Chimerica’s slippery slope to stagflation
Commentary: U.S., China are heading to another double-dip scare
May 13, 2011, 12:35 a.m. EDT
By Andy Xie
BEIJING ( Caixin Online ) — The global economy is heading toward another double-dip scare, possibly in the third quarter, in what could be a repeat of summer 2010.
Financial markets may stumble in a few months, and that could prompt the U.S. Federal Reserve to introduce a third round of quantitative easing or an equivalent, which would be another step down the path toward stagflation. In this scenario, China’s current monetary-tightening policy would be difficult to sustain.
About Caixin
Caixin is a Beijing-based media group dedicated to providing high-quality and authoritative financial and business news and information through periodicals, online and TV/video programs.
• Get the Caixin e-newsletter
A decline for the U.S. property market is accelerating. It could fall another 20% over the next 12 months.
China’s economy could slow substantially in the second half due to liquidity constraints for the property industry and local-government financing.
These factors contributing to a double-dip scare may push the U.S. Federal Reserve to launch another round of stimulus, although it may not be called QE 3. At the same time, the scare may cause oil prices to dip, easing inflation concerns.
The main aim of a QE 3 would be the same as QE 2 — to support U.S. stock and property markets. While it may succeed in reviving these asset markets, it would also yield surging oil prices and inflation.
A real double dip would occur if either the U.S. Treasury bond market crashes or appreciation expectations for China’s currency reverse on expectations of depreciation. The timing for this scenario could be fourth quarter 2012, possibly after the U.S. presidential election and the Chinese Communist Party’s 18th Congress.
Stagflation entrenches
This year’s first-quarter economic data points to a continuation of last year’s trend toward stagflation. The most important data were the U.S. annualized gross domestic product growth rate of 1.8% for the first three months of this year, compared to 3.1% in the fourth quarter 2010, and 3.8% inflation for personal-consumption expenditures (PCE), up from 1.7% for the previous three months.
The Fed pays closest attention to PCE in gauging inflation. Now, while economic growth seems to be stalling, inflation is spreading unambiguously.
Even Fed Chairman Ben Bernanke says the trade-offs for monetary policy aren’t appealing, i.e., the cost of inflation from additional monetary stimulus is probably higher than job-creation benefits.
Euro-zone inflation continued its march upward to 2.8% in April, the highest since October 2008, when oil prices rose above $140 a barrel. The European Union has upgraded the euro zone’s GDP growth rate to 1.6% for 2011. The first quarter was probably better, possibly showing a 2% annual rate.
Still, growth is not strong compared to the inflation level in Europe. Odds are that the euro zone’s inflation rate will be twice the growth rate in 2011, which fits the stagflation scenario.
The picture in China is a little different. The world’s second-largest economy reported a strong first-quarter growth rate of nearly 10%. Electricity consumption rose 12.7% from last year, obviously confirming strong growth.
Yet while trade value rose, the price effect probably dominated. China’s ports are experiencing hard times, indicating weak trade-volume growth. Global consumption data correlates a relatively subdued trade picture for China. Growth seems to depend on government spending, especially in central and western provinces.
Inflation is obviously worsening. The Chinese government’s attention has been shifting from one product price to another while trying to address inflation, the overall trend is quite worrisome. When prices do jump, they often jump high.
For example, while vegetable prices have eased a bit recently in China, fruit prices seem to have risen to extreme levels. The bottom line is that a massive stock of money in China, due to a decade of rapid growth, is in the process of turning into inflation. While money-supply growth in China has slowed, it is still 50% to 60% above China’s potential GDP growth rate. It is still stoking, not decreasing, inflationary pressure.
Tumbling growth
The global economy may slow sharply in the second half of 2011 for several reasons. Global financial markets could experience a setback that’s more serious than what occurred in the middle of 2010. The Fed rescued the markets then by launching QE 2, and may try QE 3 if markets fall again, although it would be less effective.
Most people think the U.S. housing market has already collapsed. But prices haven’t fallen sufficiently. Thus, the U.S. economy will turn downward again on falling property prices and rising oil prices.
U.S. residential property lost $6.3 trillion in value, or 28%, between 2006 and last year. The current value of $16.4 trillion is 110% of GDP, which is still much higher than its historical average. During the previous property burst, total value declined to below 80% of GDP. Thus, the U.S. property-market adjustment may be only half done.
Homeowners had hoped for the best after the Fed cut interest rates aggressively and the federal government introduced tax incentives for first-time home buyers. But the bear market remains. Now, homeowners with negative equity have no reason not to default. The U.S. housing market is beginning its second collapse.
Rising oil prices are outweighing the benefits of low interest rates. The U.S. economy consumes 23 million barrels of oil per day. For each $10 increase in the price per barrel, the additional cost to U.S. consumers is about $84 billion, directly or indirectly, or 1.3% of America’s GDP.
U.S. household debt is $13.3 trillion. Each 1% saved in interest expenses is $133 billion, or equivalent to the cost of a $16 oil-price increase. Considering how much oil prices have and could further rise, the cost of the Fed’s low-interest rate policy seems to be outweighing the benefits. This is why the Fed isn’t likely to ease more unless oil prices fall.
