Financial markets didn't wait for the smoke to clear from the Dubai debt crisis before jumping back into the happy days of shorting the dollar and piling into everything else. After the massive government bailouts in the last crisis, the markets don't have any doubt that there would be bailouts the next time. This no-downside psychology is making each market correction shorter and shallower.
The zero-interest rate environment and rapid monetary growth are scaring conservative savers into becoming budding speculators. By threatening to destroy the value of cash and by subsidizing speculation with low interest rates and bailouts, good guys really finish last. It may be better surfing the speculative waves than staying put. One may die in a speculative crash, but holding onto cash when governments are hell-bent on printing money to solve every problem seems like certain death.
The Dubai crisis wasn't even the most important event last month. The confirmation of Ben Bernanke and Obama's announcement of the surge-and-withdraw decision for the Afghan War were both more important. Both indicate that the most important decisions in the world are focused on sustaining existing trends despite catastrophic consequences in the long term.
Senators expressed huge frustration during Bernanke's confirmation hearing. They all sense the existing system is wrong. After all, the last crisis happened for a reason. Throwing around so much money to stabilize the financial system didn't cure anything. For the first time since the 1930s a global speculative boom is taking place amidst fragile economies and high unemployment rates. Of course there is something wrong with this world. On the other hand all the senators felt that Bernanke did a good job under the circumstances and there isn't another person available now to do a better job. Despite their misgivings they don't have the courage to start anew.
If you listen to how Bernanke is justifying what he has done and is doing, it sounds just like Greenspan. It is about decisions made on marginal considerations, not on the soundness of the system. The most powerful consideration is put on how the decisions impact GDP and employment in the short term. There is a Chinese saying that one could quench ones thirst by drinking poison. Bernanke seems to be prescribing exactly this to the US economy. He talks about interest rates being kept low because the unemployment rate is high, but he doesn't talk about how low it should be. He is confusing people between levels and marginal changes.
During his campaign last year Obama insisted that Iraq was the wrong war and Afghan the right one. Both were wrong. It seems that Obama didn't have the courage to go against the system and go back on his words to stop the war. Afghanistan is an infinitely tougher nut to crack than Iraq, and the chances are very slim that the US can win this war. Obama was elected on a platform of ‘change,' but so far the system has changed him more than the other way around.
If you try to search through the minutia of economic data to gain insight into the future, you are probably looking in the wrong place. The crisis threw the world out of balance. Governments throwing around trillions of dollars restore stability temporarily, but this strategy is too expensive to last. Only massive structural changes can bring the global economy into self-sustaining balance and lay the foundation for another growth cycle. The problem is that structural reforms would bring pain first and gain later. Politicians, wherever they are and whatever parties they belong to, seem incapable of talking about accepting pain. The policy consensus to prop up the global economy with stimulus will continue until inflation takes off or governments are broke.
Some of the bright spots, like bank earnings and GDP growth, that governments are touting as results of the trillions of dollars they have spent are misleading. Banks are making high profits in a fragile global economy, but the global pie is not expanding quickly. How could banks make such huge profits? The usual explanation is that banks have traded well, like borrowing short-term funds from the Fed at a zero percent interest rate and investing in treasuries at 3.5% interest rate. The US' financial sector has USD 16.5 trillions of debt. Just 2% spread from such trades could yield over USD 300 billions in profits. That seems like a miracle: nobody is hurt, and banks make billions.
The pain is actually postponed in two ways. First, the low funding cost for banks' trading will turn into inflation that dilutes everyone's cash holdings: The Fed is just redistributing money from savers to banks, only the savers don't know it yet. Second, the banks' low funding cost has a government-guarantee component. Even though the Fed keeps its funds rate at zero, without the government bailout expectation even the best run banks would pay at least 2 percentage points more for debt, i.e., their profits would be wiped out if the debt market doesn't believe in a government bailout. All the excitement about the banks repaying the TARP money is an illusion. Could these banks exist at all, let alone make huge profits, without the implicit government guarantee on their debts? The cost associated with the guarantee is effectively a free insurance policy from the taxpayers. When the next crisis hits, the cost will materialize. The financial recovery that governments are touting is really a sham; it is just another robbery.
