A Different Perspective on the Global Economy
Last February I blogged about how excess petrodollar liquidity was creating bubbles all around the world and how I was pessimistic in the short and medium term for the US economy (Macro Perspectives on Global Liquidity). Similarly, last September I wrote how every indicator was suggesting that renting made a lot more economic sense than buying real estate (Rent … unless you want to buy).
Now that the real estate bubble and finance bubble have burst, it’s a good time to take stock regarding where we stand in the global economy. In essence we have three countervailing forces:
- An inflationary force driven by emerging market growth
- A deflationary force driven by the bursting of the real estate bubble in the US
- A deflationary force driven by the bursting of the finance bubble in the US
The consensus seems to be that these forces will mostly balance out: the US economy will slow down somewhat, but the world economy will continue to do well, driven by emerging market growth.
It’s a nice story and I actually hope that it happens, but I find this scenario extremely unrealistic. The inflationary and deflationary forces are huge on both sides, and I find it hard to believe that they will essentially perfectly balance each other. There are a number of scenarios that could easily tilt the balance in one direction or the other.
Scenario 1: inflationary tilt
The decrease in US short rates, the continuing growth of the money supply, emerging market growth and continued excess liquidity created by petro dollar recycling could easily tilt the world in an inflationary mode, despite the decreasing growth in the United States.
To some extent, the market seem to be expecting this tilt as yield curves have steepened and equity markets have recovered as the money had to go somewhere and several asset classes have disappeared with the real estate and finance bubble bursting.
Scenario 2: a breaking of the Chinese and Saudi lead to a global recession
US politicians have been clamoring for China to revalue its currency. In an article last February (What’s going on in China: An introduction to macroeconomics), I argued China should let its currency float in its own interest: to take control of its monetary policy and fight inflation.
As things currently stand, 1 year US rates are around 4%, Chinese rates are 6% below the US rates given the expected 6% appreciation of the RMB. Therefore the implied forward interest rate on the RMB is around -2% on a 1 year basis. With inflation at 7% in China, real rates in China are essentially -9%. Likewise, in Saudi Arabia, real interest rates are essentially -4%. This is extremely inflationary and has driven the rush to borrow as much as possible to buy real assets.
Every decrease in US interest rates makes rates even more negative in China and Saudi Arabia and increases the probability that they break their dollar pegs.
If China breaks its peg, the move will likely be driven by an increase in the price of oil. Oil is China’s primary import and is priced in dollars. If China broke its peg, Saudi Arabia would be compelled to revalue its currency as well. Interestingly enough many of the smaller countries are starting to break their pegs: Syria broke its peg, Kuwait is shifting away from its peg and Vietnam has indicated it would like to break its peg.
If the pegs broke the following things would happen:
- Real interest rates would increase dramatically in China and the Middle East and investors in those countries would no longer need to recycle their cash in stocks, real estate, Euros, the Pound and Swiss Francs.
- As a result, the breaking of the pegs should lead to large declines in equities in emerging markets.
- Seemingly paradoxically the dollar would rise significantly against the Pound, the Euro and Swiss Francs.
- Yield curves would flatten.
This is a scenario that almost no one is considering and would have dire economic consequences in the US, Europe and most emerging market countries.
Conclusion:
As it currently stands the inflationary scenario remains much more likely, but every decrease in US interest rates and lowering of the dollar creates a strong incentive for China and Saudi Arabia to revalue their currencies and cause about the very deflationary scenario to happen. Likewise, every increase in the price of oil increases the probability that China breaks its peg, leading Saudi Arabia and others to break their peg, leading to the deflationary scenario.
Interestingly enough, what I think is the least likely scenario is the current consensus “goldilocks” scenario where we have neither inflation nor deflation and where the world economy continues to do well despite a slowing of the US economy.
Once again, I hope I am wrong!
Very interesting perspective.
