Bubble Trouble

The current generation of decision makers was raised in a string of bubble economies. This environment has greatly influenced their sense of balance between a bubble economy and growth. Every time a bubble bursts， they can save the economy by creating another bubble， so they have no fear of bubble economies fueled by low interest rates.

A prominent policymaker from the US recently stated that concerns about an Internet bubble reflected a confidence in the regained strength of the American economy. This is a common misconception amongst policymakers. All surveys report a high level of nervousness among the American people. In fact， the Internet bubble has nothing to do with the confidence at large， but merely emphasizes the dire situation the financial system is in.

The continuous chain of bubbles in the last 20 years was due to the fact that policymakers repeatedly used low interest rates to save speculators. Meanwhile， the speculators seem to firmly believe that growth solves all economic woes. As a result， even though the bubble could burst again， leading to an economic downturn， they believe they can solve their economic problems by creating another bubble. Furthermore， politicians serve relatively short terms， so they are inclined to simply delay the problems until their successors take office.

If inflating a new bubble solves the problems caused by an old bubble bursting， then we would be in paradise. Everyone would be extremely rich， and would not have to work. Clearly， no such world exists.

Inflation and bubbles are both monetary phenomena. We could offer all sorts of explanations on the specific causes of a bubble’s formation， but the truth is that without loose monetary policies， a bubble cannot possibly form. Inflation and bubbles compete for money in the market. When inflation is low for some reason， such as the outsourcing over the past 20 years， an excess supply of money will prompt the formation of a bubble. When there is no way to keep inflation rates low in the short run， then the bubble cannot be sustained as its funding gets cut off.

This time， the biggest bubble lies in government bonds， which have been seen as the safest investment， and since the world is still in an economic hole， a lot of money has been going into this type of asset. In my opinion， given that inflation has been on the rise around the world， fear of bond devaluation will eventually take over， specifically in the last quarter of 2012.

DOUBLE DIPPING

Just as it did last summer， the global economy is now winding down again. With a quarter of American homeowners having negative equity in their houses， the US housing market is taking another nosedive. As there is no immediate hope of recovery， they would be keen to hand their property back to the mortgage banks， and free themselves of debt. As the banks collect more houses， the housing market continues to slide， fearing a liquidation of the banks’ entire housing inventory. The adjustment isn’t all technical – the total US property value is still at 110% of GDP， despite a 30% drop from its peak， compared to previous cycles where it bottomed out far below 100%. In some smaller cities， residential land is down 90% from its peak value， compared to 1% for similar cities in China.

Europe’s sovereign debt crisis has reappeared， a problem that was never fully solved. The money supplied to Greece and other member states by the EU was only enough to resolve their immediate liquidity problems， without addressing their ability to pay off their debts over time. While the only solution is for Greece to default， the EU fears a contagion effect spreading to other countries， and is still waiting for a miracle. This latest crisis won’t be the last.

Japan is in the middle of a severe recession， with the March earthquake and tsunami destroying much of its productivity， and it will take a long time to recover. Hope of a quick turnaround is keeping the yen from devaluing， though this hope will soon vanish. As Japan increases imports for its reconstruction， its trade deficit will continue to worsen， making a sharp devaluation in the yen in the second half likely.

Emerging economies’ tightening of policies to curb inflation has been ineffective for two reasons. Firstly， the Fed still maintains a loose policy， spurring inflation in commodities， which emerging economies have no means to respond to. Secondly， because emerging economies raise their interest rates slower than inflation grows， their real interest is still negative， further fueling inflation. More tightening is necessary， but this would raise market concerns about its impact on economic growth.

It seems the whole world is on a downward spiral， and economic data this summer will likely be very poor and shocking， letting fear take over the financial market again.

WHO CAN RESCUE THE MARKET?

A month ago， I mentioned the possibility of QE 3， which was criticized by many as impossible. Once the market started dwindling， it seemed possible again. I believe QE 3 is possible only if oil prices drop another 25%. Once oil prices are low enough， the Fed can then introduce another stimulus package.

As in other countries， inflation is eating away any income growth in the US. The Fed still rejects the idea that its policy is ineffective in virtually every aspect， creating bubbles， hindering structural changes， and hampering consumption. It continues to stimulate its currency in hopes of reviving its economy. As the economy continues to worsen， one can only wonder how the Fed will respond this time.

If the Fed takes any action， stock prices will rise， and people will feel better for a short while. The Fed’s stimulus plans will cause oil prices to skyrocket， thus erasing any gains from rising stock prices. So no matter what the Fed does， they’re headed for disaster.

If Europe can solve its debt crisis once and for all， it will regain its confidence. It’s certain that Greece will default， but dragging this out will only affect the financial market. Once a solution is drafted， the losses are calculated for Greece’s bondholders， and the amount of refinancing required from the European banks is confirmed， the financial market will be able to move forward.

The financial market has high expectations for China， with talks every month about China’s inflation reaching its peak， and the country loosening its policy again. Although not impossible， the chances of this happening are slim. China’s inflation is very unstable right now， and experiences speak louder than statistics. In today’s China， the price of goods and services often rises by 10-30%. This illustrates the severity of China’s inflation problem.

China’s economy is approaching a slowdown， which is good news. Its current growth relies too heavily on its housing bubble， and the longer this growth lasts， the more painful the adjustment process will be.

Furthermore， China’s growth bottlenecks are becoming increasingly hard to overcome. For instance， if China decides not to curb inflation and to stimulate growth again instead， then it could face a severe energy shortage. The Fed or Europe might try to support the financial market again， but China won’t.

ROAD TO THE NEXT CRISIS

The world is approaching another economic crisis， this time centered on government debt. After the 2008 crisis， none of the major economies fully restructured in order to prevent another bubble from forming. Instead， they used stimulus packages to create growth， hoping to grow out of their problems.

The key problem in the developed countries is the high cost of social welfare. Unless they can cut costs greatly in this area， their fiscal deficits will remain high. After WWII， developed countries set up welfare state policies to obtain social peace. As the population ages， the cost of this policy becomes unbearable. At the same time， they have lost their initial competitive advantage over developing countries， making them unable to grow out of their problems. Their short-term solution is to run fiscal deficits to keep the system afloat. This means many other countries will wind up like Greece. The US is particularly in danger. Although it can print money to pay off its debts， the prospect of inflation will eventually drive Treasury investors away. The resultant high bond yield will force the Fed to tighten to avoid hyperinflation.

Developing countries should stop property bubbles from forming， as they make the ruling class richer， while leaving the workers and entrepreneurs without a penny. Developing countries like China and Vietnam are very competitive with costs， with low wages and the source of their wealth. However， they use the property bubble to redistribute wealth， which undervalues workers and businesses and encourages speculation. As fewer and fewer businesses and workers are willing to produce， inflation becomes rampant. Unless the basic governing philosophy changes the inflation crisis in emerging economies will worsen.

The world is unstable because decision-makers refuse to resolve structural problems， and short-term solutions only offer temporary relief. Once these solutions run out， the world will face another major crisis.

by Andy Xie

Independent economist

“The continuous chain of bubbles in the last 20 years was due to the fact that policymakers repeatedly used low interest rates to save speculators.”

“It seems thewhole world is on a downward spiral， and economic data this summer will likely be very poor and shocking， letting fear take over the financial market again.”