’t. The European Central Bank was structured solely to maintain price stability. With so many governments and one central bank, ECB is unlikely to change anytime soon. (…)
At some point, euro zone monetary policy may change. It would require governments in the zone’s major economies come together and change the ECB. That may come in three years, but not now. The trigger could be one country threatening to exit the euro. Italy and Spain come to mind.
Meanwhile, Japan is an enigma. It has been locked in a vicious cycle of economic decline with a strong yen and deflation. Most Japanese people have a strong yen psychology. (…)Â But I think various theories that explain Japan’s behavior are not good enough. The best explanation is that Japan is run by incompetents, and some are downright stupid. They have locked Japan in an icebox and refuse to come out.
Japan is a giant debt bubble. Its zero interest rate, supported by a strong yen and deflation, has turned the debt bubble into an iceberg. You don’t have to worry — until it melts. Unfortunately, when the temperature reaches a critical point, the iceberg will melt suddenly, all at once. That turning point will come when Japan begins to run a significant current account deficit. The day may be near.
For Japan to avoid calamity, it should deal with deflation and skyrocketing government debt now. The only way forward is for the central bank to monetize Japanese Government Bonds. That would lead to yen devaluation and inflation. Pensioners will complain, but it’s better than a complete meltdown later.
Japan’s new ruling party DPJ has no vision like that. It doesn’t have the guts to go against popular preference for a strong yen. Without a growing economy, though, the DPJ has little to play with. The whole country has sworn to debt, led by a government with a massive fiscal deficit. The DPJ may only reallocate some spending, which would make no difference for the economy. It seems Japan will remain in the icebox until the day of reckoning.
These snapshots of Britain, the euro zone and Japan suggest everyone needs a weak currency. Those that don’t have one simply don’t know yet. They’ll come around eventually. One outcome could be rotating devaluations and high inflation for the global economy.
Developing countries with healthy banks have a different problem on their hands. By responding to falling imports with stimuli, they inflated their property markets. China, India, South Korea and Hong Kong have inflated property bubbles in spite of slower economic growth rates. The contradictions between a property bubble and a weak economy can lead to zigzags in policymaking.
As China is one-third of the emerging economy bloc — and exerts a great deal of influence over commodity prices that other emerging economies depend upon — its monetary policy has a big impact on global financial markets. Its monetary stimulus in the first half of 2009 went disproportionately into property, stock and commodity markets. As profitability for the businesses that serve the real economy remain weak, little monetary stimulus went into private sector capital formation.
It seems limiting credit growth is the current policy focus. But if the economy shows further signs of weakness in the fourth quarter 2009 and first quarter 2010, the policy may revert to loose bank lending again. The zigzagging will stop when China’s loan deposit ratio is high enough, i.e. when increased lending increases interest rates. As the yuan is pegged to the dollar, China’s monetary policy would become much less flexible after excess liquidity in the banking system is gone.
And so, for Andy Xie, the big challenge ahead is creating sufficient income to favor deleveraging, while holding inflation under control (easier said than done). While it transpires from his writings that inflation is the final outcome he sees looming, it can be noticed that Andy Xie took a more cautious tone in this latter piece. As of today, nobody can really predict with certainty the outcome within a few months.
Could it be that, after the “Black Swan”, we may have the “Black Butterfly” effect ?
