Heading toward a Cliff
By Andy Xie
The global economy is likely experiencing a bigger bubble than the one that unleashed the 2008 crisis, and should it burst the ensuing recession would be mammoth
The U.S. Federal Reserve is unlikely to taper its quantitative easing in 2013. The recent improvement in the global economy is due to its surprise decision in September to not taper. The resulting return of hot money or increase in leverage for speculation boosted the economy.
The market is again increasing the odds for Fed tightening. It may trigger some deleveraging, which would cool the economy again. The Fed would be forced to postpone tapering again.
The Fed’s QE policy has caused a gigantic liquidity bubble in the global economy, especially in emerging economies and asset markets. The improvement in the global economy since 2008 is a bubble phenomenon, centering around the demand from bubble goods or wealth effect. Hence, real Fed tightening would prick the bubble and trigger another recession. This is why some talk of the Fed tightening could trigger the global economy to trend down.
Only inflation will force the Fed to tighten. Inflation at present is mainly in emerging economies. The United States’ dysfunctional financial system is slowing monetary velocity there. It is delaying inflation. But, it is a matter of time. Inflation in the United States could come through imports and expectations. When its financial system is emboldened to lend like before the 2008 crisis, inflation will surge.
As the economy is so sensitive to the Fed’s tightening, its pace will be slow, even when forced by inflation. It means that inflation will stay high and for long.
U.S. inflation would trigger the bursting of the bubbles in emerging markets, similar to what occurred in the 1980s. They will face the choice of devaluation or deflation. The global economy has seen high inflation in emerging economies and low inflation in the United States. The roles may reverse in the years ahead.
Return of the Dotcom Bubble
Wild speculation in Internet stocks brings back the bubbly days of 2000.
Facebook is trading above 100 times earnings, Amazon over 1,000. AOL and Yahoo did not go that high in the last dotcom bubble. I am sure that some clever analysts could come up with stories to sort of justify the valuation. And, of course, no one can be absolutely sure about a bubble until it bursts, which was Alan Greenspan’s justification for not acting against bubbles. I suspect that this dotcom bubble will burst in 2014, as soon as the Fed is forced to tighten.
The extremes in the new dotcom bubble tell us what the monetary condition is in the world. The real interest rate is practically negative everywhere. This is happening for probably the first time in modern history. Negative real interest rates also trigger bubbly valuation in credit, property and stocks.
The Fed’s QE policy inflated emerging markets first, while a bad financial system at home slowed the circulation of money and the rise of bubble. Property usually becomes bubbly first in emerging economies in an environment of rising liquidity. Rapidly rising prices and falling rental yields are sure signs of a bubble. From Mumbai to Beijing, the bubble has taken root.
An interesting phenomenon this time is how the property bubble in emerging economies, triggered by the Fed policy, spread back to the United States. Buyers from China, Russia and other emerging economies have pushed up property prices in central London and Manhattan. So their rental yields resemble that in hot emerging market cities rather than that in other cities in Britain or the United States.
The tight linkage between the Fed and emerging economies is mainly due to a lack of independent monetary policy in the latter. Emerging economies are much more dependent on trade than developed economies. The dollar is the currency for global trade. It is impossible for emerging economies to allow their currencies to reflect entirely financial flows and disregard the impact on trade. This tendency to resist the impact of hot money on the exchange rate is why emerging economies are so tightly linked to the Fed’s policy.
Hot money does not just disappear into emerging markets. It flows back into the U.S. financial system either through official foreign exchange reserves or private investment seeking higher returns. When hot money first emerges, the former tends to dominate, which keeps down the U.S. bond yield. As the bubble takes hold and yields on property and real interest rates decline, private investment also flows to the United States for higher returns, which pushes up the prices of risk assets, like property, stock and credit, in the United States.
The relationship between the Fed and emerging economies is like a turbocharger for asset prices around the world. The bigger the share of trade in emerging economies, the more power the turbocharger has. With China’s rise in global trade, it has played a powerful role in this dynamic. It is not a coincidence that China’s property bubble inflated so much during the Fed’s QE, despite a weak economy that would have destroyed the confidence for bubble making.
Pushing on a String
I have written many times before that the linkage between monetary policy and employment is very weak in the era of globalization. The information technology revolution has made most high paying jobs mobile. That force is equalizing compensation for many professions across the world. The equalization process is still ongoing. Hence, monetary easing alone will not increase investment at home, which leads to employment growth. Investment today depends on its global competitiveness, not a small change in the interest rate at home.
Employment in any country can be created through cutting wages. This helps explain why reemployed in the United States has lower wages on average. An economy is like a company. It can expand its market share or employment by cutting prices. That explains why competitive devaluation is such a force nowadays.
