Different Exiting Paths

Former Morgan Stanley Economist Andy Xie explains why getting out of the current finacial situation will be a lot harder than getting in.

The Australian central bank just raised its policy rate by 25 bps (0.25%), the first major central bank to do so since one year ago when the crisis caused all the major economies to cut interest rates to historical lows. Financial markets have been chattering about the end of the stimulus for the past month now and the consensus is that the central banks will keep rates extremely low through 2010 and possibly beyond.

Central banks, on their side, have been delivering the message that they know how to exit, will exit before inflation becomes a problem, and that they don’t see the need to exit anytime soon.They are trying to assure bond investors that they don’t have to worry a lot about their holdings despite low bond yields, while stock investors are told that they don’t need to worry about high stock prices as liquidity should remain strong for the foreseeable future. So far the central banks have made both parties happy, but Australia’s action is likely to cause some concerns among financial investors.

Different economies will exit at their own pace according to local conditions. The US and the UK will keep real interest rates as low as possible in order to support their financial institutions. They don’t want to stop inflation, but rather to slow it. The Fed will raise interest rates by 100 bps in 2010, 150 bps in 2011, and 200 bps in 2012.The US could be stuck with a 4-5% inflation rate by 2012 and for many years beyond.

China’s stimulus will zigzag according to its lending policy. But China’s monetary policy is still linked to the dollar. Its inflation and interest rate will likely be similar to the US. Due to their strong currencies, the euro-zone and Japan will have higher real interest rates, lower nominal interest rates and lower real economic growth rates. This gives them few reasons to raise interest rates.

My central case is that the global economy is cruising towards mild stagflation with a 2% growth rate and 4% inflation rate.This scenario has an acceptable combination of financial stability, growth and inflation. But it sits on a pinhead. 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 an economic cycle. The dirty little secret is that monetary stimulus works by inflating asset markets.By inflating asset valuation, it leads to more demand for debt that turns into demand growth; i.e., monetary policy works through creating asset bubbles. This is why national indebtedness-debt to GDP ratio has been rising over the past three decades and led to a massive debt bubble. The current crisis is due to its bursting.

The current round of stimulus is different. The household and business sectors in the developed economies have not been increasing their indebtedness despite low interest rates, as falling property and stock prices have diminished their equity capital for supporting debt. Instead, the public sector has ramped up debts to support failing financial institutions and increased government spending. Neither is easy to unwind.

The bottom line is that, regardless of what central banks say and do, there will be a lot more money in the world after the crisis than before. After a debt bubble bursts, there are two effective ways to deleverage: (1) bankruptcy, or (2) inflation. Governments’ actions in the past year show that they cannot accept the first option. A mild form of stagflation is probably the best that one could hope for after a debt bubble.

Central banks like the Fed talk tough about inflation now, in order to persuade bondholders to accept low yields.The Fed is targeting mortgage interest rates by buying Fannie Mae bonds.This is the most important part of the Fed’s stimulus policy.It effectively limits the treasury yield too.If all the treasury holders sell, the resulting high treasury yield would push down the property market again.

The Fed hopes to fool the bondholders. If not, it could lock them in through quick dollar devaluation. To some extent this has already happened. The dollar index is down 37% from the peak in 2002.A significant portion of the devaluation is down payment for future inflation.
The UK is pursuing devaluation for the same purpose. The UK is the major economy most dependent on global finance. Its currency and property have priced out other economic activities, andwith the bubble burst, its economic pillar is gone and it cannot attract other economic activities back without a major reduction in costs.The pound needs to be very low to achieve that.

Of course, the euro-zone is a mess too, with high unemployment rates, stagnant economies and imploding property markets in Southern Europe,but the euro won’t implode. The European Central Bank (ECB) was structured to maintain price stability, and with so many governments and one central bank the ECB is unlikely to change unless a country exits the currency, prompting institutional reforms.

Japan is an enigma in the world. It has been locked in a vicious spiral combining a strong yen, deflation and economic decline. Most Japanese people have a strong yen psychology. The political economy for this is its aging population and the concentration of wealth among its numerous and voting pensioners. A strong yen with deflation improves their purchasing power in theory. But, I think the various theories that explain Japan’s behavior are not good enough. The best explanation is that Japan is run by incompetent people. Some of them are downright stupid. They have locked Japan into an icebox and refuse to let it come out.

Japan is a gigantic debt bubble. The zero interest rate, supported by a strong yen and deflation, turns the debt bubble into an iceberg. There’s no need to worry until Japan begins to run a significant current account deficit. That day may not be too far away.

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. It would lead to yen devaluation and inflation, but it is better than a complete meltdown later.
The above stories suggest that everyone needs a weak currency. The ones that don’t just don’t know it yet. Eventually they will come around, and the outcome could be rotating devaluation and high inflation in the global economy.

Developing countries have a different problem on their hands. As they stimulate in response to falling exports, they have inflated their property market. The contradiction between these property bubbles and weak economies may cause their policies to zigzag.

As China is one-third of the emerging economy block and exerts so much influence on commodity prices that other emerging economies depend on, its monetary policy has a big impact on global financial markets. Its monetary stimulus in the first half of 2009 went disproportionately into the property, stock and commodity markets. As profitability for the businesses that serve the real economy remains weak, little monetary stimulus went into capital formation in the private sector. The state sector ramped up investment for policy, not profitability. Thus, China is experiencing a relatively weak real economy and red-hot asset markets. The government policy is being pushed by both concerns. Cooling the asset bubble would also cool the economy further; to not cool the bubble could lead to a catastrophe later. The monetary policy zigzags depending on which concern has the upper hand.

Loose monetary policy cannot bring back a strong economy because supply and demand are mismatched, and will be for some time. The main purpose of monetary policy is to facilitate the deleveraging process either through negative real interest rates and/or income growth. Preventing runaway inflation expectations is the key constraint on monetary policy. If oil prices take off again, it could push the Fed to raise interest rates sooner and higher than expected.

Different Exiting Paths
Andy Xie
China International Business December 2009

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