An Emerging Stimulus Disaster

The knock-on effect of stimulus from the developed world to the emerging economies is outlined in the article below. Nowhere is the ripple effect better seen than in Stimulus meant for  old economies! The pace and rate of inflation from the Emerging world to the Developed World is also traced:

Karen Maley
Published 7:28 AM, 24 Aug 2010 Last update 10:14 AM, 24 Aug 2010

As investors are increasingly throwing up their hands in despair over the failure of massive fiscal and monetary stimulus policies to breathe life into the sluggish US economy, Andy Xie, the former Morgan Stanley chief Asian economist, has come up with an extremely interesting analysis.

In a recent article in Caixin online, he argues that fiscal and monetary stimulus policies are indeed working – but that the effects are being felt in the emerging economies, rather than the developed world.

Xie notes that there is a striking division in the global economy at present. “The developed world is essentially competing on bad economic news. Major currencies move on who is worse at the moment. The Greek debt crisis caused the euro to plunge. Now the weak employment and resuming property weaknesses have caused the dollar to plunge. Maybe the yen is next.”

But it’s a completely different picture when it comes to the emerging economies, which are battling inflation and asset bubbles. The average inflation rate for emerging economies is above 5 per cent, while India is grappling with double-digit inflation. Korea, Taiwan and India have recently raised interest rates to combat inflation and overheating property markets, and China has also introduced measures to curb property market speculation.

Ultimately, Xie sees a convergence between the ice-cold developed economies and the red-hot developing economies.

He predicts that the deflation scare will cause “central banks in the developed economies to sustain a loose monetary policy. It will fuel inflation in emerging economies. Through trade, currency markets, and ultimately inflationary expectations, inflation will hit developed economies.”

Xie argues that globalisation has severely reduced the effectiveness of economic stimulus policies. It is possible to stimulate demand in the local economy, but that doesn’t mean that producers will respond by boosting investment in the local economy and creating new jobs to meet the increased demand.

Multinational companies are now able to invest anywhere in the world, which means that they can respond to an increase in demand in one economy by boosting production elsewhere.

As Xie puts it: “Essentially, demand is local, but supply is global. This is why the old assumptions on stimulus are no longer reliable.”

Xie argues that this means that whenever the US Federal Reserve or the European Central Bank adopts a stimulatory monetary policy, “they are actually stimulating the global economy as a whole”.

Indeed, he says, most of the stimulus will be felt in regions with low costs, and with healthy banking systems. “If you believe this logic, the actions of the Fed and the ECB fuel inflation and asset bubbles in emerging economies rather than stimulate growth at home.”

According to Xie, a similar dynamic was at play in the early 1990s, after the Savings & Loan crisis in the United States. The US central bank cut interest rates to 3 per cent to help its banking system recover. “The lower interest rates pushed Western banks to lend a lot to Southeast Asia, fuelling a property bubble there.

When the US's monetary policy was tightened, capital was pulled back. It caused the Asian Financial Crisis of 1997-98.”

But Xie contends that what’s happening today is far, far bigger. “The emerging economies are twice as big relative to the developed economies, with double the trade volume relative to the global economy then. Investment and financial capital can now flow with little friction across the world. I suspect that the Fed policy today would cause distortions in the global economy three times as big as it did in the early 1990s. Its consequences would cause a global calamity far bigger than the Asian Financial Crisis.”

Xie argues strongly that the future of the developed world is ultimately inflationary, rather than deflationary.

“The globalisation reality is that developed economies like Europe, Japan, and the US will suffer slow growth and high unemployment. Stimulus is the wrong medicine for solving problems. Believing this will lead to excessive stimulus, which causes inflation and bubbles in emerging economies first, and inflation in developed economies later.”

He warns ominously that "the wrong policy prescription pushes the global economy through unnecessary gyrations, stagflation and possibly another major financial crisis in the emerging economies. It's high time for Mr. Bernanke to wake up from his stimulus obsession.”