A False Prophet: 五月 2008

by Andy Xie, http://xieguozhong.blog.sohu.com/88722539.html

Inflation Returns. Sell Bonds /谢国忠（点击获取译文）
谢国忠搜狐博客　http://xieguozhong.blog.sohu.com/
The world is now entering a stagflationary period: economies are slowing down while inflation is picking up. This period may last for two years. In the second half of 2009, major central banks may begin to raise interest rates to fight inflation. It may cause a global recession in 2010. The global economy experienced a property-cum-credit bubble over the past decade. The consequences of the bursting are spread in two phases. In the first phase, major central banks are cutting interest rates and pumping liquidity to stabilize financial institutions. The priority of financial stability adds inflationary pressure. Only when financial institutions are strong enough central banks will switch priority to price stability, which may cause a global recession. The major central banks are pushing out the economic adjustment to deal with financial crisis first. The cost is that inflation will peak higher during the adjustment period.
In addition to the expansionary monetary policy, the current stock of money in the global economy is inflationary. Deflationary forces from emerging economies, which we will discuss below, checked the inflationary forces from asset inflation in the west. As the bubble bursts, the money is coming out of property and credit markets and is being channeled into commodity market, which, in addition to supply constraints, is a major force in commodity inflation. As commodity inflation pushes up living costs everywhere, wage inflation is just around the corner, which leads to a second wave of inflation. The loose monetary policy to save financial institutions is adding fuel to fire. Bursting property-cum-credit bubble slows down economic growth, which does decrease inflationary pressure on the demand side. However, the monetary environment is highly inflationary on the cost side, from industrial metals, energy, agricultural products, and, with a lag, labor.
2011 may mark the beginning of the next cycle. Would it be similar to the past, like the last upturn from 2003-2007? I think not. The past two decades of low inflation are an exception rather than the rule. The future will be more inflation prone. Businesses that have prospered on piling up debts will struggle in future even when the global economy recovers from the current crisis.
The past two decades marked a steady decline in inflation rate. Financial markets attributed the trend to the successful efforts by central banks and rewarded them by pushing down bond yield. At the bottom, the 10 year US treasury barely yielded 3%, down more than half from the prevailing level two decades ago. Alan Greenspan who presided at the Fed over this period of great disinflation was lauded as the greatest central banker of all time. Even though Greenspan always came to the rescue every time that something threatened the US economy by cutting interest rate and pumping liquidity, inflation kept dropping. Most thought Mr. Greenspan had a secret recipe to target growth and inflation at the same time.
As low inflation and strong growth continued year in and year out, Greenspan's reputation mushroomed. Phil Graham, the senator from Texas, once remarked that, if Greenspan had died, he would seat him in a chair to stabilize financial markets. Studying Greenspan became an industry. Scholars and pundits competed fiercely against each other to see who could praise him more. In 2001, the respected journalist, Bob Woodward who made his name exposing Nixon's cover-up of the Watergate scandal, wrote a book-'Maestro: Greenspan's Fed and the American Boom' to praise Greenspan for America's prosperity. He attributed Greenspan's record partly to his musical talent-the ability to pay attention to details. The chorus of sycophancy was deafening.
I wrote for many years that Alan Greenspan was leading the US economy and, indeed, the world through the status of the dollar on a wrong path. The low inflation was not due to his and other central banks' policies. It was due to the end of the Cold War and the rise of globalization. Neutral monetary policy would have required western central banks to allow prices to fall. Low inflation didn't preclude excessive monetary expansion.
When the Berlin Wall fell, it was the end of an ideological struggle. It was also a tectonic shift in the global economy. The economies of the Soviet block in the former Soviet Union ('FSU') and Central and Eastern Europe virtually collapsed overnight. These were already industrialized economies. Half of their economies were government-directed investments. As their political systems changed, the state investments collapsed. These economies all believed in the Washington Consensus and embraced an export strategy to bring their economic recovery. However, their existing capital stock couldn't produce the goods the West wanted to buy. Without exports to compensate for investment weakness, their consumption power also vanished.
As these economies crashed, their people began to flee. Russian scientists surfaced in New York as taxi drivers. The best and the brightest Polish youth became bartenders in London. Some of the most eligible women in Eastern Europe married the underclass in the West. Mittal bought steel mills in Eastern Europe for pittances and went on to build the largest steel company in the world. It was an unparalleled human tragedy for so many, but was also the greatest arbitrage opportunity for some.
China and India also shifted their economic orientation at about the same time. They were small and agrarian economies at the time. Their change was felt over time as their manufacturing expanded. China, in particular, played a remarkable role in the growth of global trade. Over the past three decades, China's exports have risen 150 times and have probably become the world's largest, exceeding Germany's, in 2008. The speed of China's rise is unprecedented. Its size also means that this rise has global implications. In particular, China has been the price setter for manufacturing products. Through relocation of manufacturing enterprises to China, it has had an enormous impact on global labor cost also.
