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Summary ------------- The government appears to have loosened bank lending in response to the pronounced ongoing economic slowdown. But the old trick of turning up the monetary spigot merely delays the needed structural reforms and leaves a bigger inflation legacy. China is facing a serious inflation challenge, despite the reported relatively benign inflation statistics lately. Inflation is the most important factor in driving social turmoils in modern Chinese history. There are limits to substituting reforms with loose monetary policy. Three years after the Global Financial Crisis the global economy is still mired in sluggish growth and above trend inflation. The policy remedy for the economic malaise is framed as austeiry vs. stimulus. Neither is the right prescription. The global economy is off the track, requiring wholesale structural reforms in all the major economies to bring it back on track. Increasing flexibility in the west and cutting taxes in China are the only viable policy combination to restore sustainable global growth. Without structural reforms, stimulus leads to more inflation, and austerity to a vicious downward spiral. After trying austerity and failing in Europe, the support for stimulating growth through public spending is gaining momentum. If it is tried, it will lead to catastrophic bond market collase. The subsequent rescue by the ECB would lead to euro collapse and surging inflation. Despite the grim consequences, the eurozone may be heading that way. Global stagflation -------------------- The much hyped US economic recovery delivered a disappointment in the first quarter. The preliminary 1Q2012 GDP estimate is 2.2% annualized growth rate on the previous quarter. On the other hand, the CPI rose by 0.9% during the quarter or 3.6% annualized. 2012 began very much like stagflation in the US. The eurozone reported 2.6% inflation rate in the first quarter and with GDP expected to grow 0.2% or 0.8% annualized. The odds are that the eurozone growth rate would disappoint, even though the base is very low due to the large contraction in the second half of 2011. It is possible that the eurozone economy may have contracted againt in the first quarter. The eurozone data fit the stagflation mode quite Among developing economies, India's industrial production is stalling with credit rating possibly downgraded to junk, and China's electricity consumption has slowed by half from last year's, while their inflation rates remain stubbornly high. The emerging economies are no longer carrying the global economy like between 2009-11. While policymakers and analysts consider inflation not a problem due to sluggish growth, the facts are that reported inflation figures around the world are higher than the historical averages. Predicting inflation on output gap isn't working now. Much of the output gap in the west is ficticious. It is outdated capacity. The high unemployment rate isn't a disinflationary force as long as labor market flexibility isn't there. Money supplies, on the other hand, continue to grow robustly, especially in developing economies, fueling energy and food prices. Hence, despite sluggish GDP growth and high unemployment rates, inflation is on the rise. Easing monetary condition has lost its effectiveness at stimulating growth but quite effective at fueling inflation. Central banks are pushing on a string. If they insist on more monetary stimulus, the world is heading towards an inflation crisis similar to what occurred in the 1970s. Eurozone making the wrong turn ------------------------------------ Austerity has become unpopular in Europe. A political backlash is unfolding. The Dutch government just collapsed over the opposition to its austerity package. The French presidential election may be decided in favor of the Socialist Party due to the popular opposition to the austerity measures imposed by the current government. Spain may buckle too as the severe economic contraction destroys the recently installed conservative government. In short, the eurozone may be abandoning austerity in favor of stimulus. While the current austerity approach alone isn't working, the alternative that the suffering countries are contemplating would lead to bigger disaster. The alternative, as many famous American economists have been advocating, is to grow out of the debt problem. The theory is that the debt level isn't too high, but the growth rate is too low. Hence, they believe that the right recipe for Europe is to stimulate growth. Of course, it means borrowing more to spend and bigger fiscal deficit. But, according to this theory, growth will revive and bring in more fiscal revenue down the road. If the bond market believes it, it should be happy to lend more. Many economists in the US fear that Europe may bring down the US economy, causing Obama the election. Their suggestion may be self-serving. But, instead of helping the US economy, it may lead to global financial turmoils, hurting the US economy. The bond market is terrified of Europe because it is not competitive. There are no macro tricks to revive its growth. Hence, while its debt levels may not be the highest, its ability to pay is very weak. Hence, when countries like France and Spain try to stimulate growth with more deficit spending, the bond market will run for life. American economists live in the la-la land and don't have a clue on how people react when their own money is on the table. Of course, the same American economists will say that the ECB could help the bond market like the Fed for the US treasuries market. Unfortunately, euro isn't a reserve currency like the dollar. If the ECB supports the market on a large scale, you can bet that private bondholders will sell to it en masse. The euro will collapse and trigger rampant inflation. A situation like this cannot be good for the US or anybody else. Austerity hasn't worked and is unlikely to work on its own. I have written in this page on the issue before. As it is being observed, the cost of austerity, as measured by lost output due to each dollar of cutting expenditure, is higher than one. But it doesn't justify the alternative to stimulate growth with more deficit spending or money printing. Only deregulation and labor market liberalization can save Europe -------------------------------------------------------------------- Austerity doesn't work because the rigidities in the economy prevent market responses to minimize the output loss. In a completely flexible economy, the output loss would be significantly less than one, as resource redeployment shifts supply to export or investment. Austerity has failed because eurozone economies have too many rigidities due to regulations and union rules. If these rigidities are not removed, pouring more money into it will merely lead to inflation, not