Central banks around the world have released massive amounts of money in response to the current financial crisis. How to exit from the current super-loose monetary environment has become a popular discussion. The central bankers are talking down the prospect of raising interest rates, arguing that the weak economy keeps inflation in check. But the proposition that a weak economy means low inflation is false. The stagflation of the 1970s proves it.

This round of monetary growth has mainly fed speculation, not credit demand for consumption or investment. Speculation has reached a dangerous point with the oil price threatening to reach triple digits again. Its implications for inflation may spook the central banks to raise interest rates quickly and trigger another crash.The excess money supply has created a new liquidity bubble.

The resulting asset inflation (stocks and bonds in developed markets and everything in emerging markets) has stabilised the global economy. The current equilibrium is one on a pinhead. The hope for strong economic recovery led by emerging economies raises investor optimism – and asset prices. This eases pressure on corporate balance sheets, spurs property production and boosts consumption through the wealth effect, making the hope self-fulfilling in the short term.

A rising oil price threatens to derail this recovery. It can trigger a surge in inflation expectation and a major crash of bond markets. The resulting high bond yields may force the central banks to raise interest rates to cool inflation fears. Another major downturn in asset prices would reignite fears about the balance sheets of global financial institutions, leading to new chaos.

The last two times the oil price surged above US$100, it wreaked havoc on the financial markets and global economy. The runaway oil prices of 2006 were the final straw that tipped the US property market. The oil price fell sharply amid the subprime crisis as the market feared a demand collapse. Then, the Fed came to the rescue and began cutting interest rates aggressively in the summer of 2007 in the name of combating the recessionary impact of the subprime crisis.

The oil price rose sharply afterwards on the optimism that the Fed would rescue the economy, and with it, oil demand. It worked to offset the Fed’s stimulus, accelerated the economic decline, and pulled the rug out from under the derivatives bubble. The ensuing demand fear again caused the oil price to collapse.

The central banks are using cheap money to inflate asset prices to stabilise the economy. But it also provides the ammunition for oil speculation. An oil bubble is different from others in two ways: it immediately redistributes income, and generates inflation; that is, it weakens consumption and tightens financial conditions on rising expectations for interest rate increases. Oil speculation is the party crasher, even though it destroys itself by destroying others.

Oil is perfect material for a bubble. Supply cannot respond quickly to price surges – it takes a long time to expand production. Demand cannot drop quickly due to the “stickiness” of consumers’ lifestyles and the modes of production.

Oil speculators are no longer restricted to secretive hedge funds. Average Joes can buy exchange traded funds (ETFs) to own oil or anything else. And, why not? The central banks have made clear their intentions to keep money supplies as high as possible, debasing the value of paper money to help debtors.

It seems that no good deed goes unpunished in this world. If you speculate big, governments will bail out when your bets go wrong and cut interest rates and guarantee your debts for you to make even bigger bets. Savers who live within their means and leave some for rainy days see their dreams shattered. Maybe everyone should be a hedge fund. The ETFs give you this opportunity. As the masses are given incentives to avoid paper money by buying hard assets like oil, a three-digit oil price appears more likely.
A word of caution for would-be speculators: run for your life as soon as the bond market starts to plunge. The oil bubble is easy to come and quick to go, because, as it kills other bubbles, the oxygen for its existence is also consumed.

The case for a double dip in 2010 is already strong. Inventory restocking and fiscal stimulus are behind the current economic recovery. The odds are quite low that western consumption will pick up when the recovery runs out of steam next year. High unemployment will keep incomes too weak to support spending.

Many analysts argue that, as long as unemployment rates are high, more and more stimuli should be applied. As I have argued before, the demand and supply mismatch rather than demand weakness per se is the main reason for high unemployment. Further stimuli will only trigger inflation and financial instability.

The current generation of central bankers has ignored asset inflation and believed in maximising employment through monetary stimulus. They have ignored the fact that the economy needs to purge deadwood from time to time.

