Heading toward a Cliff
By Andy Xie



The global economy is likely experiencing a bigger bubble than the one that unleashed the 2008 crisis, and should it burst the ensuing recession would be mammoth


The U.S. Federal Reserve is unlikely to taper its quantitative easing in 2013. The recent improvement in the global economy is due to its surprise decision in September to not taper. The resulting return of hot money or increase in leverage for speculation boosted the economy.

The market is again increasing the odds for Fed tightening. It may trigger some deleveraging, which would cool the economy again. The Fed would be forced to postpone tapering again.

The Fed’s QE policy has caused a gigantic liquidity bubble in the global economy, especially in emerging economies and asset markets. The improvement in the global economy since 2008 is a bubble phenomenon, centering around the demand from bubble goods or wealth effect. Hence, real Fed tightening would prick the bubble and trigger another recession. This is why some talk of the Fed tightening could trigger the global economy to trend down.

Only inflation will force the Fed to tighten. Inflation at present is mainly in emerging economies. The United States’ dysfunctional financial system is slowing monetary velocity there. It is delaying inflation. But, it is a matter of time. Inflation in the United States could come through imports and expectations. When its financial system is emboldened to lend like before the 2008 crisis, inflation will surge.

As the economy is so sensitive to the Fed’s tightening, its pace will be slow, even when forced by inflation. It means that inflation will stay high and for long.

U.S. inflation would trigger the bursting of the bubbles in emerging markets, similar to what occurred in the 1980s. They will face the choice of devaluation or deflation. The global economy has seen high inflation in emerging economies and low inflation in the United States. The roles may reverse in the years ahead.

Return of the Dotcom Bubble

Wild speculation in Internet stocks brings back the bubbly days of 2000.

Facebook is trading above 100 times earnings, Amazon over 1,000. AOL and Yahoo did not go that high in the last dotcom bubble. I am sure that some clever analysts could come up with stories to sort of justify the valuation. And, of course, no one can be absolutely sure about a bubble until it bursts, which was Alan Greenspan’s justification for not acting against bubbles. I suspect that this dotcom bubble will burst in 2014, as soon as the Fed is forced to tighten.

The extremes in the new dotcom bubble tell us what the monetary condition is in the world. The real interest rate is practically negative everywhere. This is happening for probably the first time in modern history. Negative real interest rates also trigger bubbly valuation in credit, property and stocks.

Bubble Globalization

The Fed’s QE policy inflated emerging markets first, while a bad financial system at home slowed the circulation of money and the rise of bubble. Property usually becomes bubbly first in emerging economies in an environment of rising liquidity. Rapidly rising prices and falling rental yields are sure signs of a bubble. From Mumbai to Beijing, the bubble has taken root.

An interesting phenomenon this time is how the property bubble in emerging economies, triggered by the Fed policy, spread back to the United States. Buyers from China, Russia and other emerging economies have pushed up property prices in central London and Manhattan. So their rental yields resemble that in hot emerging market cities rather than that in other cities in Britain or the United States.

The tight linkage between the Fed and emerging economies is mainly due to a lack of independent monetary policy in the latter. Emerging economies are much more dependent on trade than developed economies. The dollar is the currency for global trade. It is impossible for emerging economies to allow their currencies to reflect entirely financial flows and disregard the impact on trade. This tendency to resist the impact of hot money on the exchange rate is why emerging economies are so tightly linked to the Fed’s policy.

Hot money does not just disappear into emerging markets. It flows back into the U.S. financial system either through official foreign exchange reserves or private investment seeking higher returns. When hot money first emerges, the former tends to dominate, which keeps down the U.S. bond yield. As the bubble takes hold and yields on property and real interest rates decline, private investment also flows to the United States for higher returns, which pushes up the prices of risk assets, like property, stock and credit, in the United States.

The relationship between the Fed and emerging economies is like a turbocharger for asset prices around the world. The bigger the share of trade in emerging economies, the more power the turbocharger has. With China’s rise in global trade, it has played a powerful role in this dynamic. It is not a coincidence that China’s property bubble inflated so much during the Fed’s QE, despite a weak economy that would have destroyed the confidence for bubble making.

