A Different Perspective on the Global Economy
October 20, 2007
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.
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!