Andy Xie: The big burnout

Central banks around the world have released massive amounts of money in response to the current financial crisis. How to exit from the current super-loose monetary environment has become a popular discussion. The central bankers are talking down the prospect of raising interest rates, arguing that the weak economy keeps inflation in check. But the proposition that a weak economy means low inflation is false. The stagflation of the 1970s proves it.

This round of monetary growth has mainly fed speculation, not credit demand for consumption or investment. Speculation has reached a dangerous point with the oil price threatening to reach triple digits again. Its implications for inflation may spook the central banks to raise interest rates quickly and trigger another crash.The excess money supply has created a new liquidity bubble.

The resulting asset inflation (stocks and bonds in developed markets and everything in emerging markets) has stabilised the global economy. The current equilibrium is one on a pinhead. The hope for strong economic recovery led by emerging economies raises investor optimism – and asset prices. This eases pressure on corporate balance sheets, spurs property production and boosts consumption through the wealth effect, making the hope self-fulfilling in the short term.

A rising oil price threatens to derail this recovery. It can trigger a surge in inflation expectation and a major crash of bond markets. The resulting high bond yields may force the central banks to raise interest rates to cool inflation fears. Another major downturn in asset prices would reignite fears about the balance sheets of global financial institutions, leading to new chaos.

The last two times the oil price surged above US$100, it wreaked havoc on the financial markets and global economy. The runaway oil prices of 2006 were the final straw that tipped the US property market. The oil price fell sharply amid the subprime crisis as the market feared a demand collapse. Then, the Fed came to the rescue and began cutting interest rates aggressively in the summer of 2007 in the name of combating the recessionary impact of the subprime crisis.

The oil price rose sharply afterwards on the optimism that the Fed would rescue the economy, and with it, oil demand. It worked to offset the Fed’s stimulus, accelerated the economic decline, and pulled the rug out from under the derivatives bubble. The ensuing demand fear again caused the oil price to collapse.

The central banks are using cheap money to inflate asset prices to stabilise the economy. But it also provides the ammunition for oil speculation. An oil bubble is different from others in two ways: it immediately redistributes income, and generates inflation; that is, it weakens consumption and tightens financial conditions on rising expectations for interest rate increases. Oil speculation is the party crasher, even though it destroys itself by destroying others.

Oil is perfect material for a bubble. Supply cannot respond quickly to price surges – it takes a long time to expand production. Demand cannot drop quickly due to the “stickiness” of consumers’ lifestyles and the modes of production.

Oil speculators are no longer restricted to secretive hedge funds. Average Joes can buy exchange traded funds (ETFs) to own oil or anything else. And, why not? The central banks have made clear their intentions to keep money supplies as high as possible, debasing the value of paper money to help debtors.

It seems that no good deed goes unpunished in this world. If you speculate big, governments will bail out when your bets go wrong and cut interest rates and guarantee your debts for you to make even bigger bets. Savers who live within their means and leave some for rainy days see their dreams shattered. Maybe everyone should be a hedge fund. The ETFs give you this opportunity. As the masses are given incentives to avoid paper money by buying hard assets like oil, a three-digit oil price appears more likely.
A word of caution for would-be speculators: run for your life as soon as the bond market starts to plunge. The oil bubble is easy to come and quick to go, because, as it kills other bubbles, the oxygen for its existence is also consumed.

The case for a double dip in 2010 is already strong. Inventory restocking and fiscal stimulus are behind the current economic recovery. The odds are quite low that western consumption will pick up when the recovery runs out of steam next year. High unemployment will keep incomes too weak to support spending.

Many analysts argue that, as long as unemployment rates are high, more and more stimuli should be applied. As I have argued before, the demand and supply mismatch rather than demand weakness per se is the main reason for high unemployment. Further stimuli will only trigger inflation and financial instability.

The current generation of central bankers has ignored asset inflation and believed in maximising employment through monetary stimulus. They have ignored the fact that the economy needs to purge deadwood from time to time.

The stagflation in the 1970s discredited Keynesians who ignored the inflation consequences of sustained monetary expansion. This crisis will discredit those who ignore asset bubbles. – SCMP


See also:
Analysts fear impending asset bubble burst in China

The big burnout
October 22, 2009
By Andy Xie for South China Morning Post

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