The stagflation in the 1970s discredited Keynesians who ignored the inflation consequences of sustained monetary expansion. This crisis will discredit those who ignore asset bubbles. – SCMP

~~~

See also:
Analysts fear impending asset bubble burst in China

Source:
The big burnout
October 22, 2009
By Andy Xie for South China Morning Post

http://www.temasekreview.com/2009/10/22/andy-xie-the-big-burnout/

Category: Think Tank

Please use the comments to demonstrate your own ignorance, unfamiliarity with empirical data and lack of respect for scientific knowledge. Be sure to create straw men and argue against things I have neither said nor implied. If you could repeat previously discredited memes or steer the conversation into irrelevant, off topic discussions, it would be appreciated. Lastly, kindly forgo all civility in your discourse . . . you are, after all, anonymous.

4 Responses to “Andy Xie: The big burnout”

  1. insaneclownposse says:

    it is truly remarkable how many well informed and thoughtful people think that $80 oil somehow constitutes a bubble. If this is a freakin’ bubble, why is natural gas near historic lows and oil near historic highs? Speculators have the same opportunity to purchase natural gas with an ETF.
    There is a simple reason for the high oil price: scarcity. We can find all the oil fields we want that are located under five miles of water, but we can’t pump them quickly enough to make up for the depletion of mature oil fields in areas ranging from the North Sea to Mexico to Kuwait.
    Wake up! Cheap oil is a thing of the past. No true bubble in history has ever magically reinflated just one year later. Last year’s $140 a barrel oil is just a preview of what is to come. And it’s not that big of a deal because we will simply find another way to power our vehicles. The world changes and life goes on.

  2. 4horsemen says:

    Looks like the peak oil fear-mongers are out from under their rocks again. First point, if you understand anything about the localized supply-demand economics of natural gas vs crude oil, you should also understand why it is possible for oil to be in a bubble while gas is not. Just because something is in a bubble does not mean investors do not have a rational argument for making the investment. More people are drawn to the global demand story for crude, as opposed to the very North America centric S&D story for gas. Bubbles generally begin with solid fundamental foundation and only get out of hand when they become self-reinforcing, as we see now.

    Say what you want about peak oil, but even in this market, the days of supply and inventory levels are extremely high at present – meaning the level of demand recovery being priced into the commodity is becoming increasingly challenging. I also believe this to be the case for many other assets/commodities, although not natural gas (still trading only marginally higher than cost of production).

    One more thing, your final comments essentially dampen your entire argument. “And it’s not that big of a deal because we will simply find another way to power our vehicles. The world changes and life goes on” — Exactly. The world changes. Life goes on. We adapt. The amazing advances in drilling technology over the past 2 years are a clear example of that. Energy trusts that were winding down with production declines now see growth due to access to previously unreachable sources. Electric cars and hybrids are now being produced much sooner than expected. The changes are numerous, and while they take time, the one thing they do suggest is that demand can not be assumed to continue straight-line ad infinitum, and extrapolations about production declines are dangerous as well. Even the Saudis are concerned about their long-term future and are well-aware that alternatives will one day make the source of their wealth far less valuable. Basic Economics: the short-term supply curve may be fairly inelastic, but the long-term curve is always elastic.

  3. 4horsemen,

    nice post.

    Andy,

    another excellant article, and w/this: “The case for a double dip in 2010 is already strong. Inventory restocking and fiscal stimulus are behind the current economic recovery. The odds are quite low that western consumption will pick up when the recovery runs out of steam next year. High unemployment will keep incomes too weak to support spending.

    Many analysts argue that, as long as unemployment rates are high, more and more stimuli should be applied. As I have argued before, the demand and supply mismatch rather than demand weakness per se is the main reason for high unemployment. Further stimuli will only trigger inflation and financial instability.

    The current generation of central bankers has ignored asset inflation and believed in maximising employment through monetary stimulus. They have ignored the fact that the economy needs to purge deadwood from time to time.

    The stagflation in the 1970s discredited Keynesians who ignored the inflation consequences of sustained monetary expansion. This crisis will discredit those who ignore asset bubbles.”

    strong conclusion, that’ll be proved correct.

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