However, I think your opening — which strongly suggests that your previous prognostications have proven correct — is highly misleading.
You note that last September you wrote about how it was better to rent than buy — and how subsequent events have proven you right.
However, while that may still prove to be correct, the reality is far from that so far. As you note in that post, you live in Manhattan. Now, it may well be that there is a real estate bubble in Manhattan, but if so, it is yet to burst (unlike many other parts of the country) — in fact prices keep going up, and rental yields are increasing even more rapidly. In your post you compare the cost of renting with the cost of a mortgage, but a better comparison is the cost of a borrowing versus the rate of return you earn on your capital. If you can borrow money at 7% (as you could have then), then surely you should borrow as much as possible if you expect your nominal return on capital to be greater than that? And surely an entrepreneur like you must expect to earn more than 7% ROI?
Great article, I like your real-world parallels. I especially liked your “Goldilocks” example.
Midas,
The reason most people buy real estate is that it is one of the few ways in which people can get leverage.
Even though I would like to believe the ROI on my projects is above 7%, no bank will lend me money given how intangible the collateral would be.
That said, most people are probably better off putting their money in 5% savings acconts these days than borrowing to buy real estate.
I also agree that the Manhattan real estate bubble has not burst yet.
–1- mathematically speaking your supposition about immense balancing forces being unlikely to sum to a net of zero is unquestionably true: A physical analog would be a flying aircrafts forces of lift balancing gravity. Say you chunked on a 2X load almost instantaneously…what are the chances rev’ing the engines would compensate without the passengers feeling a bump? Not much. –2– Chinese currency situation is the king willing the tide not to come in. They can delay but is unstoppable force. Other factors and your comments regarding negative real interest rates leads me to repeatedly hypothesize that the market is in conspiracy of ignorance to break currency pegs. –3– Regarding your conclusion on results of currency pegs being broken OH SHIT. I had overlooked this particular observation in my own thinking. Problem here is I think you are right. (OUCH…its going to hurt). Can you further explain the **Seemingly paradoxically the dollar would rise significantly against the Pound, the Euro and Swiss Francs** comment? I’ve been a little snowed as to why the pound has gotten so strong. –3–You said you thought EITHER inflationary or deflationary scenario were the most likely. Is not it more likely that the standard bubble build and pop includes both? Example would be real estate in USA. First your house goes up in dollar value. OR in other words the value of your dollar goes down since the house ain’t changed. Sounds like inflation. Then the bubble pops, credit is hard to get and the asset value falls. I’m going to refer your arty to a friend who was just talking to me about currency trading and another that is a pretty heavy trader.
There is another scenario probably worth mentioning. I think it’s a lower probability scenario, but the Fed seems to be taking it seriously in light of the rate cuts.
Scenario 3: the bursting of the real estate and finance bubbles are much stronger than we expect and lead the
US and probably the world in recession
We are only at the beginning of the real estate bubble bursting. National prices have only fallen 3% and with huge inventories of unsold houses the market has not yet cleared. With a large number of adjustable rate mortgages resetting in 2008, there is a long way to go on the downside.
The reason I think it’s an unlikely scenario is that there is so much excess liquidity and growth on a global level that it seems more likely to outweigh the continued weakness in the US real estate market. However, in light of the rate cuts, the Fed takes this risk seriously.
In regard the real estate….you are not old enough ( probably ) to remember the 1990-ish real estate recession. Unfortunately I am. It lasted from around 89 to 95-ish. Real estate bubbles seem to take a while to work their way through. I have an older friend who is 62-ish who got into real estate early after college graduation intimated that it tends to increase in spurts. The last big spurt similar to the one we just experience came at the same time as oils big push in the late 70’s. The money supply was grown too fast during the 60’s and 70’s. The Vietnam war was on for part of this era. See the 3 part similarity here? If you have any older friends who can break down what happened during that era to you there might be some insight to be gained. Should you get anything good post it !!!
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