Inventory recovery, fiscal stimulus and asset inflation have been the three factors behind the recent economic recovery. The global economy probably grew at a 4% year-on-year rate in the fourth quarter. Inventory recovery is contributing to most of the current growth. When credit conditions tightened after Lehman's collapse, businesses were forced to shed inventory to raise liquidity. The subsequent demand collapse further reinforced the inventory destocking dynamic. Fiscal stimulus is mostly in the form of a stabilizer, i.e., governments don't cut spending when revenues fall during recession. It doesn't boost growth per se, but it stops the recession's multiplier effect through the government's budget constraints.
Asset inflation is making a significant contribution to global growth, mainly in emerging economies and in the housing, auto and commodity sectors. The perceived robust growth in emerging economies is mainly an asset inflation story, which is fed by the weak dollar-driven hot money. What's occurring is similar to what happened in 1995. Then the emerging economies had robust growth amidst asset inflation while the dollar was making a historical low.
Inflation will likely drive the next crisis. The normal lag between money creation and inflation is one year and a half – though it is probably longer now due to globalization. Massive money creation took place one year ago, so inflation will likely become apparent in 2011. A vicious wage-price spiral could take place in 2012, similar to that which occurred in the late 1970s. Inflation would scare central banks into tightening dramatically in 2012, which will pop the current asset bubble. By then the global problem would be more serious than now: in addition to the leverage problem in the household and financial sectors, the government sector would also be hugely leveraged. The global economy would experience something similar to what the US experienced in early 1980s, in fact probably worse.
The next crisis will be Bernanke's. While he is justified to keep interest rates low after a financial crisis, the issue is how low? Bernanke is keeping the short term rate at zero and the long term rate at 3.5% through the Fed's purchase program. The manipulation along the whole yield curve is creating massive distortion in capital allocation, essentially in favor of speculation. The slower Bernanke raises interest rates, the bigger the next crisis.
The next crisis will essentially be a continuation of the last one. Out of political concerns governments and central banks have thrown trillions of dollars towards preventing necessary economic adjustments, believing that stimulus will bring back growth. The money is buying some time, but the costs are (1) that the governments won't have enough money to cushion the pain during the coming economic restructuring and (2) that inflation will increase misery in an economic downturn.
The whole world is drinking poison to quench its thirst. It may feel like relief now, but the sickness will strike in 2012.
The zero-interest rate environment and rapid monetary growth are scaring conservative savers into becoming budding speculators. By threatening to destroy the value of cash and by subsidizing speculation with low interest rates and bailouts, good guys really finish last. It may be better surfing the speculative waves than staying put. One may die in a speculative crash, but holding onto cash when governments are hell-bent on printing money to solve every problem seems like certain death.
The Dubai crisis wasn't even the most important event last month. The confirmation of Ben Bernanke and Obama's announcement of the surge-and-withdraw decision for the Afghan War were both more important. Both indicate that the most important decisions in the world are focused on sustaining existing trends despite catastrophic consequences in the long term.
Senators expressed huge frustration during Bernanke's confirmation hearing. They all sense the existing system is wrong. After all, the last crisis happened for a reason. Throwing around so much money to stabilize the financial system didn't cure anything. For the first time since the 1930s a global speculative boom is taking place amidst fragile economies and high unemployment rates. Of course there is something wrong with this world. On the other hand all the senators felt that Bernanke did a good job under the circumstances and there isn't another person available now to do a better job. Despite their misgivings they don't have the courage to start anew.
If you listen to how Bernanke is justifying what he has done and is doing, it sounds just like Greenspan. It is about decisions made on marginal considerations, not on the soundness of the system. The most powerful consideration is put on how the decisions impact GDP and employment in the short term. There is a Chinese saying that one could quench ones thirst by drinking poison. Bernanke seems to be prescribing exactly this to the US economy. He talks about interest rates being kept low because the unemployment rate is high, but he doesn't talk about how low it should be. He is confusing people between levels and marginal changes.
During his campaign last year Obama insisted that Iraq was the wrong war and Afghan the right one. Both were wrong. It seems that Obama didn't have the courage to go against the system and go back on his words to stop the war. Afghanistan is an infinitely tougher nut to crack than Iraq, and the chances are very slim that the US can win this war. Obama was elected on a platform of ‘change,' but so far the system has changed him more than the other way around.
