Money Cannot Buy Growth
Authored by Andy Xie, originally posted at Caixin,
Money Cannot Buy Growth
China and the United States are running the greatest experiment in monetary stimulus in modern economic history, and the evidence shows it is not working
Since Alan Greenspan became the Fed chairman in 1987, there has been a policy consensus on the primary role and effectiveness of monetary policy in cushioning an economic downturn and kicking it back to growth. Fiscal policy, due to the political difficulties in making meaningful changes, was relegated to a minor role in economic management. Structural reforms have been talked about, but not taken seriously as a tool in reviving growth.
In the four years after the global financial crisis that began in the summer of 2008, the United States' monetary base more than tripled and China's M2 has doubled. This is the greatest experiment in monetary stimulus in modern economic history.
Staving off crisis and reviving growth still dominate today's conversation. The prima facie evidence is that the experiment has failed. The dominant voice in policy discussions is advocating more of the same. When a medicine isn't working, it could be the wrong one or the dosage isn't sufficient. The world is trying the latter. But, if the medicine is really wrong, more and more of the same will kill the patient one day.
When the crisis began, I predicted how central banks and governments would react: they would ease monetary policy and increase fiscal deficits, the medicines wouldn't work, they would increase the dosage and the end game is worldwide stagflation. I argued in favor of monetary and fiscal stimulus to the extent to stabilize the situation, not to revive growth. The latter needed structural reforms to be achieved.
Structural reforms are difficult because they would upset a lot of people and are slow in producing results. Smart and powerful people usually want to produce quick results to show their worth. This is why policy actions often take the path of least resistance, even if they lead the world to the edge of the cliff.
Smart People, Great Harm
The effectiveness of monetary policy was last discredited in the 1970s. The persistent attempts to revive growth with easy money led to stagflation. The lesson had a powerful impact at the time. Many theories were developed to explain why monetary policy didn't work. The rational expectation theory was the main one. Soon after inflation was killed by high interest rate policy and the resulting recession, many theories were developed to revive the argument in favor of monetary policy. Smart people want to be relevant and effective. This is why they cannot hold onto a theory that denies their relevance in the real world. This is why the economics profession so quickly embraced monetary stimulus again so soon after it failed so miserably.
In parallel with the new fondness for monetary stimulus, the economics profession in the 1980s advanced the theory of an efficient market with respect to finance. It is a child of the rational expectation theory applied to finance. Even though the economics profession found enough ammunition to shoot it down in monetary policy, it embraced it for financial markets. The combination led to Greenspan's monetary policy and financial supervision at the Fed for nearly two decades. He created possibly the greatest man-made economic catastrophe in human history. The world still lives under his shadow.
The real world has turned to be opposite to the favored positions of the economics profession: the financial market is not only inefficient but systematically bubble-prone, and monetary stimulus has abetted in bubble creation and its growth impact is merely the bubble spillover. Greenspan managed the U.S. economy largely through building up asset bubbles, even though he may have believed otherwise. As the U.S. dollar is the reserve currency for the global economy, Greenspan's policy was responsible for bubbles around the world.
Is Bernanke Greenspan II?
When the subprime crisis hit in 2007, the Bernanke Fed cut interest rates to ease the pressure. The policy triggered a massive increase in commodity prices, which depressed the U.S. and other developed economies and increased the pressure for the debt bubbles to burst. By mid-2008, it became apparent that the U.S.'s financial system was bankrupt because its underlying assets were hugely overpriced. The Fed turned its focus to saving the financial system through direct loans and cutting interest rates aggressively to ease the pressure on asset deflation. It has been successful at saving the financial system. Of course, a central bank can always print money to save its financial system, if it doesn't mind depreciating its currency. The unique status of the dollar as the sole global reserve currency gave the Fed plenty of room to increase money supply.
The Fed has failed in reviving growth in almost four years. Five years after the crisis first began, U.S. employment is still lower and household real income is also lower. The Fed still believed that it could get growth going and introduced a third round of quantitative easing and QE4 for that purpose. As I have argued many times before that globalization has cut the feedback loop between demand and supply even for a large economy like the United States'. The traditional thinking on stimulus is unlikely to be relevant in today's world.
One angle in QE3 and QE4 is their focus on decreasing mortgage interest rates. When a central bank targets a particular asset, it's likely to work in the short term. The current U.S. housing revival is largely due to the Fed's policy. Unfortunately, the revival is strongest in areas where housing prices are already high, threatening another bubble.
The most visible byproduct of QE is rising stock prices. After QE1 and QE2, stock prices around the world did well for six to nine months. When the Fed buys assets, some investors get the cash. The ones who get the cash first have the incentive to buy stocks to front-run the ones who would get the cash later. This dynamic is self-fulfilling in pushing up stock prices.
The Fed seems worried about some localized bubbles and threatens to end QE this year. Its action could be (1) to slow asset price appreciation or (2) to shed responsibility for the bubble consequences. It is too early to say which. One thing clear is that Ben Bernanke can't be Greenspan II. The world has changed: the debt levels are already too high, and the global economy is inflationary, as emerging economies are already experiencing high inflation. He couldn't run a bubble economy even if he intended to.