Pushing on a String

I have written many times before that the linkage between monetary policy and employment is very weak in the era of globalization. The information technology revolution has made most high paying jobs mobile. That force is equalizing compensation for many professions across the world. The equalization process is still ongoing. Hence, monetary easing alone will not increase investment at home, which leads to employment growth. Investment today depends on its global competitiveness, not a small change in the interest rate at home.

Employment in any country can be created through cutting wages. This helps explain why reemployed in the United States has lower wages on average. An economy is like a company. It can expand its market share or employment by cutting prices. That explains why competitive devaluation is such a force nowadays.

If one economy cannot use its monetary policy effectively, the global economy could be stimulated through collective monetary easing. Hot money sort of plays the role of exporting the United States’ monetary policy around the world. The trouble is that the main force behind hot money is speculation. Hot money earns a profit only if it creates a bubble and leaves a hot potato for others to hold. The Fed’s QE may have stimulated emerging economies, which in turn benefited the U.S. economy. It is mainly a bubble phenomenon. When the bubble bursts, the global economy tanks again, leaving behind collateral damage like bad loans.

Despite its terrible record, the Fed continues to believe in the power of its policy in creating employment. It has created one bubble after another. Each bursting leads to a downturn, which justifies another round of monetary stimulus and the making of another bubble.

Rising Inequality

Rising inequality in income and wealth has become a major social issue around the world. I would argue that it is a major drag on the economy and contributes to bubble formation. The latter further increases inequality and, hence, a vicious cycle forms.

Statistics suggest that the top 5 percent account for most wealth and almost as much in income. The concentration generates instability in circulation among income, demand and production. When income is so concentrated, a few must lend to others to finance demand. As people pile up debt, they pay interest and, hence, must borrow more for the same demand. As debt piles up, a crisis is inevitable. The crisis leads to monetary stimulus and more bubbles.

A bubble is a zero-sum game at best and, due to a misallocation of resources, a negative-sum game most of the time. While in aggregate, a bubble may be zero sum, significant redistribution occurs in the process. History tells us that wealthy and high-income people are more likely to win than others. Serial bubble-making by central banks only exacerbates inequality.

Activist monetary policy is possibly one of the most destructive forces in modern economic history. It creates the illusion of effectiveness during bubble formation, which justifies its relevance despite so many financial disasters.

Tapering Talk

When the Fed talked about tapering QE, global financial markets reacted furiously. Emerging markets saw money leaving, currencies falling and stocks tumbling. The tightening financial condition led to a string of weak economic data, which was partly used to justify the Fed’s decision not to taper in September, contrary to the market consensus. The decision was followed by hot money returning and some improvement in economic data. The sensitivity between financial speculation and economic strength reflects how bubbly the global economy is.

Better economic data is increasing market expectation for the Fed to taper. That expectation would again trigger speculation declining and economic data weakening. Such back and forth is likely to haunt the Fed’s decision to taper or not to taper. In the end, it cannot do so any time soon. But, the fluctuations in the market expectation will cause a great deal of volatility in financial markets.

The tapering will come when the Fed is forced to do so, probably by inflation rising above its target. As there is a long lag between monetary policy and inflation, whatever it does then, inflation will keep rising. The Fed, when it does taper, is unlikely to be aggressive. It begins by cutting stimulus. Raising interest rates is many months away. When it does raise interest rates, it may not do so fast enough to catch the rise in inflation, i.e., the real interest rate would still be declining.

After the 2008 financial crisis, I expected massive stimulus around the world. But, the stimulus would not bring back a healthy economy. It will eventually take the global economy to stagflation. I still hold this view.

Another Global Recession

The odds are that the world is experiencing a bigger bubble than the one that unleashed the 2008 Global Financial Crisis. The United States’ household net wealth is much higher than at the peak in the last bubble. China’s property rental yields are similar to what Japan experienced at the peak of its property bubble.