While the collapse of the Soviet block triggered prolonged weakness in commodity prices, China's rise kept manufacturing cost low. The combination led to low global inflation. Greenspan was at the right place and the right time. Falling inflation didn't have much to do with central banks at all. In anything, they made a mistake by maintaining loose monetary policy during this period. From the western perspective, the rest of the world was put on sale at a massive discount. It could enjoy the low prices but also face sluggish wage growth. There was a distribution challenge. The net impact was positive.
Major central banks, led by the Fed, made a big mistake by interpreting low inflation as a license for keeping loose monetary policy. I wrote on many occasions arguing that the Fed should not make haircuts more expensive to offset the declining prices of imported shoes. In the new environment, neutral monetary policy could have meant declining CPI, as long as the broadest price gauge, GDP deflator, remained positive.
The loose monetary policies had a large impact on asset prices. The deflationary forces from the ex-Soviet Block and China prevented rising money supply from working into CPI, i.e., rising money supply didn't lead to rising CPI. Instead, money flowed into asset markets and turned into rising asset prices. Bond prices rose and yields dropped sharply in the 1990s. When bond market couldn't take in more money, it flowed into stock market and formed a bubble in tech stocks. When the tech bubble burst in 2000, it flowed into property market through new credit instruments. Property prices were already overvalued during the bond and tech bubbles due to falling financing costs and rising wealth effect. The latest bubble made credit available to people who couldn't qualify. Most of the excess money growth in the world since 2001 has gone into property.
The bursting property bubble has cast a long shadow over Greenspan's legacy. A mini industry has risen to revalue his legacy. For self defense, Greenspan wrote a column titled 'We will never have a perfect model of risk' for the Financial Times on March 17. He defended his long-held view that a central bank couldn't identify a bubble ex ante and could only lessen the pain by loosening monetary policy after a bubble had burst. Further, he claimed that property bubble was taking place simultaneously in many countries and, hence, the Fed's policy couldn't have stopped it. He is wrong on both counts and should bear major responsibility for today's catastrophe.
Bubbles have happened repeatedly in modern history. The basic valuation metrics usually tell the story. When a stock market rises substantially above three times book value, it is usually a bubble. When property price rises substantially faster than income for three years or longer, it is usually a bubble. Of course, exceptions have happened in the past and could happen in future. However, because tolerating a bubble has such a serious consequence in future, a central bank should lean against an asset market even when it is not 100% sure that it is a bubble. Greenspan's logic is the opposite. He believes that a central bank should tolerate a rising market trend for as long as possible because it cannot be sure that it is a bubble. His philosophy doesn't balance the benefit of the current boom against the potential loss of a future burst. I was just shocked how the best and the brightest bought into his argument. That shows the power of wishful thinking even among thinking people.
Greenspan's recipe for healing is also flawed. Excessive money supply is usually part of a bubble story. When it bursts, printing more money could worsen inflation problem. Nobody questioned his recipe because inflation was not a significant concern at the time. But, printing money eventually leads to inflation. Printing more money leads to more inflation. The Fed is doing what Greenspan prescribed. The world is now inflation prone. The Fed's policy will cause inflation to peak a high level. Of course, the current Fed inherited the bubble from Greenspan and doesn't have a choice. The government has refused to use fiscal policy to stabilize the financial system. Between financial and price stability, the Fed is now choosing the former.
The second part of his argument is that property bubble was happening in so many countries that the cause couldn't be the Fed. That is again wrong. The forces that I described brought inflation down globally and made inflation less sensitive to money supply. The Fed took the lead in expanding money supply among all central banks. As the dollar is the base currency for global trade, other central banks faced the choice of currency appreciation or following the Fed. Most were concerned about their economies and opted to follow the Fed, i.e., the Fed was the most important factor in causing property bubbles around the world. One byproduct of globalization is that monetary policy generates external effects. If one country suppresses inflation, it suffers less growth and helps bring down inflation elsewhere. The spillover makes each central bank reluctant to tighten. This dynamic has a serious impact on how inflation evolves over the next two years. The net effect is that inflation will peak at a level that all central banks panic at the same time.
The global economy is now at the end of a cycle, characterized by a bursting bubble and slowing growth. In due time the economy will surely recover and another cycle will begin. The dynamics of the transition are important. I believe that central banks will tighten before the new growth cycle kicks into full steam, as they switch from financial to price stability in the second half of 2010. The global economy will probably have a double dip then. The second dip is probably more serious than the current one.
A more interesting and longer term perspective is how the next cycle differs from the current one. I believe that inflation will become much more sensitive to money supply. Ceteris paribus, interest rate will have to be higher to maintain price stability. This forecast is based on the view that (1) the countries in the ex-Soviet block have recovered and (2) China has reached the limits of low cost expansion. The strong disinflationary forces in the past two decade were one-time. As central banks tackle cyclical issues, they should keep in mind of the secular change. Interest rates should be significantly higher in future.
