Andy Xie: For Economic Stimuli, a Revolving Exit Door

Can interest rate adjustments, currency devaluation and zigzag policymaking help unwind economic stimuli? It depends.

Australia recently raised its policy interest rate 25 bps, becoming the first major economy to do so since the financial crisis a year ago prompted all major economies to rapidly cut interest rates to historical lows.

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.

Second, China’s stimulus program will zigzag mainly through its lending policy. China’s currency will be pegged to the U.S. dollar for the foreseeable future, which determines the end point for China’s monetary policy. Its inflation and interest rates will likely be similar to those in the United States.

Third, due to their strong currencies, countries in the euro zone and Japan will have higher real interest rates, lower nominal interest rates, and lower real economic growth rates. They will raise interest rates more slowly than the United States, and will have lower inflation rates as well.

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.

The current stimulus round is different in terms of its effects. Despite low interest rates, household and business sectors in developed economies have not been increasing indebtedness; falling property and stock prices have diminished their equity capital for supporting debt. The public sectors have rapidly ramped up debt to support failing financial institutions and increase government spending to cushion the economic downturn. Neither is easy to unwind.

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.

Hyperinflation was used in Germany in the 1920s and Russia in late 1990s to wipe slates clean. The technique was essentially mass default by debtors. But robbing savers en masse has serious political consequences. Existing governments, at least, will fall. Most governments would rather find another way out. Mild stagflation is probably the best one can hope for after a debt bubble. A benefit is that stagflation can spread the pain over many years. A downside is that the pain lingers.

If a central bank can keep real interest rates at zero, and real growth rates at 2.5 percent, leverage could be decreased 22 percent in a decade. If real interest rates can be kept at minus 1 percent, leverage could drop 30 percent in a decade. The cost is probably a 5 percent inflation rate. It works, but slowly.

If stagflation is the goal, why might central banks such as the Fed talk tough about inflation now? The purpose is to persuade bondholders to accept low bond yields. The Fed is effectively influencing mortgage interest rates by buying Fannie Mae bonds. This is the most important aspect of the Fed’s stimulus policy. It effectively limits Treasury yields, too. The Fed would be in no position to buy if all Treasury holders decide to sell, and high Treasury yields would push down the property market once again.

The Fed hopes to fool bondholders or lock them in by quickly devaluing the dollar. Foreign bondholders have already realized losses. The dollar index is down 37 percent from its 2002 peak. A significant portion of this devaluation is a down payment for future inflation.

I think Britain is pursuing devaluation for the same reason. Among all major economies, Britain’s is the most dependent on global finance. It benefited greatly during the global financial boom that began in the mid-1990s. The British currency and property values appreciated dramatically, pricing out other economic activities. But now that the global financial bubble has burst, its economic pillar is gone. Other economic activities cannot be brought back to Britain without major cost cuts. But it can’t cut taxes to improve competitiveness, as fiscal revenues depend on the financial sector and already face a major shortfall. Another option is to let property prices fall, as they have in Japan. But that choice might sink Britain’s entire banking sector. Hence, devaluing the pound is probably the only available option for stabilizing the British economy.

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. Hence, it won’t respond to a strong euro quickly. A strong euro and low inflation could form a self-generating spiral, as we see in Japan. Even as interest rates in other economies rise, the euro zone’s real interest rate could be higher still, supporting a strong euro.

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. Politicians and central bank leaders reflect this popular sentiment, which is based on an aging population. Wealth is concentrated among voting pensioners for whom a strong yen and deflation theoretically improve their purchasing power. 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.

The state sector ramped up investment somewhat for policy, not profit, concerns. Thus, China is experiencing a relatively weak real economy and red hot asset markets. Government policy is being pushed by both concerns. Cooling the asset bubble would cool the economy further. Not to cool the bubble could lead to a catastrophe later. Monetary policy zigzags, shifting according to concerns that arise, has the up hand.

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.

I think Australia is raising interest rates ahead of others for a unique set of concerns. Australia has been experiencing property and household debt bubbles similar to those in the United States and Britain. Its bubbles are probably larger than America’s. But because its commodity exports have performed well, its economy has fared better than others. Hence, its property market has seen less of an adjustment. A relatively good economy could embolden Australia’s household sector to borrow more and continue the game. This is why it needs to increase interest rates — to prevent the bubble from re-inflating. The United States and Britain don’t have this problem; their household sectors are convinced that the game is finished and they must change.

A review of unique factors and institutional biases around the world shows that exiting a stimulus would be quite different in different economies. The United States and Britain, the euro zone and Japan, and China and India are three blocs that face varying challenges and will handle stimuli exits in different ways.

Most analysts think a benchmark for exiting a stimulus is robust economic recovery. That’s not so. Loose monetary policy cannot bring back a strong economy due to the supply-demand mismatch formed during the bubble. Re-matching takes time, and no stimulus can bring a quick solution.

The main purpose of monetary policy ahead is facilitating the deleveraging process, either through negative real interest rates and-or income growth. Preventing runaway inflation expectation is a key constraint on monetary policy. One key variable to watch is the price of oil, with its major impact on inflation expectation. If oil prices take off again, the Fed could be pushed to raise interest rates sooner and higher than expected.


For Economic Stimuli, a Revolving Exit Door
Andy Xie
Caijing Magazine, 10-12 09

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