If you try to search through the minutia of economic data to gain insight into the future, you are probably looking in the wrong place. The crisis threw the world out of balance. Governments throwing around trillions of dollars restore stability temporarily, but this strategy is too expensive to last. Only massive structural changes can bring the global economy into self-sustaining balance and lay the foundation for another growth cycle. The problem is that structural reforms would bring pain first and gain later. Politicians, wherever they are and whatever parties they belong to, seem incapable of talking about accepting pain. The policy consensus to prop up the global economy with stimulus will continue until inflation takes off or governments are broke.
Some of the bright spots, like bank earnings and GDP growth, that governments are touting as results of the trillions of dollars they have spent are misleading. Banks are making high profits in a fragile global economy, but the global pie is not expanding quickly. How could banks make such huge profits? The usual explanation is that banks have traded well, like borrowing short-term funds from the Fed at a zero percent interest rate and investing in treasuries at 3.5% interest rate. The US' financial sector has USD 16.5 trillions of debt. Just 2% spread from such trades could yield over USD 300 billions in profits. That seems like a miracle: nobody is hurt, and banks make billions.
The pain is actually postponed in two ways. First, the low funding cost for banks' trading will turn into inflation that dilutes everyone's cash holdings: The Fed is just redistributing money from savers to banks, only the savers don't know it yet. Second, the banks' low funding cost has a government-guarantee component. Even though the Fed keeps its funds rate at zero, without the government bailout expectation even the best run banks would pay at least 2 percentage points more for debt, i.e., their profits would be wiped out if the debt market doesn't believe in a government bailout. All the excitement about the banks repaying the TARP money is an illusion. Could these banks exist at all, let alone make huge profits, without the implicit government guarantee on their debts? The cost associated with the guarantee is effectively a free insurance policy from the taxpayers. When the next crisis hits, the cost will materialize. The financial recovery that governments are touting is really a sham; it is just another robbery.
Inventory recovery, fiscal stimulus and asset inflation have been the three factors behind the recent economic recovery. The global economy probably grew at a 4% year-on-year rate in the fourth quarter. Inventory recovery is contributing to most of the current growth. When credit conditions tightened after Lehman's collapse, businesses were forced to shed inventory to raise liquidity. The subsequent demand collapse further reinforced the inventory destocking dynamic. Fiscal stimulus is mostly in the form of a stabilizer, i.e., governments don't cut spending when revenues fall during recession. It doesn't boost growth per se, but it stops the recession's multiplier effect through the government's budget constraints.
Asset inflation is making a significant contribution to global growth, mainly in emerging economies and in the housing, auto and commodity sectors. The perceived robust growth in emerging economies is mainly an asset inflation story, which is fed by the weak dollar-driven hot money. What's occurring is similar to what happened in 1995. Then the emerging economies had robust growth amidst asset inflation while the dollar was making a historical low.
Inflation will likely drive the next crisis. The normal lag between money creation and inflation is one year and a half – though it is probably longer now due to globalization. Massive money creation took place one year ago, so inflation will likely become apparent in 2011. A vicious wage-price spiral could take place in 2012, similar to that which occurred in the late 1970s. Inflation would scare central banks into tightening dramatically in 2012, which will pop the current asset bubble. By then the global problem would be more serious than now: in addition to the leverage problem in the household and financial sectors, the government sector would also be hugely leveraged. The global economy would experience something similar to what the US experienced in early 1980s, in fact probably worse.
The next crisis will be Bernanke's. While he is justified to keep interest rates low after a financial crisis, the issue is how low? Bernanke is keeping the short term rate at zero and the long term rate at 3.5% through the Fed's purchase program. The manipulation along the whole yield curve is creating massive distortion in capital allocation, essentially in favor of speculation. The slower Bernanke raises interest rates, the bigger the next crisis.
The next crisis will essentially be a continuation of the last one. Out of political concerns governments and central banks have thrown trillions of dollars towards preventing necessary economic adjustments, believing that stimulus will bring back growth. The money is buying some time, but the costs are (1) that the governments won't have enough money to cushion the pain during the coming economic restructuring and (2) that inflation will increase misery in an economic downturn.
The whole world is drinking poison to quench its thirst. It may feel like relief now, but the sickness will strike in 2012.
By Andy Xie.
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