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Last updated: November 19, 2010 7:36 pm
Decoupling used to be a good thing. Throughout the years of the credit bubble, the belief that China and the rest of the emerging world had found a way to grow independent of the economies of the west justified all kinds of optimism and excess. This coexisted with an ever tighter coupling of capital markets. Money could readily flow not only to the developed world, but to the developing world.
Decoupling is not merely a good thing for financiers trying to sell stock to investors. It is also good for the world’s poor. Now, however, “decoupling” is known instead as “global imbalances”. The shift in vocabulary recognises that China and the US have priorities so different that the progress that has been made in the two years since the global financial crisis now appears to be imperilled. Two moments were crucial in digging out of the hole created by the Lehman Brothers bankruptcy.
First, in October 2008, China unveiled an aggressive fiscal and monetary expansion. Chinese growth soon resumed the trend that it had briefly but dramatically broken. The risk, as ever with such a policy, was of overheating down the road. Meanwhile, the US decided to try to ease its banks through the horrible lending decisions they had made by offering them financing at incredibly generous terms. Few believed that a more drastic formal workout of the debt problems, probably involving nationalisation, could be avoided. But once the big banks started making money again, in March last year, so investors returned to risky assets, and the economy itself began to pick up. Officially, the recession in the US ended in the summer of last year.
The problem is that in a world of fungible capital, these solutions were incompatible. That has grown ever more apparent in the past week. In China, the trade balance surged upwards again, showing that it was exporting far more than it imported – lousy news for the US. As the chart shows, higher Chinese trade balances overlap naturally with poorer performances for US manufacturing. Chinese inflation also picked up. The dreaded overheating may finally be happening.
What China now needs to do is slam on the brakes. But it is not clear it can do so, because of the US. Having embarked on the policy of muddling through with cheap money, the US now has no choice but to see it through. The political window for taking decisive action over the banks is now closed. Last week’s midterm elections rule out further fiscal stimulus. As discussed last week, the US housing market remains moribund. So there is nothing to do but continue to make money cheaper, through bond purchases (or QE2 as the practice is now universally known), and hope that eventually this induces a tipping point at which houses are so affordable that people start buying in significant numbers once more.
The problem is that the money finds its way to the strongest returns. That increasingly means commodities. With strong demand from China, and with a widespread and reasonable fear that the Fed’s policies will lead to greater inflation, cheap money in the US is leading to higher commodity prices. Gold grabs the attention, but various industrial metals and agricultural commodities have hit new highs in recent weeks, while oil has set a new post-crisis high.
That is a problem for China, both because it needs to import these basic commodities, and because the population relies on them. Higher commodity prices mean higher Chinese inflation. So the US policy directly contributes to the overheating of China. Not only China, but several other large emerging economies, notably Brazil, must deal with big inflows of capital. What do they do about this? Classically, you slow an economy down by raising interest rates. But while the US has virtually zero rates on its cash, that is unlikely to work. US investors desperate for yield will instead put their money where it can make a slightly higher return, and higher rates will only encourage them. That in turn stokes the imbalances still further.
In short, the policies with which the big two economies successfully averted disaster two years ago are now directly undermining each other. Politicians might yet break the impasse, but the most obvious way to do that would be by shuttering the free movement of capital once more. Friday’s G20 communique, while understandably short of solutions, did at least seem to acknowledge the difficulty of the situation.
If capital stays unimpeded, it will be left to markets to break the impasse. If the US housing market springs back into life again, and QE2 actually works, it would solve a lot of problems for everyone. If QE2 does not work as desired, markets’ tendency is to overshoot, and to chase trends to destruction before snapping back. Now that beneficent decoupling has morphed into a menacing global imbalance, the prospect of leaving the market to impose balance suggests thrills lie ahead.
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