http://english.caijing.com.cn/2009-08-20/110227359.html
Andy Xie: New Bubble Threatens a V-Shaped Rebound
08-20 08:04 Caijing
A growing liquidity bubble that ignores structural facts is the basis for today's happy talk about a comeback for the global economy.
By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.
(Caijing Magazine) The United States is beginning to report data showing strong economic growth. Analysts are upgrading their outlooks for the U.S. economy, which is expected to grow at an annualized pace of 3 to 4 percent. And even before the U.S. revival emerged in the third quarter, China's data pointed toward a quick rebound in the second quarter.
Is the global economy staging a V-shaped bounce? The buoyant financial market had been expecting a rebound for months. Was the market right?
At the end of last year, I said I expected global stock markets to stage a big bounce in spring 2009, and the global economy to rebound in the second half. I also expected analysts to upgrade outlooks by this time. I warned that the economic pickup was due to inventory cycle and stimulus, and that the global economy would experience a second dip in 2010.
In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won't it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.
The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.
Many policymakers actually don't think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven't done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don't think so.
The lifespan of a bubble depends on how it affects demand. The longest-lasting are property and technology bubbles. The multiplier effect of a property bubble is multifaceted, stimulating investment and consumption in the short term. The supply chain it impacts is very long. From commodity producers to real estate agents, it could stimulate more than one-fifth of an economy on the supply side. On the demand side, it stimulates credit growth and financial sector earnings, and often boosts consumption through the wealth effect. Because a property bubble is so powerful, the negative effects of a bursting are great. Excess supply created during a bubble's lifespan takes time to consume. And a bust destroys the credit system.
A technology bubble occurs when investors exaggerate a new technology's impact on corporate earnings. A breakthrough such as the Internet improves productivity enormously. However, consumers receive most of the benefits. Competition eventually shifts temporarily high corporate profitability toward lower consumer prices. Because the emergence of an important technology brings down consumer prices, central banks often release too much money, which flows into asset markets and creates bubbles. While an underlying technology leads to an economic boom, the bubble feels real. More capital pours into the technology. That leads to overcapacity and destruction of profitability. The bubble bursts when speculators finally realize that corporate earnings won't rise after all.
The cost of a technology bubble is essentially equal to the amount of over-investment involved. Because a technological breakthrough expands the economic pie, the costs of a technology bubble are easy to absorb. An economy can recover relatively quickly.
A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn't take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble's burst.
What we are seeing now in the global economy is a pure liquidity bubble. It's been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.
What occurred in China in the second quarter and started happening in the United States in the third quarter seems to lend support to this view. I think the market is being misled. The driving forces for the current bounce are inventory cycle and government stimulus. The follow-through from corporate capex and consumption are severely constrained by structural challenges. These challenges have origins in the bubble that led to a misallocation of resources. After the bubble burst, a mismatch of supply and demand limited the effectiveness of either stimulus or a bubble in creating demand.
The structural challenges arise from global imbalance and industries that over-expanded due to exaggerated demand supported in the past by cheap credit and high asset prices. At the global level, the imbalance is between deficit-bound Anglo-Saxon economies (Australia, Britain and the United States) and surplus emerging economies (mainly China and oil exporters). The imbalance was roughly equal to US$ 1 trillion, or 2 percent of global GDP. The imbalance was supported by: 1) the willingness of central banks in surplus, emerging economies to hold down exchange rates and recycle their surpluses into the deficit economies by buying government bonds; 2) the willingness of consumers in deficit countries to buy with borrowed money; and 3) Wall Street's ability to dress up high-risk consumer loans as low-risk derivative products. I am describing these factors to underscore that central banks are unlikely to bring back yesterday's equilibrium.
Recent data point to a sharp increase in the household savings rate in the United States. Over two years, it rose above 5 percent from minus 2 percent. The current level is still below the historical average 8 percent. If normalization remains on track, it should rise above 8 percent, and probably reach above 10 percent, to bring debt levels down to the historical average.