At the bottom of its debt crisis ten years ago, Russian economy was priced below $300 billion. Its currency collapsed. Its real output collapsed. The former superpower was worth less than Taiwan. Its economy has since recovered above $1 trillion and is growing at over 6% in real terms. Its currency is strong. Due to its high inflation, the real currency appreciation is much higher. The recovery has depended on surging oil price, which is partly due to western monetary policy. The rising income has led to recovery in its own consumption of natural resources. Russian domestic oil consumption shrunk by half between 1989-99. The reduction was higher the demand growth in China during the period. Its demand is now growing at over 4% per annum. While rising oil price is the main driver for its recovery, its expanding economy is raising its own oil demand, which is inflationary for the world.
The Central and Eastern European countries in ('CEECs') have joined the European Union and have made great progress towards reaching western living standard. Like Russia, they suffered weak economies and weak currencies in the 1990s. Their economies grew by 1.2% between 1989-99. They have improved in the current growth cycle and have averaged 5% growth rate since 2000. These economies already total $3 trillion in dollar terms. Similar to Russia, their oil consumption shrank by more than half between 1989-1999 but is growing at over 3% per annum at present.
Russia plus CEECs are bigger than China in nominal GDP and consume 70% as much oil. In terms of resource consumption, they were a massive deflationary shock to the world economy. Their oil consumption reduction was twice as much as China's consumption growth between 1989-1999. Their recovery plays an equally important role as China's demand in the energy market. In terms of labor supply, the CEECs have lower unemployment rates than in the Western Europe. Both CEECs and Russia suffer from aging like the west. Their labor market, in my view, is also inflationary to the global economy. Despite strong currencies, their domestic inflation trends tell the story. The CEECs are experiencing 6% plus inflation now, much higher than in Western Europe. Russia's inflation rate is hitting a double digit rate.
China's manufacturing expansion has been the other factor keeping inflation low. The low cost expansion is now running into limits. Four key inputs-labor, land, coal, and environment are running into supply constraints. For a long time, coal mining was not profitable. Coastal assembly plants could order tens of thousands of workers from central China without raising wages. Local governments competed against each other to attract factories by offering cheap industrial land and tax breaks. They ignored environmental protection as an incentive to factory operators.
Coal accounts for two thirds of China's energy consumption. Its price has become sensitive to demand growth as all mines are producing at maximum capacity. We can only guess the price elasticity to demand growth. It may be 3-5, i.e., 10% growth may cause price to rise by 30-50%. Measured at international prices, China's energy consumption cost is already over 10% of GDP. Of course, price control and subsidies keep the figure a bit lower. As the share of energy in GDP is so high, its price increase causes inflation to rise significantly. Hence, as China's manufacturing expands, its energy cost will rise as a share of total cost.
Youth labor is in 'short supply'. The Pearl River Delta ('PRD') has been reporting labor 'shortage' for three years. It actually reflects that the PRD is not raising wages to market equilibrium levels. That is a major turning point in China's labor market. Until two years ago, the PRD factories could get as many workers as they wanted. They usually negotiated with interior governments first before they would help in recruiting workers. The negotiations were to keep the wages from falling. The expansion of the economy and the shrinkage of the youth pool are the reasons for the turnaround. In future, factories have to raise wages if they want to expand.
Residential and commercial land prices have skyrocketed in China, in many tier-1 cities by 10 times or more since 2000. Local governments still try to keep their industrial land prices down to keep or attract more factories. However, land inflation works into overall production cost nevertheless through rising living cost, which needs to be offset by wage increase. Many companies already consider local property prices in selecting expansion locations. My guesstimate is that property price determines half of the wage level.
Last but not least, lax environmental protection has been a significant factor in China's low cost expansion. When manufacturing expansion began two decades ago, the level of environmental degradation was low and the incremental pollution was small relative to the environmental capacity. Now, the environmental degradation has reached the limits and, as manufacturing now is ten times bigger than two decades ago, the incremental pollution is large. China has to adopt stringent environmental protection standards to prevent a disaster. That is another factor in raising production costs.
Emerging economies inflate for many reasons. Excessive monetary expansion leads to currency depreciation and inflation. This is not necessarily inflationary for the world. Depreciation and inflation can cancel each other in terms of the effect on other countries. For example, China's inflation was -4% in US dollar terms in the 1980s and zero in 1990s. Hence China was deflationary for the world. But, the dollar inflation has averaged 5.1% since 2000, higher than the inflation rate in the US. The trend is still up. China is likely to be inflationary for the global economy in the next ten years, i.e., its dollar inflation is higher than that of the rest of the world.
The recoveries of the CEECs and Russia have removed a major deflationary force in commodity demand. If anything, their demand is rising faster than the world as a whole and is an inflationary force. Their labor is no longer deflationary due to aging and domestic demand recovery. China's manufacturing expansion is running into input constraints. Its inflationary pressure cannot be removed by building more factories.
The most important implication of the inflation conclusion is for the bond market. It experienced one quarter century of a bull market starting from early 1980s. The 10Y US treasury yield declined from a double digit rate to 3%. If my analysis is right, it is entering a prolonged bear market, possibly lasting for ten years.
谢国忠搜狐博客　http://xieguozhong.blog.sohu.com/

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