growth. Italy, while running up ?2 trillion of national debt in the past decade and a half, hasn't grown one bit. It is ridiculous to believe that more deficit spendings would achieve more now. As I wrote in this page last month, Europe needs to remove the rigidities in its troubled economies to stop the debt crisis. Financial market isn't so shortsighted not to lend to viable governments in Europe. Southern European economies could increase greatly their output, possibly by over one fifth, if they deregulate to increase business competition and liberalize labor market to increase work hours. On the other hand, if Europe swings to stimulus without introducing the necessary structural reforms, it will lead to catastrophe. I remain pessimistic on European reforms. Europeans are in denial. They don't blame themselves for the crisis and look for easy ways out. The goal is to defend the status quo. I thought that Europe would be in mild stagflation for many years to decrease debt burden, while its living standard erodes. That is the best scenario for Europe without structural reforms. It appears that Europeans don't want to reform but don't accept declining living standard. There are politicians who promise spending out of their problems, backed up by famour American economists. We should soon see what the consequences are. The US is lucky, but ----------------------- The US economy is on the mend, even though the growth rate is low. That is because the US is rich in natural resources and farm land. Its rising energy and agriculture production has strengthened the country's competitiveness, decreasing trade deficit and improving terms of trade. In this world, without improving competitiveness, one doesn't deserve growth. The US enjoys what it gets from God. It should really be grateful at this moment. Most US policymakers and well-known pundits are not satisfied. They advocate more stimulus to accelerate growth. The Fed is in favor of this view. It signals QE 3 whenever the financial market is worried about growth outlook. The Bernane Fed is quite likely trying to perk up the stock market to stimulate demand. The Greenspan Fed tolerated subprime and CDOs to keep the US economy going with catastrophic consequences. Bernanke may fare no better. I suspect that Bernanke will bring out some form of QE 3 in the second half of 2012. It will work for a month or two by juicing up the stock market, which may be good enough to get Obama reelected. But it will expand the internet bubble and leave more inflation behind. Fast tightening in 2013 may be forced, causing another economic collapse. The German model ---------------------- Germany is touted as a model in Europe. Travellers in Europe may get a different impression. Germany looks more depressed than Italy. Its wage is very low. Many, if not most, factory towns are depressed. The German success shows up in trade surplus and corporate earnings, not anywhere else. I'm not denigrating the German model. It involves sacrifices by the masses for the country. The sacrifices are accepting low wage, reduced welfare, and shifting national resources to winners like the automobile industry and dumping commodity industries that suffer from Chines competition. In return housing and education are cheap and of high quality. Germany has succeeded in maintaining a vibrant industrial sector. In the globalized world, the consequences of success and failure are magnified. Dumping losers and investing in winners are the only way forward for most mid-sized economies. South Korea, for example, depends on two companies-Samsugn Electronics and Hyundai Motors. This model increases risk. But, alternatives are worse. Italy and Spain may have to undergo similar reforms to dump losers and invest in winners. Of course, to do so requires wholesale reforms to increase economic flexibilities. This is the lesson from Germany. Manipulating demand doesn't work -------------------------------------- The economics profession has brought probably more harm than good. So many bright people armed with so much knowledge want to do something good. One good is to eliminate business cycle by manipulating demand. Stagflation in the 1970s was due to central bankers wanting to cure unemployment. Greenspan's midas touch turned out to be a huge bubble with catastrophic consequences for the US and the world. Nowadays, the press often heaps praise on central bankers and policymakers for fighting the financial crisis. But, they caused it in the first place. And, the fighting seems to make things worse too. Globalization is making demand manipulation less effective than before. Multinational companies have made production completely movable. Hence, no government could count on some local virtuous cycle between demand and supply, which is the necessary condition for demand stimulus to be effective. I suspect that today's central bankers are making fools out of themselves trying to restore growth to everyone's satisfaction. The most important economic development in the past two decades is the rise of true multinational companies that can move production and sales effortlessly across the globe. IT and China are the most important factors in realizing this global economy. Any policymaker or economist who doesn't understand how today's MNCs work are not qualified to do their job. Multinational companies have become an independent force from their countries. They are stronger than most countries in the world. In this world, there is huge asymmetry between labor and capital in mobility. No economic remedy is effective without taking this into consideration. Despite sluggish economic growth everywhere, multinational companies are reporting good earnings and cash flow. This is no coincident. The global economy is probably growing at 6-7% in nominal terms, most of it inflation though. Through cost arbitrage and technical progress, multinational companies can growth their profits at 10%. The rise of multinational companies limits national policies. For example, labor market has to be totally flexible for an economy to function well in this world. Otherwise, MNCs can just move somewhere else to avoid the extra cost. It has become difficult to tax MNCs. They can park their income anywhere. Governments cannot count on profit tax for income redistribution. I suspect most countries need to move to global tax on personal income. Some sort of global agreement on what income tax should be is necessary for this world to function. Income redistribution needs to be in more productive forms like education and housing. The governance structure of the 20th century is in full crisis. Policymakers and pundits are advocating the same old solutions like fiscal and monetary stimulus. As long as such people are in power, the global crisis will not end. |
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