High oil prices are the most important factor behind the sharp slowdown for the U.S. economy and accelerating inflation in the first quarter. While there is widespread hope that the U.S. economy will bounce back in the second quarter, it is unlikely to happen without a major decline in oil prices. When the second quarter disappoints again, the fear of a double dip may resurface.
Meanwhile, China’s monetary tightening is causing a liquidity crunch among property developers and local governments. Their spending in the second half could decline significantly. Local-government spending and the property sector have been leading China’s growth since 2008. Their funding problem is surely to translate into less demand.
China’s electricity demand has been growing at above 13% per annum for the past eight years and was up 12.7% in the first quarter. It could slow substantially in the second half, possibly to below 10%.
Policy crunch
Weak growth alone may not prompt an easing by the Fed. But falling stock markets could. As the U.S. household sector suffers weak income growth, falling property values and high indebtedness, the stock market offers the only place where the economy can feel better. Fears of a stock market decline could become self-fulfilling, as it weakens consumption, which in turn weakens corporate earnings.
A weak stock market last summer prompted the Fed to pursue QE 2. Its direct impact was quite limited, as measured by its impact on Treasury yields. But it was the factor that powered a stock market rally in the fourth quarter, which contributed to the economic rebound. The impact reversed in the first quarter, partly due to QE 2’s impact on oil prices.
Bernanke is clearly worried about oil prices, especially that it reduces the household sector’s consumption power. Even though he doesn’t admit it, he must know that U.S. monetary policy is a major factor, probably the most important one, in supporting oil prices.
The trade-off is prompting him not to expand QE, even though economic growth, employment and the housing market are very weak.
Global stock market performance seems to affect oil prices. When stocks fall, the oil market is spooked by weakening demand and the price falls. If stock markets decline substantially in the third quarter, oil prices could fall significantly too, just as they did last summer.
That may create conditions for the Fed to ease again through a QE 3, in name or otherwise. Its short-term impact would be to revive stock markets, but oil prices would surge too. It would have less impact on growth but more on inflation than last year’s QE 2. This would be another step down stagflation’s slippery slope.
China’s monetary tightening is creating a liquidity crunch for the property industry and local governments. The economic impact is still limited because these groups are resorting to not paying suppliers — a strategy that only works so long. In the third quarter, the economy may slow significantly.
Would the government ease policy in response to a slowdown? I think not right away. Inflation is clearly causing social instability. The political cost seems too high at the moment. So the United States is more likely than China to ease first. When it does, China would have less room to ease, as surging oil prices would keep inflation pressure high.
Wrong medicine
Loose monetary policy is the cause of inflation, and its intended purpose is to stimulate growth. But when such policy is sustained despite inflation, it signals deeper problems. When stimulus fails to revive growth, it suggests structural problems.
In today’s world, deep structural problems are impeding economic growth. But most governments don’t have the political will or power to deal with them. Instead, they pursue easy solutions, such as printing money, which leads to stagflation.
The United States and China have structural problems that can’t be solved through monetary policy. The wrong medicine may push the global economy toward another crisis, possibly in the last quarter 2012.
The United States is obviously suffering legacy problems from the financial crisis, such as a collapsing construction industry and loss of household wealth. These make economic recovery more difficult and, when things get going again, slower. But its bigger problems are structural inefficiencies on the supply side and unsustainable social welfare on the expenditure side. The bubble initially hid these problems. It would be wrong to blame U.S. economic problems on the financial crisis per se.
Health care, the financial sector and the military-industrial complex account for about 30% of the U.S. economy — more than twice the levels found in other developed economies, or in the United States three decades ago. This suggests the United States is carrying a 15% extra cost to generate the same output. Of course, the economy should be slow.
But the U.S. government is trying to simulate the demand side to solve a supply-side problem. That doesn’t resolve the problem but instead creates a new one — inflation. No amount of monetary stimulus by the Fed can bring high growth back to the United States, in my view.
Ballooning health-care expenditures in the United States are a demand as well as a supply problem. The U.S. health-care system incentivizes the supply side to keep prices very high, while it does not discourage demand when prices rise. Unless this changes, the system will bankrupt the country.
China’s problem is the high and rising share of the state sector in the economy. My rough estimate is that state-sector spending is half of GDP. Two years ago, the state sector was big on the supply side. Now, it’s big on the demand side.
The inefficiencies associated with public-sector spending are easy to identify: Image projects across China have sprouted like spring bamboo shoots over the past three years. And this declining efficiency is the main reason for inflation.
The state sector has negative cash flow. Its magnitude grows with the size of state-sector spending. Hence, monetary supply needs to grow faster, ceteris paribus, with an expanding state sector.
This characteristic poses a unique challenge to China’s tightening policy. The policy’s impact on state-sector spending has been discontinuous, and implies the suspensions of many ongoing projects.
But if idle projects become waste, given that so many individual interests are involved, enormous political pressure will build until the projects resume. Thus, it remains to be seen how long China’s tightening policy can be maintained. Of course, if the government chooses loose monetary policy due to political pressure, inflation would surge. See this commentary at Caixin Online.
News 
Market Data 
Discover 
