Economy sputters into motorcycle model
The global economy has stumbled into a growth model based on the United States' consumption and China's investment. These two sources of demand resemble the two wheels of a motorcycle that is pulling the rest of the world along.
The wealth disparity between emerging and OECD (the Organization for Economic Co-operation and Development) countries has pushed the global economy on to such a growth path of consumption based on wealth in OECD countries and investment based on export income in emerging economies.
This model is, in our view, likely to persist until the wealth gap between OECD and emerging economies has narrowed sufficiently.
Inflation is not a problem, as the demand in OECD countries automatically creates supply in emerging economies. It is, however, very prone to asset bubbles, because excess money creation does not lead to inflation, and the surplus liquidity finds a home in asset markets.
For example, the world has experienced a massive liquidity bubble since the Asian financial crisis of 1997-98. The global economy is now suspended inside a liquidity bubble, I believe. A significant adjustment is inevitable. Some US officials blame China's currency peg as the culprit.
I believe the main cause is the United States inflated the liquidity bubble to avoid adjustment after the tech burst in 2000.
The world needs a recession in the United States, in my view. A Chinese revaluation will not be significant enough to solve the world's problem. The 'motorcycle' growth model may be unusual, but can last for another decade or two.
What has occurred is the excessive liquidity from the Fed since 2000 has overheated the system. It needs to pause and cool down. A recession in the United States would serve the purpose.
The global economy would return to the same system afterwards.
When the tech bubble began to burst, financial markets were expecting the worst. It was the biggest bubble since the 1920s, and, in conventional wisdom, was bound to cause a big recession.
The US and global economies surprisingly did not experience a serious downturn. The US economy grew 0.75 per cent and consumption by 2.5 per cent in 2001. In the previous two recessions, US personal consumption bottomed at 0.17 per cent in 1991 and -0.28 per cent in 1980.
With the benefit of hindsight, the 2001 experience was merely the pause before the global economy surged to new heights in 2003 and 2004. The global economy grew at its fastest pace in two decades last year.
It wasn't a miracle.
The Fed cut interest rates quickly and aggressively. Before the speculative enthusiasm collapsed with NASDAQ, the Fed managed to channel that enthusiasm into property.
Rising property prices more than offset the negative effects of the falling NASDAQ on household wealth. US household wealth, therefore, did not feel the pain from the declining stock market, and could respond to declining interest rates by borrowing more to fund consumption.
Macro is not about inflation.
The past five decades have been the golden era for central banking. Balancing between inflation and growth has been the primary function for central banks. The oil shock of the 1970s caused inflation to go out of control. The major central banks lost credibility and had to crack down hard on inflation in the early 1980s to regain credibility.
The central bank discount rate was generally declining in all major economies. Inflation also kept falling. Inflation bottomed in 1998 for most major economies, with the noticeable exception of Japan.
Considering how low rates are around the world, it is astonishing to see such low inflation everywhere. Inflation rates would be more than 10 per cent in major economies if the global economy were the same as in the 1980s, in my view.
The world changed 15 years ago. The industrialized countries in the former Soviet Union abandoned socialism. The biggest developing countries China and India embraced globalization as the best avenue for economic development.
These changes introduced nearly 3 billion people into the global trading system. The system was previously composed of OECD countries, Southeast Asia and Latin America, which, combined, had about 2 billion people.
The countries that joined the global economy were less productive than the OECD countries, but were more productive than other emerging countries in Latin America and Southeast Asia.
The series of crises in Latin America and Southeast Asia were adjustments from the old to the new global economy, in my view.
Through the series of emerging market crises, the global economy has stumbled on an unusual growth model: US residents borrow and consume and Chinese borrow and invest.
The US consumer and the Chinese investor are like two wheels of a motorcycle. The fuel for the motorcycle is dollar liquidity from the Fed.
Alan Greenspan, the Federal Reserve's chairman, is essentially riding this motorcycle. He sticks dollar bills into the fuel tank from time to time to keep it going. The growth spillover in this model is mainly via China.
When US residents borrow to spend, the money goes to China via its surging exports. The money lands in China's banking system and goes automatically out to State-owned enterprises or property developers to invest.
The surging investment creates demand for raw materials and equipment. The money then travels to countries like Japan and Saudi Arabia. These countries, failing to find sufficient investment at home, take the money to the United States to buy treasuries.
What has occurred since 2000 is Greenspan has stuck too much money into the fuel tank and the motorcycle has become overheated. This world needs to rest.