Bernanke is scheduled to leave the Fed in 2014. If inflation isn't serious then, he would be lucky and pass the hot potato to the next chairman. If inflation hits before his exit, he would have to take action. The Fed's balance sheet may top US$ 4 trillion then. It would be extremely difficult to shrink it fast enough to stop inflation. I suspect that the Fed would accept the money out already there turning into inflation.
China's Tipping Point
China's monetary policy has been an amplifier for the Fed's policy. When the latter is successful in increasing credit to expand demand, China's monetary policy would increase capacity to contain the former's inflationary effect. China could further increase money supply to run a bubble economy on the side without worrying about currency devaluation. This bicycle monetary machine ended when the United States' debt level became too high to grow. This is why the monetary growth between 2008 and 2012 had such low effectiveness on growth and many side effects like inflation, a property bubble and overcapacity.
In 2012, China's M2 rose by 13.8 percent and net fund-raisings reached 30 percent of GDP. The resulting growth was quite low. The National Bureau of Statistics showed no growth in thermal power production compared to 12.5 percent per annum in the previous decade. The Ministry of Railroads showed that the freight traffic in the first eleven months declined by 1.1 percent compared to 6 percent annual growth in the six previous years. Listed companies showed middle single digit revenue growth, which is likely in line with nominal GDP growth. Considering inflation was quite high, adjusting the nominal growth of listed companies for inflation suggests that the real economy had a very low growth rate in 2012.
How could so much capital (30 percent of GDP) have created so little growth? Add up depreciation cash, retained corporate earnings and the portion of fiscal revenue in investment, and the total investment in 2012 probably reached 50 percent of GDP again. For such a high level of investment, a growth rate of 10 percent would be considered low. China's official statistics showed a GDP growth rate of 7 to 8 percent. My estimate is 3 to 5 percent. Either would show extremely low efficiency in turning monetary resources into growth.
The global economy was a debt bubble, functioning on China over-borrowing and investing and the West over-borrowing and consuming. The dynamic came to an end when the debt crises exposed debt levels in the West as too high. The last source of debt growth, the U.S. government, is coming to an end, too, as politics forces it to reduce the deficit. When the West cannot increase debt, China doing so is not effective on growth and could trigger yuan devaluation.
Only Reforms Can Revive Growth
Globalization has changed how a national economy works, even one as big as the United States'. The biggest change is that national policies can't affect wages. They are internationally determined. When a government tries to stimulate with more fiscal spending and lower interest rates, its short-term effect, if any, is to increase capital income. As technologies become more effective in spreading work around the world, the wage squeeze in the developed economies would become more intense.
The technology shock to the white-collar economy in the West is just beginning. It makes it easier to shift white-collar jobs around the world and eliminates even more jobs. The resulting efficiency gain is hard to realize if the displaced workers cannot find alternative employment quickly. The labor market statistics in the West strongly suggest the importance of this force. In the United States, the labor force has shrunk because, I believe, many found the available wage not worth the bother. These dropouts are better off shifting to pensions or disability benefits. The only way to bring them back into the labor force is to cut the cost of living to make the low wage worthwhile.
I believe that the developed economies must make their labor market highly flexible, income redistribution efficient, and non-tradable components of the living cost – housing, health care and education – low and effective. This is a simple prescription. But it takes time to produce benefits and could upset vested interests in many industries. The easy way out is to print money, hoping that the pie would grow to take care of everyone. This has failed and will do so again.
China's competitive advantage is its labor cost. It is the reason for China's growth in the past decade. But, the system has been allocating the fruits from growth through asset inflation. It is disproportionately in favor of the government. One effect is to increase investment beyond what a normal market economy would allow. The system essentially sucks in the labor productivity gains into the government through inflation tax. It has worked because the pie was expanding fast enough to withstand this burden. As the pie stops growing quickly, the inflation tax is hard to collect. This is why the property bubble is deflating and the government is short of money.
So many who have benefited from the system long for the return of yesterday. The policy focus so far is to change perceptions through propaganda, hoping to revive asset markets. The problem is that China cannot put on this show alone. While the West suffers debt crises, China cannot crank up exports to charge up an asset bubble. The bad news is obviously not acceptable to those who are used to easy bubble money. China's policy focus is likely to remain on changing perceptions in 2013.
The Inflation Explosion
Trying to bring back yesterday through monetary growth will eventually bring inflation, not growth. Emerging economies are already experiencing high inflation. Historically they worry about inflation, but don't do much about it as long as their exchange rates are stable. India is already facing devaluation. It is taking inflation more seriously. Other big emerging economies don't face the same pressure. They are not taking action. Their exchange rates will tumble when the Fed raises interest rates.
The developed economies have low inflation rates because their labor markets are depressed and their economies are mostly about labor costs. Their inflation will come when either their labor markets tighten up due to declining labor force or imported inflation raises inflation expectation and wage demand. Both forces are intensifying. The Fed has promised to take action when the United States' inflation rises above 2.5 percent. It was 2 percent last year. In 2014 it would break through the level. The Fed has to raise interest rates in 2014.
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