All This Stimulus Will Lead to Inflation

Andy Xie is my new favourite economist.

Andy Xie, former Chief Asian Economist at Morgan Stanley, delivered a refreshingly concise view of global economics in the Caixin online recently.

See discussion on the topic on my blog www[dot]rustin[dot]co.
That's co not com!

He says that due to globalisation the massive stimulus efforts in developed countries are in fact driving demand in emerging economies, fueling inflation there, and that this inflation will in turn come back home in due course.

“We are seeing the interplay between the forces of globalization and policy mistakes. Globalization has severely restricted the effectiveness of economic stimulus. Trade plus FDI are half of the global GDP. Trade is visible in terms of stimulus leakage. But, where investment occurs in response to demand growth is far more important. Multinationals can invest anywhere in response to demand. It cuts the linkage between demand stimulus and investment response. The latter is crucial to employment growth, which is necessary for sustaining demand growth beyond stimulus. Essentially, demand is local, but supply is global. This is why the old assumptions on stimulus are no longer reliable.

The above analysis always applies to a small, open economy. A typical macroeconomics textbook will study the extreme cases of a small, open economy and a large, closed economy. In the former, the leakage is so powerful that stimulus is futile. The latter has no leakage and has maximum stimulus effectiveness. The economies in the real world are in between. A large economy like the U.S.’s is always assumed to resemble a closed economy, while a small trade-oriented economy like Singapore’s is close to a completely open economy.

Multinational-led globalization has made large economies behave like small, open economies. Demand is still local, but supply is global. When the Fed or the ECB tries to stimulate, they are actually stimulating the global economy as a whole. Water, no matter where it comes from, flows downwards. Stimulus, similarly, flows to where costs are low and banking systems are healthy. 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.

A similar move occurred after the U.S.’s Savings and Loans crisis in the early 1990s. The Fed cut interest rates to 3 percent to help its banking system recover. The lower interest rates pushed Western banks to lend a lot to Southeast Asia, fueling a property bubble there. When the U.S.’s monetary policy was tightened, capital was pulled back. It caused the Asian Financial Crisis of 1997-98.

Today’s story is much bigger and with more dimensions. 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.”
-Andy Xie, Caixin Online