The global economy needs to grow slowly for two or three years, which would cause the US trade deficit to decrease and China's investment growth rate to calm down.
Afterwards, the global economy will likely be back to the same game. Why the motorcycle? Why has the world stumbled into the motorcycle model? There are three major reasons:
US residents and Chinese are very optimistic. So, if you give money to either, it gets spent. The baby boomers of the United States are biased towards consumption for some unfathomable reason.
The Chinese are biased towards investment for a good reason, because they are still poor and need to accumulate capital. Optimism nourishes demand growth, but it can lead to excesses and crises.
It is not a rational force, but is the most important driver for rapid economic development, because optimism can substitute for profit.
The high cost of capital is the main barrier to rapid economic development. When people are optimistic, they only need a dream to invest or consume. Germany and Japan were developed on discipline and careful planning. They are the exceptions rather than the rule, in my view. Their cultural backgrounds well suit them for effective co-ordination on a large scale.
The United States is the world's superpower and richest country, and the dollar is the undisputed currency for the global economy. The United States enjoys the ultimate safe-haven status. It creates high demand for dollar assets. Because the United States is by far the richest country, it can keep incurring foreign liability without foreigners worrying about its solvency.
China's banking system quickly turns export income into investment, which encourages imports of equipment and raw materials.
China's development model is based on maximizing exports and investment to create jobs. Probably 400 million workers need to leave villages to join the industrial world. Political stability requires China to create as many jobs as possible.
As long as global investors are not worried about the solvency of the US Government and Chinese people believe in the solvency of China's banking system, the game keeps going.
There are two major constraints in this growth model. The availability of natural resources is the most important one, in my view. When natural resources are in short supply, liquidity flows into that sector, which lifts prices of natural resources and leads to cost-push inflation everywhere.
Second, there is a speed limit to the global demand for US dollar assets.
When the US current account deficit frightens investors, it will cause the cost of capital to rise for the United States. It slows down the motorcycle.
The Fed is effectively the central bank for the global economy. Other central banks can affect their domestic liquidity through accumulating or decreasing their foreign exchange reserves. The Fed cannot pump a lot of money without triggering global inflation, as it has done.
However, it has excessively stimulated asset markets, resulting in a huge US trade deficit and an investment bubble in China. The latter has prompted inflation of natural resources costs.
Last year, the global economy had the highest growth rate in three decades on strong US consumption and strong Chinese investment, with a stimulating effect on emerging economies through increasing commodity prices.
However, the high GDP (gross domestic product) growth rate came with deteriorating financial health. The US trade deficit rose 13.5 per cent, to a record 5.2 per cent of GDP, despite a weak dollar.
China's fixed investment doubled from 2001 to 2004, laying the seeds of overcapacity. Another wave of bad debts is, in our view, almost a certainty.
Financial stability, rather than inflation, should be the primary concern for the Fed and the Chinese Government. The recent bout of inflation is mainly due to rising prices of raw materials. The surging fixed investment in China is the main cause.
However, as China's investment boom is likely to lead to excess capacity, inflation today may trigger deflation tomorrow. There is scant evidence of wage-price spirals in any major economy.
The sustainability of the motorcycle model depends on the sustainability of the US trade deficit and the affordability of natural resources to China.
In my view, the Fed should watch the US trade deficit and the prices of natural resources to determine its monetary policies. On these two accounts, its policy is too easy, in my view.
I believe the Fed should raise interest rates quickly until oil prices decline sufficiently and the US trade deficit halves. Inflation in the US may decline to 1 per cent or lower when it happens.
But it should not be the excuse to cut interest rates again. The Fed should accept low inflation or even a little deflation.
In terms of employment creation, the Fed should lean more on labour market flexibility rather than macro stimulus. Targetting full employment with monetary policy is suicidal, in my view.
I believe the United States needs a recession. Recession is a necessary phase in cleansing an economy of excesses during a boom. Refusing to have a recession is destabilizing.
The instability in the global economy is primarily due to the fact the United States stimulated massively, and quickly, after the tech burst, which prevented the necessary cleansing.
Many US officials think a major revaluation by China would solve the US's need to have a recession. This is naive, in my view.
If China were to revalue enough to have a meaningful impact on the US economy, it would prompt the hot money to leave China and, hence, trigger a hard landing, which would add more pressure on the US economy.
A small move by China would not do anything and might incite more speculation, which would overheat the motorcycle further and leave behind a bigger bill to pay afterwards.
The author is an economist with Morgan Stanley.
(China Daily 03/14/2005 page18)
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