Is the Bubble Economy
Set to Burst?
My friend Andy Xie, based in Shanghai, is a very independent-minded
investment analyst and economist. With a PhD from MIT, he has been at the IMF
and was a star economist for the Morgan Stanley Asia-Pacific group. His
ofttimes bearish calls on various parts of the Chinese economy have elicited a
lot of criticism from Chinese officials and retail investors. I have been on
the stage with him several times, both on the same side of debates and on
opposite sides – he is a formidable opponent! We do have one thing in common:
While we may be often wrong, we are seldom in doubt and certainly not afraid of
letting others know what we think. Forcefully.
This week Andy posted an essay in
the South China Morning Post:
“The bubble economy is set to burst, and US elections may well be the trigger.”
I find that interesting. Here I am looking at the problems in China as
potentially triggering global problems, and he is looking at elections in the
US.
Andy says of himself that he has a
reasonably good record at calling bubbles:
I wrote my
doctoral thesis arguing that Japan was a bubble in late 1980s, a long report at
the World Bank in the early 1990s arguing that Southeast Asia was a bubble,
research notes at Morgan Stanley in 1999 calling dotcom boom a bubble, and
numerous research notes from 2003 onwards arguing that the U.S. property market
was a bubble. On the other hand I have never called something a bubble that
turned out not to be a bubble.
In today’s Outside the Box Andy looks
at what he thinks is the cause of the current bubbles that he sees around the
world: central bank intervention. And I agree. I find it fascinating that
Yellen & crew are puzzled at the lack of inflation in their CPI measure but
don’t see a problem with inflation in asset prices. In fact, they see rising
home prices and nosebleed-high stock prices as good things and are quite proud
of having fostered those. The fact that they came along with credit bubbles
around the globe, fostered by ultra-low rates, is something they are willing to
ignore.
I know that Trump is going to be
appointing a new Fed chair and Fed governors, but I have to tell you, there is
simply not enough money to make me want to sit around that table and be
responsible for cleaning up the mess that the present denizens have created. I
think the FOMC is going to find itself in a situation where they have no good
choices, and probably not even merely difficult ones. But they will be forced,
or at least feel like they are forced, to “do something”; and that something is
going to once again take the form of lower rates and more quantitative easing
–and maybe even a few little innovations like negative rates and asking Trump
and Congress for permission to shift out of their normal “We can only buy
government-backed assets” mode. Much as the Bank of Japan, the ECB, and the
Swiss National Bank have done. (Trivia: The Swiss National Bank owns almost 2%
of Apple. How much more do they have to buy before they want a board seat?
[That’s a joke, gentle reader.] But it does take 66 pages to print a list of
all the stocks the SNB owns.)
I am more convinced than ever that
we are rapidly moving into a world where the unthinkable –and I mean truly
unthinkable – is going to be not only thought about but acted upon. Damn the
torpedoes and all that stuff. I think you will enjoy Andy’s insights.
Now, the kitchen is calling me: I
have a very large prime roast, chili, and mushrooms to make. Shane is also
going to make chili for the guests that are a little less tolerant of “heat.”
There are some 15 independent
advisors and brokers from around the country coming over, along with my various
partners and associates. These evening dinners have evolved into a meet and
greet with hors d’oeuvres and wine, then the food, and then we all move to the
“family room” (it’s really just a big open space) where I sit on a high stool
and answer questions. We start by asking these advisors what is the one thing
their clients are most worried about and what is the one thing they themselves
are most worried about. It makes for a provocative conversation.
I woke up yesterday morning finally
feeling normal again and able to sit down and begin to work through my email
inbox, where I found 415 messages. That’s after I deleted the obvious ones.
Sigh – I know what I will be doing for a few days. You have a great week, and
try not to let your inbox overwhelm you – get out and do something fun.
Your wondering how central banks
get off the horns of this dilemma analyst,
John Mauldin, Editor
Outside the Box
The bubble economy is set to burst, and US elections may well be the trigger
By Andy Xie
Central banks continue to focus on
consumption inflation, not asset inflation, in their decisions. Their attitude
has supported one bubble after another. These bubbles have led to rising
inequality and made mass consumer inflation less likely.
Since the 2008 financial crisis,
asset inflation has fully recovered, and then some. The US household net worth
is 34 per cent above the peak in 2007, versus 30 per cent for nominal GDP.
China’s property value may have surpassed the total in the rest of the world
combined. The world is stuck in a vicious cycle of asset bubbles, low consumer
inflation, stagnant productivity and low wage growth.
The US Federal Reserve has
indicated that it will begin to unwind its QE (quantitative easing) assets this
month and raise the interest rate by another 25 basis points to 1.5 per cent.