Some argue that, if low interest rates revive the property market, American households may be willing to borrow and spend again. This scenario is possible but not likely. The United States has not experienced serious property bubbles in the past because land is privately owned and plentiful. A supply overhang from one bubble takes a long time to digest. And American culture tends to swing to frugality after a bubble. One's outlook either for a normal recovery or a bubble-inspired boom depends on the outlook for the U.S. household savings rate. Unless the U.S. household sector is willing to borrow and spend again, emerging economies will not be able to revive the export-led growth model.
If one accepts that the U.S. household savings rate will continue to rise, emerging economies must decrease their savings rates, increase investment, or decrease production. The best choice is to decrease savings rates. But savings rates are hard to change. They depend mainly on demographics and wealth levels. The quickest possible way out would involve creating an asset bubble that inflates household wealth and decreases savings. Many advocates of inflated property and stock markets in China have this effect in mind. Japan's bubble after the Plaza Accord in 1985 had its origin in the same dilemma. This approach, if it works, has catastrophic long-term consequences. Japan remains mired in stagnation two decades after its bubble began to burst.
Andy Xie: New Bubble Threatens a V-Shaped Rebound
08-20 08:04 Caijing
A growing liquidity bubble that ignores structural facts is the basis for today's happy talk about a comeback for the global economy.
By Andy Xie, guest economist to Caijing and a board member of Rosetta Stone Advisors Ltd.
(Caijing Magazine) The United States is beginning to report data showing strong economic growth. Analysts are upgrading their outlooks for the U.S. economy, which is expected to grow at an annualized pace of 3 to 4 percent. And even before the U.S. revival emerged in the third quarter, China's data pointed toward a quick rebound in the second quarter.
Is the global economy staging a V-shaped bounce? The buoyant financial market had been expecting a rebound for months. Was the market right?
At the end of last year, I said I expected global stock markets to stage a big bounce in spring 2009, and the global economy to rebound in the second half. I also expected analysts to upgrade outlooks by this time. I warned that the economic pickup was due to inventory cycle and stimulus, and that the global economy would experience a second dip in 2010.
In a normal economic cycle, an inventory-led recovery would be followed by corporate capital expenditure, leading to employment expansion. Rising employment leads to consumption growth, which expands profitability and more capex. Why won't it work this time? The reason, as I have argued before, is that a big bubble distorted the global economic structure. Re-matching supply and demand will take a long time.
The process is called Schumpeterian creative destruction. Keynesian thinking ignores structural imbalance and focuses only on aggregate demand. In normal situations, Keynesian thinking is fine. However, when a recession is caused by the bursting of a big bubble, Keynesian thinking no longer works.
Many policymakers actually don't think along the line of Keynes versus Schumpeter. They think in terms of creating another bubble to fight the recessionary impact of a bubble burst. This type of thinking is especially popular in China and on Wall Street. Central banks around the world, although they haven't done so deliberately, have created another liquidity bubble. It manifested itself first in surging commodity prices, next in stock markets, and lately in some property markets. Will this strategy succeed? I don't think so.
The lifespan of a bubble depends on how it affects demand. The longest-lasting are property and technology bubbles. The multiplier effect of a property bubble is multifaceted, stimulating investment and consumption in the short term. The supply chain it impacts is very long. From commodity producers to real estate agents, it could stimulate more than one-fifth of an economy on the supply side. On the demand side, it stimulates credit growth and financial sector earnings, and often boosts consumption through the wealth effect. Because a property bubble is so powerful, the negative effects of a bursting are great. Excess supply created during a bubble's lifespan takes time to consume. And a bust destroys the credit system.
A technology bubble occurs when investors exaggerate a new technology's impact on corporate earnings. A breakthrough such as the Internet improves productivity enormously. However, consumers receive most of the benefits. Competition eventually shifts temporarily high corporate profitability toward lower consumer prices. Because the emergence of an important technology brings down consumer prices, central banks often release too much money, which flows into asset markets and creates bubbles. While an underlying technology leads to an economic boom, the bubble feels real. More capital pours into the technology. That leads to overcapacity and destruction of profitability. The bubble bursts when speculators finally realize that corporate earnings won't rise after all.
