Like 2010 it is a transition year. Fiscal and monetary stimulus in the west and asset bubbles in the developing world have kept the global economy stable for the time being. The fundamental problems that the 2008 crisis exposed, both legacy and structural problems, have not been addressed. The catalyst for the next crisis would either be a fiscal crisis in the west or inflation crisis in the developing world. The timing for the next crisis is likely in 2012, possibly late in that year.
Wish didn't come true in 2010
2010 began with overwhelming bullish sentiment. The consensus was 'the cycle has turned', i.e., the uptrend would last for years. By the middle of the year the evidences came in to suggest that the economic bounce didn't expand beyond the stimulus. The global economy didn't behave like a stalled car that would take off after a big push. The double dip fear sent markets tumbling. The selling stopped when the Fed began to talk about QE 2, which sent the stock market soaring. The Obama tax cut package added to optimistic sentiment. The upward momentum has carried to the year's end.
The news on sovereign credit crises dominated the news flow out of Europe. Euro went on a roller coaster ride on the news. But, euro ends the year at quite a good level. To think through why it is so will help us to understand the magnitude of the euro zone's problems relative to the US's. Exchange rate is a relative price. Many things influence its short-term fluctuation, like GDP growth or debt crisis. On such concerns the euro zone stacks up well against the US. The state governments in the US are struggling with fiscal problems as big as the fringe euro-zone countries. The US's debt level is much higher and rising faster.
Even China's monetary tightening steps have not spooked the bulls. Everyone has a theory that China wouldn't tighten and, if it does, it doesn't mean it. The view is correct so far. China's steps are tiny compared to the magnitude of the country's inflation problem. The inflation is a runway train. The policy steps are like sprinkling sands on the track. What is puzzling is why the market should cheer China being behind the curve. It means more growth now, but higher risk of a hard landing later. Well, it is like this all the time. Financial markets are like kids, just wanting to have fun now and not worry about the future.
The dark shadows
Three dark shadows have already reached us. First, oil price has increased by 20% since the Fed began to talk about QE 2. Is it due to the expectation of rising demand or rising money supply? Analysts take sides on this, often depending on their attitude towards the QE 2. I'm in the second camp. The global oil consumption in 2010 is up a bit, possibly by one million barrels per day, but is still below the level in 2007 or 2008. I don't see any change in the economic outlook in the past few months to justify such a big rise. Financial demand, rather than real demand, is behind such a fast and big increase.
Such financial speculation has a good chance to succeed. When the Fed releases more dollars, it makes producers less willing to produce. As the price elasticity of oil demand is low in the short term, the price can be pushed up and stay there for quite a while. The price needs to be very high to motivate Soudi Arabia-the only producer has much spare capacity in the world to produce more. The price needs to be that high also to change consumption behavior. Before the price is high enough for either or both to occur, financial speculation in the oil market is profitable.
How high would the oil price rise in 2011? I suspect that it would rise gradually in the first quarter and may fall by mid year when the economic data turn less favorable. It would really surge when the Fed starts to talk about QE 3, possibly in the second half of the year.
Second, the US treasury market has fallen quite a bit. It is far from a crisis situation yet. But, the correction is a warning shot across the bow. No government, not even the US's, could borrow recklessly forever. The treasury yield isn't sustainable. The market believes in low or no inflation. But, Bernanke wants inflation and will keep printing money until he sees it. Why wouldn't the market believe him? If you believe that Bernanke would achieve his goal, the 10Y treasury yield should be close to 6%, rather than 3.4%.
Bernanke once suggested to the BoJ to push yen out of a helicopter over Tokyo to end deflation. Such a tactic surely will work. What he is doing isn't so different from pushing money out of a helicopter. When Obama cuts taxes by running up fiscal deficit and Bernanke buys the treasuries to fund it, it is exactly like pushing money out of a helicopter.
It is a matter of time that the treasury yield will surpass 6%, probably in 2012. By then, the US government debt would be US$ 16 trillion. At 6% interest rate the interest payment would be nearly $1 trillion. The US government revenue is under $2 trillion now. Maybe it improves to $2.5 trillion with inflation. It's hard to see how a government can function when the interest payment on its debt is 40% of its revenue. When the bond market normalizes, the US fiscal situation could get out of control. When the market realizes it, it can fall sharply, fearing the Federal government bankruptcy risk. The resulting spike in interest rate can make it self fulfilling.
Third, China's monetary tightening steps signal a bigger problem over the horizon. China's inflation problem is really about money supply. It is about funding the property market that in turn funds government spending. China's inflation is a form of tax. It is nothing new. Inflation in modern China is always about taxing the savers to fund the government. When one looks at how big the property market is, it is dizzying to think how it could land at all.
Most people who are in this vast industry (property) believe that it must keep going, because the consequences of an adjustment are unthinkable. To keep it going, the Chinese government should build enough public housing to pacify the angry masses. Afterwards, the market can keep going up, being the rich folks' playground. There are two holes in this logic. First, funding the property market the way it is will cause rampant inflation, which can cause devaluation and destabilise the society. Second, the market is so vast that it can't just be the playground for rich men. The later are holding empty flats on the hope to sell to the people who can't afford it now but could through rising wages in future. When the common folks disappear into the affordable housing sector, how could the few rich people justify buying millions of flats to keep them empty?
Live for the day again
I don't see serious reforms to tackle the structural problems facing the global economy. Even the legacy problems from the financial crisis, e.g., bad debts and incentive system for financial institutions, have not been dealt thoroughly. Big banks continue to pursue profits in tradition investment banking businesses, usually relying on their cheap cost of capital that comes from implicit government guarantees. It forces investment banks to take on more risks to offset their disadvantages in funding cost. It makes financial markets unstable, because only high volatility can allow investment banks to cover the cost gap with the big commercial banks.
The structural problems are (1) high social costs in the developed economies and (2) high inflation and asset bubbles in the developing economies. The former requires retrenchment and redistribution. We are seeing some of it in Europe. France, for example, just increased its retirement age. It is probably not enough. The critical indicator for successfully dealing with the problem is stabilising national debt to GDP ratio. We haven't seen that in any major developed economy. The US is moving in the opposite direction. The US government is adding debt quickly, hoping that the resulting stronger economy from the stimulus would bring enough revenue down the road to bring down the debt level. Good luck, Uncle Sam.
Emerging economies are benefiting from trade and foreign investment. They are expanding rapidly. An expanding pie is certainly good news. But, the environment is inflationary and bubble-prone. When this dark force is not dealt with properly, it could destabilize their societies. Indeed, with excesses accumulating over so many years, they would face economic hard landing and financial crisis down the road.
In some emerging economies, those who benefit from asset bubbles have disproportionate influences over their national policies. Hence, their policies are geared towards bubble making rather than bubble fighting.
China's property bubble is especially dangerous. It leads to massive income redistribution from the household to the government sector. The massive financial resources available to the later have led to rising expenditures. Such expenditures are sticky, because they usually involve projects that last for years. Hence, any tightening would lead to huge push back from the government sector itself. The longer the bubble lasts, the more power the force against tightening.
China's inflation fighting and property tightening measures are insufficient so far. Unless property price falls substantially, inflation isn't likely to be held back, as money supply is mainly to feed the property market. It is still too early to say if China can avoid a hard landing.
