Editor's Note: This article is translated from Andy Xie’s essay on http://www.chinareviewnews.com 2011-06-07 13:15:36
The global economy is falling again. Last summer, a similar scene had appeared. The Federal Reserve System (also known as the Federal Reserve, and informally as the Fed) has reversed the downward trend by giving the global stock market a lift using the second round of quantitative easing. However, this wealth effect is short-lived, because the surge in oil prices had a significant impact on consumers. Therefore, after the end of this favorable trend, the structural problems are once again exposed, while, in the meantime, the second round of quantitative easing was just implemented not long ago.
The U.S. real estate market once again is diving. About a quarter of the U.S. real estate owners have their property values in negative territory (mortgage debts greater than property values). If they have no hope for a fast recovery, they are more willing to give their properties back to the mortgage banks to remove the debts. Banks are recovering more and more properties. For fear of banks selling the houses they held, the real estate market continues to decline.
The sovereign debt crisis in Europe resurged again. This issue has never been fully resolved. The European Union (EU) only gave enough assistance to Greece and other member countries for them to solve their immediate liquidity crisis, but not enough to increase their solvency. The only solution is to let Greece go bankrupt. The EU, fearing that this crisis will spread to other countries, is waiting for a miracle. Therefore, the debt crisis in Europe feels like a chronic disease. The outbreak of this crisis will not be the last one.
Japan is in a serious recession. The 9.0 earthquake destroyed a large part of its production capacity. It will take a long time to recover. The hope for a rapid recovery will soon be broken. It is exactly this hope that has kept the yen from falling. But the reality is that when Japan increases imports to rebuild the country, its trade imbalance will continue to deteriorate. During the ssecond half of the year, the yen is likely to face a sharp depreciation.
In response to the crisis, emerging economies are tightening their policies. But inflation does not seem to be tamed. This battle against inflation has two disadvantages. First, the very loose monetary policy implemented by the Fed is fueling commodity inflation. Emerging economies cannot effectively deal with the situation. Second, interest rates in emerging economies rise slowly, slower than the inflation rate. Therefore, their real interest rates remain negative, further increasing inflation. To be effective, it is necessary to adopt policies of greater austerity. But this would make the market worry that economic growth will be affected.
It seems that the global economy is declining synchronously. The economic data of this summer are likely to be very poor and terribly surprising. Fear will take over the financial markets.
Who Can Save the Market?
A month ago I mentioned in this column the possibility of a third round of quantitative easing. But the response was not enthusiastic. Almost everyone told me that was not possible. But after the market began to fall, a new idea appeared. Suddenly a third round of quantitative easing becomes possible. I think the oil price will have to decrease by another 25% to make a third round of quantitative easing realistic; only when the poor economic data give people big surprises, can a third round of quantitative easing be implemented. When oil prices have dropped enough, the Fed can take the opportunity to push for a re-stimulus plan.
Inflation is eating away the U.S. revenue growth the same way as in other countries. The Fed is still reluctant to believe that its policies, whether from any point of view, are detrimental to the production. The Fed policies have stimulated the growth of bubbles, slowed structural reforms and curbed consumption. But the Fed is still not repentant. It has blind faith in its monetary stimulus to promote economic recovery. Thus, with a further decline in the U.S. economy, the Fed cannot be sidelined, and will definitely intervene. This would be a massive third round of quantitative easing, or some other policies. It is hard to say which.
If the Fed does act, then the stock market will go up, making people feel better. But this feeling would be short-lived. The Fed's stimulus would cause oil prices to jump up, and erase all the benefits from the rising markets. The Fed is now riding a tiger: no matter what it does, it would be a disaster.
If Europe can decisively resolve its debt crisis, its confidence will recover. It is almost beyond doubt that Greece will default; further delay will only affect the financial markets. Once the solution is introduced, which specifically determines the loss amount of the Greek bondholders and the refinance amount of the affected European banks, the financial market will price these negative messages, and then moves on.
The financial markets have great expectations for China and hope that China will relax its policy. Almost every month the market is talking that China's inflation will soon peak and it is possible to relax its policy again. Although we cannot deny this possibility, such an opportunity is very slim. China's inflation is currently in an unstable period. In comparison, the statistics are less important than what people have seen and felt. In the normal inflation circumstances, goods and service prices often consumed by people may rise a few percent. However in today's China, the prices of products and services usually increase by as much as 10% to 30%. This shows how serious the problem of inflation is.
Just as I noted in this column two weeks ago, China's economic growth over-relied on a real estate bubble. The longer this growth continues, the more painful the final adjustment will be.
In addition, the bottleneck of China's economic growth has become increasingly difficult to overcome. For example, the energy shortage this year could be very serious. If the Chinese abandon curbing inflation and stimulate economic growth again, then the energy shortage will likely become a serious crisis. The Fed or Europe may once again support the financial markets, but China will not. If the market recovers, that would also be temporary.
The global economy is moving toward another crisis. This time the core is the government debt crisis. After the 2008 financial crisis, none of the major governments has undergone sufficient restructuring to resolve the bubbles and to address the underlying structural factors. Instead, the major economies promoted economic growth by stimulating measures, hoping to solve the problem through growth. This is why only two years after the crisis, the world is in an unstable state again.
The nature of the problem in developed countries is the high social welfare costs. Unless they can dramatically reduce the costs, their deficits will continue to remain high. After World War II, developed countries implemented welfare-state policies in exchange for social peace. As the populations age, the cost of this policy becomes unsustainable. Also, in comparison with developing countries, the developed countries also lost their original competitive advantages, so they cannot solve the problem by means of economic growth. Their short-term solution is to maintain this system running through budget deficits. Other countries also cannot escape the fate of Greece. The United States is particularly in danger. Although the country can repay its debt by printing money, the resulting inflation expectations will one day lead to a flight of the U.S. bond investors. The high bond yields triggered will force the Fed to tighten monetary policy to avoid super-inflation.
Asset bubbles have made the ruling classes rich, but ordinary workers and entrepreneurs poor. Developing countries should stop this phenomenon. China, Vietnam and other developing countries have strong cost competitiveness; low wages is the source of their wealth. But when redistributing wealth through asset bubbles, workers and entrepreneurs are undervalued. As a result, enterprises and workers are keen on speculation. With fewer and fewer enterprises and workers willing to engage in production, inflation becomes even more rampant. Unless the basic concept of governance is changed, the inflation crisis in the emerging economies will become more serious.