Andy Xie Explains Why China's Inflation Will Prevent Bernanke from Printing Money

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Andy Xie:

The developed world is essentially competing on bad economic news. Major currencies move on who is worse at the moment. The Greek debt crisis caused the euro to plunge. Now the weak employment and resuming property weaknesses have caused the dollar to plunge. Maybe the yen is next.

On the other side of the world, inflation is sweeping over the emerging economies. Oil has climbed above US$ 80 per barrel again. Copper is back above US$ 7,000 per ton, closing in on the pre-crisis peak. The prices of agricultural commodities are gapping up. India is seeing double digit inflation. Emerging economies as a whole are experiencing inflation rates above 5 percent on average. India, Korea, and Taiwan have recently raised their interest rates, fearing accelerating inflation and an overheated property market. China has taken steps to rein in the overheating property market. It is still reporting moderate inflation. But, as the data loses touch with what people feel on the street, the pressure for rate hikes may become too strong to resist. Inflation and asset bubbles dominate the concerns of emerging economies…

… We are seeing the interplay between the forces of globalization and policy mistakes. Globalization has severely restricted the effectiveness of economic stimulus. Trade plus FDI are half of the global GDP. Trade is visible in terms of stimulus leakage. But, where investment occurs in response to demand growth is far more important. Multinationals can invest anywhere in response to demand. It cuts the linkage between demand stimulus and investment response. The latter is crucial to employment growth, which is necessary for sustaining demand growth beyond stimulus. Essentially, demand is local, but supply is global. This is why the old assumptions on stimulus are no longer reliable…

… Multinational-led globalization has made large economies behave like small, open economies. Demand is still local, but supply is global. When the Fed or the ECB tries to stimulate, they are actually stimulating the global economy as a whole. Water, no matter where it comes from, flows downwards. Stimulus, similarly, flows to where costs are low and banking systems are healthy. If you believe this logic, the actions of the Fed and the ECB fuel inflation and asset bubbles in emerging economies rather than stimulate growth at home.

A similar move occurred after the U.S.’s Savings and Loans crisis in the early 1990s. The Fed cut interest rates to 3 percent to help its banking system recover. The lower interest rates pushed Western banks to lend a lot to Southeast Asia, fueling a property bubble there. When the U.S.’s monetary policy was tightened, capital was pulled back. It caused the Asian Financial Crisis of 1997-98.

Today’s story is much bigger and with more dimensions. The emerging economies are twice as big relative to the developed economies with double the trade volume relative to the global economy then. Investment and financial capital can now flow with little friction across the world. I suspect that the Fed policy today would cause distortions in the global economy three times as big as it did in the early 1990s. Its consequences would cause a global calamity far bigger than the Asian Financial Crisis.

The big difference from the 1990s is the employment response to the stimulus in the developed economies. Despite trillions of dollars in stimulus and a sharp one-year rebound in the global economy from the middle of 2009, the developed economies have virtually seen no employment growth. The consequences of the financial crisis have eaten away quite a big chunk of the stimulus. It is, however, not the full explanation. We are seeing overheating in emerging economies. The stimulus is just working somewhere else.

For the stimulus to work in developed economies, it needs to inflate costs in emerging economies so much that the multinationals want to add additional capacity in the developed economies. That is unlikely. The average wage in developed economies is about ten times the average level in emerging economies. And there are five people in emerging economies for each one in developed economies. The math just wouldn’t work out for this approach.

Financial capital is turbo-charging the oil price both due to speculation and inflation hedging. Speculators are trying to anticipate the producers’ willingness to supply and the demand from inflation hedges. Such motivations don’t necessarily cause bubbles. But, when there are too many speculators, the price loses its normal signaling functions and just reflects speculative demand. When interest rates are near zero, speculators mushroom. If the Fed does pursue “QE 2,” oil prices are very likely to rise above US$ 100 again.

Many analysts think that gold is in a bubble now. Quite a lot of money has been pulled out of gold lately. I think that the gold price just reflects how loose the monetary environment is now. If the Fed does a “QE 2,” gold prices could rise above US$ 1,500 per ounce quickly and may move much higher afterwards.

When the Fed cut interest rates in the summer of 2007, in response to the first signs of the sub-prime crisis, the commodity index (‘CRB’) surged 50 percent in the following ten months. It then collapsed by 60 percent when Bear Stearns and Lehman Brothers collapsed. It has recovered by over 30 percent from the bottom. The recent history shows how volatile commodity prices can be. If the Fed does pursue “QE 2,” the CRB index will surely surge. And, it won’t collapse like last time. There is so much more money in the world now. Some of it should turn into inflation through commodities. The value of commodities is about one tenth of the global GDP. It is a powerful force in turning money supply into inflation.

Labor costs in the emerging economies are rising due to their overheating. Global trade is about one fifth of the global GDP in value. One often hears that labor costs are only one tenth of the cost at most factories. But, the components that often account for over half of the cost are made by labor in other factories. The infrastructure and logistics services have significant labor costs too. The total labor content for export goods is probably over one third in emerging economies. When labor cost rises at 20-30 percent per annum, it becomes a serious source of inflation.

Read the original story at Israel’s Financial Expert