China has been clipping the debt wings of grey rhinos and pouring cold water on
property speculation. They are worried about asset bubbles.
But, if recent history is any
guide, when asset markets begin to tumble, they will reverse their actions and
encourage debt binges again.
Recently, some central bankers have
been puzzled by the breakdown of the Philipps Curve: that falling unemployment
rates would lead to wage inflation first and consumer price inflation next.
This shows how some of the most powerful people in the world operate on flimsy
assumptions.
Despite low unemployment and
widespread labour shortages, wage increases and inflation in Japan have been
around zero for a quarter of a century. Western central bankers assumed that
the same wouldn’t happen to them without understanding the underlying reasons.
The loss of competitiveness changes
how macro policy works. Japan has been losing competitiveness against its Asian
neighbours. As its population is small, relative to the regional total, lower
wages in the region have exerted gravity on its labour market. This is the
fundamental reason for the decoupling between the unemployment rate and wage
trend.
The mistaken stimulus has the
unintended consequences of dissipating real wealth and increasing inequality.
American household net worth is at an all-time high of five times GDP,
significantly higher than the bubble peaks of 4.1 times in 2000 and 4.7 in 2007,
and far higher than the historical norm of three times GDP. On the other hand,
US capital formation has stagnated for decades. The outlandish paper wealth is
just the same asset at ever higher prices.
The inflation of paper wealth has a
serious impact on inequality. The top 1 per cent in the US owns one-third of
the wealth and the top 10 per cent owns three-quarters. Half of the people
don’t even own stocks. Asset inflation will increase inequality by definition.
Moreover, 90 per cent of the income growth since 2008 has gone to the top 1 per
cent, partly due to their ability to cash out in the inflated asset market. An
economy that depends on asset inflation always disproportionately benefits the
asset-rich top 1 per cent.
There have been so many theories on
why inequality has risen. The misguided monetary policy may be the culprit.
Germany and Japan do not have significant asset bubbles. Their inequality is
far less than in the Anglo-Saxon economies that have succumbed to the allure of
financial speculation.
While Western central bankers can
stop making things worse, only China can restore stability in the global
economy. Consider that 800 million Chinese workers have become as productive as
their Western counterparts, but are not even close in terms of consumption.
This is the fundamental reason for the global imbalance.
China’s model is to subsidise
investment. The resulting overcapacity inevitably devalues whatever its workers
produce. That slows down wage rises and prolongs the deflationary pull. This is
the reason that the Chinese currency has had a tendency to depreciate during
its four decades of rapid growth, while other East Asian economies experienced
currency appreciation during a similar period.
Overinvestment means destroying
capital. The model can only be sustained through taxing the household sector to
fill the gap. In addition to taking nearly half of the business labour outlay,
China has invented the unique model of taxing the household sector through
asset bubbles. The stock market was started with the explicit intention to
subsidise state-owned enterprises. The most important asset bubble is the property market. It redistributes about
10 per cent of GDP to the government sector from the household sector.
The levies for subsidising
investment keep consumption down and make the economy more dependent on
investment and export. The government finds an ever-increasing need to raise
levies and, hence, make the property bubble bigger. In tier-one cities,
property costs are likely to be between 50 and 100 years of household income.
At the peak of Japan’s property bubble, it was about 20 in Tokyo. China’s
residential property value may have surpassed the total in the rest of the
world combined.
How is this all going to end?
Rising interest rates are usually the trigger. But we know the current bubble
economy tends to keep inflation low through suppressing mass consumption and
increasing overcapacity. It gives central bankers the excuse to keep the
printing press on.
In 1929, Joseph Kennedy thought
that, when a shoeshine boy was giving stock tips, the market had run out of
fools. Today, that shoeshine boy would be a genius. In today’s bubble, central
bankers and governments are fools. They can mobilise more resources to become
bigger fools.
In 2000, the dotcom bubble burst
because some firms were caught making up numbers. Today, you don’t need to make
up numbers. What one needs is stories.
Hot stocks or property are sold
like Hollywood stars. Rumour and innuendo will do the job. Nothing real is
necessary.
In 2007, structured mortgage products
exposed cash-short borrowers. The defaults snowballed. But, in China, leverage
is always rolled over. Default is usually considered a political act. And it
never snowballs: the government makes sure of it. In the US, the leverage is
mostly in the government. It won’t default, because it can print money.
The most likely cause for the
bubble to burst would be the rising political tension in the West. The bubble
economy keeps squeezing the middle class, with more debt and less wages. The
festering political tension could boil over. Radical politicians aiming for
class struggle may rise to the top. The US midterm elections in 2018 and
presidential election in 2020 are the events that could upend the applecart.
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