Inside Wealth

US and Europe Have Run Out of Monetary Tricks: Andy Xie

Andy Xie, Caixin Columnist

The following is an opinion piece from Caixin, a Beijing-based media group specializing in Asia business news and financial information.

Industrial production is stalling in India, and its credit rating may be downgraded to junk. Power consumption in China has slowed to about half of last year's level, while consumer price inflation remains stubbornly high.


It's obvious the world's largest emerging economies are no longer in a position to carry the global economy through tough times, as they did during the "recovery" years of 2009-'11. And that spells trouble for the U.S. and Europe.

The euro zone economy may have contracted again in the first quarter; its data fits the stagflation model quite well. Inflation grew 2.6 percent in the first quarter, and gross domestic product is expected to grow no more than 0.8 percent this year, rising from a low base due to a contraction in the second half 2011.

Stagflation also seems to be settling over the U.S. economy. A much-hyped recovery delivered a disappointing first quarter, with preliminary estimated GDP growth up 2.2 percent from the previous three months and the consumer price index climbing 0.9 percent, or 3.6 percent on an annual basis.

Policymakers and analysts say inflation's not a problem when growth is sluggish. What they're overlooking, however, is that inflation figures reported in recent months around the world are higher than historical averages. No longer can one predict inflation based on output gaps.

Much of the output gap in the West is fictitious. It's actually outdated capacity. And high unemployment rates will not act as a disinflationary force as long as there's no flexibility in the labor market.

On the other hand, money supplies worldwide, especially in developing countries including China, are growing at a robust pace, fueling higher prices for energy and food. This monetary easing is no longer stimulating growth. Instead, it's proving to be an effective means of fueling inflation.

Central banks are pushing on a string. If they insist on more monetary stimulus, the world could head toward an inflation crisis with similarities to what happened in the 1970s.

Thus, central bankers may be making fools of themselves while trying to restore growth to everyone's satisfaction. But globalization is making demand manipulation less effective than in the past, as multinational corporations have made production completely movable. Hence, no government can count on a localized, the kind of virtuous cycle that balances supply and demand and is necessary for demand stimulus to work.

The rise of the true multinational corporation has been the most important economic development since 1990. These are independent forces, and many are stronger than most countries. Any policymaker or economist who doesn't understand the work of today's multinationals is not qualified for the job.

Since corporations can now move production and sales effortlessly around the world, China and IT are the most important factors affecting the global economy. And no economic remedy will be effective without taking these factors into consideration.

Multinationals are reporting good earnings and cash flow, which is no coincidence. Through cost arbitrage and technical progress, multinationals can growth profits at 10 percent, even if the global economy is growing at no more than 7 percent in nominal terms, mainly due to inflation.

The rise of multinationals limits government policymakers. For example, an economy's labor market must be flexible to compete in the world, or risk watching multinationals move elsewhere to save money. Moreover, it's become difficult to tax multinationals, since they can park income anywhere.

I suspect most countries will have to start taxing their citizens' global earnings. Some sort of global agreement on income taxes may be necessary for the proper functioning of the world. Income redistribution is needed to support more productive forms of public spending, such as education and housing.

Until we change, however, the governance structure left over from the 20th century will continue in full crisis mode. Policymakers and pundits are still advocating the same old solutions, including fiscal and monetary stimulus. As long as people with these worn-out ideas are still in power, the global crisis will see no end.

Euro Zone Wrongs

A political backlash is unfolding in Europe as austerity becomes increasingly unpopular. The Dutch government just collapsed over opposition to its austerity package. The French presidential campaign election was shadowed by debates over austerity measures. Spain may buckle as severe economic contraction destroys its recently installed, conservative government.

Eventually, the euro zone may abandon austerity in favor of stimulus. But that's an alternative that would lead to an even greater disaster for these suffering countries.

A separate alternative many famous American economists have been advocating is to grow out of the debt problem. Many fear Europe may bring down the U.S. economy, costing President Barack Obama this year's election. So they theorize that debt levels are not too high but growth rates are too low. Hence, they think stimulating growth is the right recipe for Europe.

Of course, that means borrowing more to spend and expanding fiscal deficits. But growth, according to this theory, would be revived and bring in more fiscal revenue down the road. If the bond market believes this reasoning, it should be happy to lend more.

American economists live in la-la land. Europe terrifies the bond market because the continent is not competitive, and there are no macro tricks available to revive its growth. Hence, while Europe's debt levels may not be the highest in the world, the ability to pay is very weak. Hence, bond investors will flee for their lives when countries such as France and Spain try to stimulate growth with more deficit spending.

Of course, American economists say the European Central Bank could help the bond market in the same way the U.S. Federal Reserve backs the market for U.S. Treasuries. Unfortunately, the euro isn't a reserve currency like the dollar. So if the ECB provides large-scale market support, you can bet private bondholders will sell to it en masse. The euro will collapse and that will trigger rampant inflation. A situation like this cannot be good for the United States — or anyone else.

The economics profession has probably done more harm than good. So many bright people armed with so much knowledge who want to do something good. One attempt at doing good has been to eliminate the business cycle by manipulating demand.

On its own, though, austerity hasn't worked in the past and it's unlikely to work in the future. The cost of austerity, as measured by lost output per dollar cut from expenditures, is greater than one. But it doesn't justify stimulating growth with more deficit spending or by printing more money.

In fact, only deregulation and labor market liberalization can save Europe. Austerity doesn't work because the rigidities in the economy — regulations and union rules — prevent market responses to minimize output losses.

In a completely flexible economy, output loss would be significantly less than one, as resource redeployment shifts supply to exports or investments. Pouring in more money leads to inflation, not growth. Italy, while running up a 2 trillion euro national debt over the past 15 years hasn't grown one bit. It is ridiculous to believe more deficit spending would achieve more now.

As I wrote last month, Europe needs to remove rigidities in its troubled economies to end the debt crisis. Financial markets are not so shortsighted as not to lend to viable governments in Europe. Southern European economies could greatly increase their output, possibly by more than one-fifth, if they deregulate to increase business competition and liberalize the labor market by, for example, increasing work hours. On the other hand, swinging to stimulus without introducing necessary structural reforms will lead Europe to catastrophe.

Germany is touted as a model in Europe. But much of Germany looks more depressed than Italy, with low wages and depressed factory towns. Germany's success shows up in its trade surplus and corporate earnings, but nowhere else.

I'm not denigrating the German model. Its people sacrifice a lot by accepting low wages, shifting resources to the auto industry and dumping commodity industries that can't compete against China. In the globalized world, the consequences of success and failure are magnified, so dumping losers and investing in winners is the only way forward for most mid-sized economies. Italy and Spain may have to undergo similar reforms by dumping losers and investing in winners — a lesson learned in Germany.

However, I remain pessimistic on European reforms. Europeans are in denial. They aren't blaming themselves for the crisis, but instead seek easy ways out. Their goal is to defend the status quo.

- Andy Xie is a board member of Rosetta Stone Advisors Limited.