Asia/Pacific: The Motorcycle Diary
Andy Xie (Hong Kong)
The global economy has stumbled into a growth model based on the United States’ consumption and China’s investment. These two sources of demand resemble the two wheels of a motorcycle that is pulling the rest of the world along. The wealth disparity between emerging and OECD countries has pushed the global economy on to such a growth path on consumption based on wealth in OECD countries and investment based on export income in emerging economies. This model is, in our view, likely to persist until the wealth gap between OECD and emerging economies has narrowed sufficiently.
Inflation is not a problem, as the demand in OECD countries automatically creates supply in emerging economies. It is, however, very prone to asset bubbles, because excess money creation does not lead to inflation, and the surplus liquidity finds a home in asset markets. For example, the world has experienced a massive liquidity bubble since the Asian Financial Crisis of 1997–98.
The global economy is now suspended inside a liquidity bubble, I believe. A significant adjustment is inevitable. Some US officials blame China’s currency peg as the culprit. I believe that the main cause is that the US inflated the liquidity bubble to avoid adjustment after the tech burst in 2000. The world needs a US recession, in my view. A Chinese revaluation will not be significant enough to solve the world’s problem.
[BINGO! The imbalances are so extreme there is no way other than a recession to sure them - mish]
The ‘motorcycle’ growth model may be unusual but can last for another decade or two.
[It can last for another decade or 2. Quite simply this is silly - Mish]
What has occurred is that the excessive liquidity from the US Federal Reserve since 2000 has overheated the system. It needs to pause and cool down. A US recession would serve the purpose. The global economy will be back to the same system afterwards.
The Missing Recession
When the tech bubble began to burst, financial markets were expecting the worst. It was the biggest bubble since the 1920s and, in conventional wisdom, was bound to cause a big recession. The US and global economies, surprisingly, did not experience a serious downturn. The US economy grew by 0.75% and consumption by 2.5% in 2001. In the previous two recessions, US personal consumption bottomed at 0.17% growth in 1991 and -0.28% in 1980. With benefit of hindsight, the 2001 experience was merely the pause before the global economy surged to new heights in 2003 and 2004. The global economy grew at its fastest pace in two decades last year.
It wasn’t a miracle. The Fed cut interest rates quickly and aggressively. Before the speculative enthusiasm collapsed with NASDAQ, the Fed managed to channel that enthusiasm into property. Rising property prices more than offset the negative effect of the falling NASDAQ on household wealth. US households, therefore, did not feel the pain from the plummeting stock market and could respond to declining interest rates by borrowing more to fund consumption.
Macro Is Not About Inflation
The past five decades have been the golden era for central banking. Balancing between inflation and growth has been the primary function for central banks. The oil shock of the 1970s caused inflation to get out of control. The major central banks lost credibility and had to crack down hard on inflation in the early 1980s to regain credibility. It was a resounding victory by the middle of that decade. Between 1981 and 1986, the US inflation rate declined to 1.9% from 10.4%, Japan’s to 0.6% from 4.9%, and West Germany’s to -0.1% from 6.3%.
As monetary authorities eased after their victories over inflation, inflation backed up steadily in the major economies. By 1990, the US inflation rate was at 5.4%, Japan’s 3.1%, and West Germany’s at 2.7%. It was clear that the global economy was prone to inflation and that , without the constraining effect of tight monetary policy, inflation would drift up.
Something unusual happened in the 1990s. The central bank discount rate was generally declining in all major economies. Inflation also kept falling. Inflation bottomed in 1998 for most major economies with the noticeable exception of Japan. Between 1991 and 1998, US inflation came down to 1.6% from 4.3%, the Eurozone’s to 1.3% from 5.3%, and Japan’s to 0.7% from 3.2%.
Inflation has since picked up slowly. Last year, the US rate was 2.7%, the Eurozone’s 1.9%, and Japan’s 0%. Considering how low rates are around the world, it is astonishing to see such low inflation everywhere. Inflation rates would be more than 10% in major economies if the global economy were the same as in the 1980s, in my view.
[Exactly this is not 1974 like almost everyone including Roach seems to think. Mish]
The ‘Motorcycle’ World
The world changed 15 years ago. The industrialized countries in the Soviet bloc abandoned socialism. The biggest developing countries — China and India — embraced globalization as the best avenue for economic development. These changes introduced nearly three billion people into the global trading system, which was previously comprised of OECD countries, Southeast Asia, and Latin America, which together had about two billion people.
The countries that joined the global economy were less productive than the OECD countries but were more productive than other emerging countries in Latin America and Southeast Asia. The series of crises in Latin America and Southeast Asia were adjustments from the old to the new global economy, in my view.
Through the series of emerging market crises, the global economy has stumbled on an unusual growth model: Americans borrow and consume, and Chinese borrow and invest. The American consumer and the Chinese investor are like two wheels of a motorcycle. The fuel for the motorcycle is dollar liquidity from the Fed, and its chairman, Mr. Greenspan, is essentially riding this motorcycle. He sticks dollar bills into the fuel tank from time to time to keep it going.
The growth spillover in this model is mainly via China. When Americans borrow to spend, the money goes to China via its surging exports. The money lands in China’s banking system and goes automatically out to state-owned enterprises or property developers to invest. The surging investment creates demand for raw materials and equipment. The money then travels to countries like Japan and Saudi Arabia. These countries, failing to find sufficient investment at home, take the money to the US to buy treasuries.