The cost of a technology bubble is essentially equal to the amount of over-investment involved. Because a technological breakthrough expands the economic pie, the costs of a technology bubble are easy to absorb. An economy can recover relatively quickly.
A pure bubble tied to excess liquidity that affects one or many financial assets cannot last long. Its multiplier effect on the broad economy is limited. It could have a limited impact on consumption due to the wealth effect. As it neither stimulates the supply side nor boosts productivity, whatever story it is based on will have holes that become apparent to speculators. It doesn't take long for them to flee. Furthermore, a pure liquidity bubble without support from productivity can easily lead to inflation, which causes tightening expectations that trigger a bubble's burst.
What we are seeing now in the global economy is a pure liquidity bubble. It's been manifested in several asset classes. The most prominent are commodities, stocks and government bonds. The story that supports this bubble is that fiscal stimulus would lead to quick economic recovery, and the output gap could keep inflation down. Hence, central banks can keep interest rates low for a couple more years. And following this story line, investors can look forward to strong corporate earnings and low interest rates at the same time, a sort of a goldilocks scenario for the stock market.
What occurred in China in the second quarter and started happening in the United States in the third quarter seems to lend support to this view. I think the market is being misled. The driving forces for the current bounce are inventory cycle and government stimulus. The follow-through from corporate capex and consumption are severely constrained by structural challenges. These challenges have origins in the bubble that led to a misallocation of resources. After the bubble burst, a mismatch of supply and demand limited the effectiveness of either stimulus or a bubble in creating demand.
The structural challenges arise from global imbalance and industries that over-expanded due to exaggerated demand supported in the past by cheap credit and high asset prices. At the global level, the imbalance is between deficit-bound Anglo-Saxon economies (Australia, Britain and the United States) and surplus emerging economies (mainly China and oil exporters). The imbalance was roughly equal to US$ 1 trillion, or 2 percent of global GDP. The imbalance was supported by: 1) the willingness of central banks in surplus, emerging economies to hold down exchange rates and recycle their surpluses into the deficit economies by buying government bonds; 2) the willingness of consumers in deficit countries to buy with borrowed money; and 3) Wall Street's ability to dress up high-risk consumer loans as low-risk derivative products. I am describing these factors to underscore that central banks are unlikely to bring back yesterday's equilibrium.
Recent data point to a sharp increase in the household savings rate in the United States. Over two years, it rose above 5 percent from minus 2 percent. The current level is still below the historical average 8 percent. If normalization remains on track, it should rise above 8 percent, and probably reach above 10 percent, to bring debt levels down to the historical average.
Some argue that, if low interest rates revive the property market, American households may be willing to borrow and spend again. This scenario is possible but not likely. The United States has not experienced serious property bubbles in the past because land is privately owned and plentiful. A supply overhang from one bubble takes a long time to digest. And American culture tends to swing to frugality after a bubble. One's outlook either for a normal recovery or a bubble-inspired boom depends on the outlook for the U.S. household savings rate. Unless the U.S. household sector is willing to borrow and spend again, emerging economies will not be able to revive the export-led growth model.
If one accepts that the U.S. household savings rate will continue to rise, emerging economies must decrease their savings rates, increase investment, or decrease production. The best choice is to decrease savings rates. But savings rates are hard to change. They depend mainly on demographics and wealth levels. The quickest possible way out would involve creating an asset bubble that inflates household wealth and decreases savings. Many advocates of inflated property and stock markets in China have this effect in mind. Japan's bubble after the Plaza Accord in 1985 had its origin in the same dilemma. This approach, if it works, has catastrophic long-term consequences. Japan remains mired in stagnation two decades after its bubble began to burst.