If one economy cannot use its monetary policy effectively, the global economy could be stimulated through collective monetary easing. Hot money sort of plays the role of exporting the United States’ monetary policy around the world. The trouble is that the main force behind hot money is speculation. Hot money earns a profit only if it creates a bubble and leaves a hot potato for others to hold. The Fed’s QE may have stimulated emerging economies, which in turn benefited the U.S. economy. It is mainly a bubble phenomenon. When the bubble bursts, the global economy tanks again, leaving behind collateral damage like bad loans.
Despite its terrible record, the Fed continues to believe in the power of its policy in creating employment. It has created one bubble after another. Each bursting leads to a downturn, which justifies another round of monetary stimulus and the making of another bubble.
Rising inequality in income and wealth has become a major social issue around the world. I would argue that it is a major drag on the economy and contributes to bubble formation. The latter further increases inequality and, hence, a vicious cycle forms.
Statistics suggest that the top 5 percent account for most wealth and almost as much in income. The concentration generates instability in circulation among income, demand and production. When income is so concentrated, a few must lend to others to finance demand. As people pile up debt, they pay interest and, hence, must borrow more for the same demand. As debt piles up, a crisis is inevitable. The crisis leads to monetary stimulus and more bubbles.
A bubble is a zero-sum game at best and, due to a misallocation of resources, a negative-sum game most of the time. While in aggregate, a bubble may be zero sum, significant redistribution occurs in the process. History tells us that wealthy and high-income people are more likely to win than others. Serial bubble-making by central banks only exacerbates inequality.
Activist monetary policy is possibly one of the most destructive forces in modern economic history. It creates the illusion of effectiveness during bubble formation, which justifies its relevance despite so many financial disasters.
When the Fed talked about tapering QE, global financial markets reacted furiously. Emerging markets saw money leaving, currencies falling and stocks tumbling. The tightening financial condition led to a string of weak economic data, which was partly used to justify the Fed’s decision not to taper in September, contrary to the market consensus. The decision was followed by hot money returning and some improvement in economic data. The sensitivity between financial speculation and economic strength reflects how bubbly the global economy is.
Better economic data is increasing market expectation for the Fed to taper. That expectation would again trigger speculation declining and economic data weakening. Such back and forth is likely to haunt the Fed’s decision to taper or not to taper. In the end, it cannot do so any time soon. But, the fluctuations in the market expectation will cause a great deal of volatility in financial markets.
The tapering will come when the Fed is forced to do so, probably by inflation rising above its target. As there is a long lag between monetary policy and inflation, whatever it does then, inflation will keep rising. The Fed, when it does taper, is unlikely to be aggressive. It begins by cutting stimulus. Raising interest rates is many months away. When it does raise interest rates, it may not do so fast enough to catch the rise in inflation, i.e., the real interest rate would still be declining.
After the 2008 financial crisis, I expected massive stimulus around the world. But, the stimulus would not bring back a healthy economy. It will eventually take the global economy to stagflation. I still hold this view.
Another Global Recession
The odds are that the world is experiencing a bigger bubble than the one that unleashed the 2008 Global Financial Crisis. The United States’ household net wealth is much higher than at the peak in the last bubble. China’s property rental yields are similar to what Japan experienced at the peak of its property bubble.
The biggest part of today’s bubble is in government bonds valued at about 100 percent of global GDP. Such a vast amount of assets is priced at a negative real yield. Its low yield also benefits other borrowers. My guesstimate is that this bubble subsidizes debtors to the tune of 10 percent of GDP or US$ 7 trillion dollars per annum. The transfer of income from savers to debtors has never happened on such a vast scale, not even close. This is the reason that so many bubbles are forming around the world, because speculation is viewed as an escape route for savers.
The property market in emerging economies is the second-largest bubble. It is probably 100 percent overvalued. My guesstimate is that it is US$ 50 trillion overvalued.
Stocks, especially in the United States, are significantly overvalued too. The overvaluation could be one-third or about US$ 20 trillion.
There are other bubbles too. Credit risk, for example, is underpriced. The art market is bubbly again. These bubbles are not significant compared to the big three above.
When the Fed does normalize its policy, i.e., the real interest rate becomes positive again, this vast bubble will burst. Given its size, its bursting will likely bring another global recession worse than the one after the 2008 crisis.
The disinflationary force from globalization, especially from East Asian economies driving down the prices of manufacturing goods, is the background for the serial bubbles over the past three decades. As China’s labor surplus is gone and no other country is taking over the disinflationary role, the big background for bubbles seems to be winding down. The disinflationary force for the current bubble is weak demand in developed economies, not rising productivity. This is why inflation will come to end this one.
When inflation emerges and persists, interest rates will have to rise. For example, the U.S. 10-year bond yield may double to 5 percent. Bubbles are less likely in an environment of rising interest rates. I suspect that the current bubble is the last one for a long time to come.