What has occurred since 2000 is that Mr. Greenspan has stuck too much money into the fuel tank and the motorcycle has become overheated. This world needs to rest, i.e., the global economy needs to grow slowly for two or three years, which would cause the US trade deficit to decrease and China’s investment growth rate to calm down. Afterwards, the global economy will likely be back to the same game.
Why the Motorcycle?
Why has the world stumbled into the motorcycle model? There are three major reasons. First, both Americans and Chinese are very optimistic. So if you give money to either, it gets spent. The baby boomers of America are biased towards consumption for some unfathomable reason. The Chinese are biased towards investment for a good reason, because they are still poor and need to accumulate capital.
Optimism nourishes demand growth, but it can lead to excesses and crises. It is not a rational force but is the most important driver for rapid economic development, because optimism can substitute for profit. High cost of capital is the main barrier to rapid economic development. When people are optimistic, they need only a dream to invest or consume.
Germany and Japan were developed on discipline and careful planning. They are the exceptions rather than the rule, in my view. Their cultural backgrounds well suit them for effective coordination on a large scale, i.e., socialism seems to work in Germany or Japan.
Second, the US is the world’s superpower and richest country, and the dollar is the undisputed currency for the global economy. The US enjoys the ultimate safe haven status. It creates high demand for dollar assets. Because the US is by far the richest country in the world, it can keep incurring foreign liability without foreigners worrying about its solvency.
Third, China’s banking system quickly turns export income into investment, which encourages imports of equipment and raw materials. China’s development model is based on maximizing exports and investment to create jobs. Probably 400 million workers need to leave villages to join the industrial world. Political stability requires China to create as many jobs as possible. The state-owned banking system is therefore an instrument of the Communist Party to turn export income into investment that creates jobs. Thus, when the Fed creates liquidity to boost consumption in the US, China becomes a powerful multiplier through its imports, which lift equipment producers (e.g., Japan and Germany) and commodity exporters (e.g., Australia, Brazil, and South Africa).
The institutional anchors to this growth model are the credibility of US Treasuries as the ultimate vehicle for wealth storage and the willingness of China’s banking system to take on risks. The by-products of this growth model are the US trade deficit and China’s bad debts. As long as global investors are not worried about the solvency of the US government and Chinese people believe in the solvency of China’s banking system, the game keeps going.
There are two major constraints in this growth model. The availability of natural resources is the most important one, in my view. When natural resources are in short supply, liquidity flows into that sector, which lifts prices of natural resources and leads to cost-push inflation everywhere. Second, there is a speed limit to the global demand for US dollar assets. When the US current account deficit frightens investors, it will cause the cost of capital to rise for the US. It slows down the motorcycle.
The World Needs a US Recession
The Fed is effectively the central bank for the global economy. Other central banks can affect their domestic liquidity through accumulating or decreasing their foreign exchange reserves. The Fed cannot pump a lot of money without triggering global inflation, as it has done. However, it has excessively stimulated asset markets, resulting in a huge US trade deficit and an investment bubble in China. The latter has prompted inflation of natural resources costs.
Last year, the global economy had the highest growth rate in three decades on strong US consumption and strong Chinese investment, with a stimulating effect on emerging economies through rising commodity prices. However, the high GDP growth rate came with deteriorating financial health. The US trade deficit rose by 13.5% to a record 5.2% of GDP, despite a weak dollar. China’s fixed investment doubled from 2001 to 2004, sowing the seeds of overcapacity. Another wave of bad debts is, in our view, almost a certainty.
Financial stability, rather than inflation, should be the primary concern for the Fed and the Chinese government. The recent bout of inflation is mainly due to rising prices of raw materials. The surging fixed investment in China is the main cause. However, as China’s investment boom is likely to lead to excess capacity, inflation today may trigger deflation tomorrow. There is scant evidence of wage-price spirals in any major economy.
The sustainability of the motorcycle model depends on 1) the sustainability of the US trade deficit and 2) the affordability of natural resources to China. In my view, the Fed should watch the US trade deficit and the prices of natural resources to determine its monetary policies. On these two counts, its policy is too easy, in my view.
I believe the Fed should raise interest rates quickly until oil prices decline sufficiently and the US trade deficit halves. Inflation in the US may decline to 1% or lower when this happens, but it should not be the excuse to cut interest rates again. The Fed should accept low inflation or even a little deflation. In terms of employment creation, the Fed should lean more on labor market flexibility rather than macro stimulus. Targeting full employment with monetary policy is suicidal, in my view.
[My only real gripe with this well written piece is the need to hike until oil prices fall. Oil because of peak oil concerns and increasing demand from places like Brazil, China, etc, and with geopolitical concerns to boot, simply might not fall significantly without rates going to absurd levels. I believe this would trigger a world wide depression, not recession. The other point is once the US consumer gives up, things are going to come unglued rather quickly. The FED can keep hiking until that happens, but once it does, there will not be a need for escalating hikes. I agree that Greenspan should keep his foot off the gas pedal at that point, but I doubt he will. Mish]
I believe that the US needs a recession, which is a necessary phase in cleansing an economy of excesses during a boom. Refusing to have a recession is destabilizing. The instability in the global economy is primarily due to the fact that the US stimulated massively and fast after the tech burst, which prevented the necessary cleansing.
Many US officials think that a major revaluation by China would solve the US’s need to have a recession. This is naive, in my view. If China were to revalue enough to have a meaningful impact on the US economy, it would prompt the hot money to leave China and, hence, trigger a hard landing, which would add more pressure on the US economy. A small move by China would not do anything and might incite more speculation, which would overheat the motorcycle further and leave behind a bigger bill to pay afterwards.
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