(A revised version was recently printed in Bloomberg)
American pundits, Nobel laureates included, are predicting Japan style deflation for the US economy and the western world and are urging the Fed to pursue another round of quantitative easing or QE2 to stop the onset of an ice age for the western economies. The Fed didn’t oblige in its last meeting but threw a bone to the deflation crowd by promising not to pull money out of its previous QE.
On the other side of the world inflation is sweeping the emerging market block. India is registering double digit inflation. The emerging market block as a whole is seeing inflation above 5%. China just reported 3% plus inflation rate. But it surely feels a lot higher for average Chinese. One could really feel the heat in the property market across the emerging market world. Million dollar flats in Mumbai have panoramic view of the city’s slums. Hong Kong’s property market has nearly reclaimed its 1997 peak, though its economy has barely grown. Overpaid bankers who pay 15% tax in Hong Kong are very stretched to buy Beijing or Shanghai properties. Moscow is somehow always on top of the list of the most expensive cities in the world. The emerging market block feels like on fire.
I don’t know if fried ice cream is to your taste. Unless you swallow it fast, it turns into a mess. The global economy seems like that. The deflation dudes in the west are in for a rude awakening. Eastern fire will turn western ice into a mess. It may not be as fast as fried ice cream. 2012 looks like the year of melting. And the fuel for the fire is from the deflation fighting western stimulus.
Stimulus is prescribed as panacea for recession. In today’s globalized economy it isn’t effective in the best circumstances and is outright wrong for what ails the west. Trade and FDI total half of global GDP. Multinational corporations (‘MNCs’) drive both. They shop around the world for lowest cost production locals and ship products to wherever demand is. Demand and supply are disjoint. Hence, when a government introduces stimulus, the initial demand increase doesn’t necessarily lead to local supply increase. More importantly, if MNCs decide to invest somewhere else, there wouldn’t be employment increase to sustain demand growth beyond stimulus.
Water flows downwards. Stimulus, wherever it is initiated, affects low cost economies more. As the west pours money into the global economy through central banks expanding balance sheets or large fiscal deficits, the emerging economies are drowning in excess liquidity. Everything turns red hot this side of the world.
How would this game end? The ideal scenario for the west is that, before inflation happens in the west, the cost in emerging economies rises high enough for MNCs to invest and hire in the west again. I wouldn’t count on that. The average wage in the developed economies is ten times that in the emerging economies. There are five people in the later for one in the former.
A more likely scenario is that the west must stop stimulus when inflation spreads to it from the emerging economies. The most immediate channel is through rising commodity prices. It’s tax on the west to benefit emerging economies that produce them. That’s the irony: the stimulus in the west can immediately bring harm to itself. That’s the magic of globalization.
The prices of imported consumer goods will rise with increasing labor cost in the emerging economies. China’s nominal GDP is rising at around 20% per annum. The odds are that its labor cost will rise more as its labor shortage bites.
Lastly, labor in the west will demand wage increase to compensate for current and future inflation. One may argue that high unemployment rate will keep wage in check. Think again. In the 1970s the US suffered the price-wage spiral despite high unemployment, because the labor saw through the Fed’s ‘growth first and inflation be dammed’ intention.
In 2012 the Fed will run out of all excuses not to raise interest rate. As the excess liquidity in the global economy would be gigantic then, the tightening will likely trigger a global crisis as asset bubbles burst.
What really ails the west is declining competitiveness. Globalization is pitting the Wang’s in China or Gandhi’s in India against Smith’s in the US or Gonzalez’s in Spain. MNC’s like General Electric or Siemens are deciding whom to hire. The Wang’s and the Gandhi’s have productivity but no wealth. They are willing to accept low wages to accumulate wealth. The Smith’s and the Gonzalez’s have wealth and won’t accept third world wage. When their governments give them money to spend, their demand just makes the Wang’s and the Gandhi’s richer and themselves poorer with rising national debts. The west must wait for the Wang’s and the Gandhi’s to become rich enough so that they demand western wage and spend like the Smith’s and Gonzalez’s. It is a long and painful process for the west. Unfortunately, there is no way around it.