The biggest part of today’s bubble is in government bonds valued at about 100 percent of global GDP. Such a vast amount of assets is priced at a negative real yield. Its low yield also benefits other borrowers. My guesstimate is that this bubble subsidizes debtors to the tune of 10 percent of GDP or US$ 7 trillion dollars per annum. The transfer of income from savers to debtors has never happened on such a vast scale, not even close. This is the reason that so many bubbles are forming around the world, because speculation is viewed as an escape route for savers.

The property market in emerging economies is the second-largest bubble. It is probably 100 percent overvalued. My guesstimate is that it is US$ 50 trillion overvalued.

Stocks, especially in the United States, are significantly overvalued too. The overvaluation could be one-third or about US$ 20 trillion.

There are other bubbles too. Credit risk, for example, is underpriced. The art market is bubbly again. These bubbles are not significant compared to the big three above.

When the Fed does normalize its policy, i.e., the real interest rate becomes positive again, this vast bubble will burst. Given its size, its bursting will likely bring another global recession worse than the one after the 2008 crisis.

The disinflationary force from globalization, especially from East Asian economies driving down the prices of manufacturing goods, is the background for the serial bubbles over the past three decades. As China’s labor surplus is gone and no other country is taking over the disinflationary role, the big background for bubbles seems to be winding down. The disinflationary force for the current bubble is weak demand in developed economies, not rising productivity. This is why inflation will come to end this one.

When inflation emerges and persists, interest rates will have to rise. For example, the U.S. 10-year bond yield may double to 5 percent. Bubbles are less likely in an environment of rising interest rates. I suspect that the current bubble is the last one for a long time to come.

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.

15 Responses to “Heading toward a Cliff”

  1. chartist says:

    I am going to respond to the title: I don’t see it, because it’s happened before. You think the Fed doesn’t know everything that Xie is saying? Wake me when the money velocity chart starts soaring. Also, do we still have to insert the word cliff to get people to read our opinions?

  2. MayorQuimby says:

    Great read. But the idea that the Fed determines rates ie…is in control…and that they will normalize rates is one I take issue with.

  3. BennyProfane says:

    The bursting of the bubbles will only effect the rich. Who will get harmed when Dot Com II falters? A small, sheltered segment of our society that lives within a short radius of S.F., and the sleazy Wall Streeters handling their money. The rest of America could care less, because they own no dot com stocks. As a matter of fact, they own no stocks (outside of the pension fund they will benefit from, if they are so lucky), because they have no savings. Which brings us to another bubble you speak of, the stock market. One could argue whether or not it is bubbled, but, again, 95% of America could care less, as I said, because they are deep in debt and have no savings.

    We’re still floating along on the last bubble, as the central banks keep the banks and debtors alive, when they should have failed. Imagine a world without QE. It would be very ugly.

    Inflation will not be a problem for a long time. Wages in the developed world will drop for decades as the third world continues to come on line and add billions to the work force. And, the slow moving train wreck of the Boomer generation in America, the 73 million citizens who are now starting to enter the end game with no savings and deep in debt who fueled the great consumer culture of the post WW2 period will impede any kind of economic growth in the west for a few decades, at least. Let’s not even go near the Euro debacle, which will keep half of Europe in a depression for years.

  4. george lomost says:

    Yowza!. This is one scary article. I have read in many places that each new Fed chairman has been tested in a major crisis right after their appointment. I wonder if this is the crisis that will challenge Yellen next year.

    To “chartist”: my daddy taught to ignore what people say and watch what they do and the folks at the Fed act as if ” the Fed doesn’t know everything that Xie is saying.”

    • Greenspan started August 87 — 2 months before the crash.

      Bernanke was appointed February 2006 — 2 years before Bear Stearns fall, and 30 months before LEH, AIG, et/ al.

  5. theexpertisin says:

    Still, we invest.

  6. denim says:

    “The U.S. Federal Reserve is unlikely to taper its quantitative easing in 2013. The recent improvement in the global economy is due to its surprise decision in September to not taper. The resulting return of hot money or increase in leverage for speculation boosted the economy.”

    No, it boosted the stock market. The Fed’s mandate is regulate prices and employment. The most important prices to a banker is the overall prices of the “means of production.” Just look at the indices for evidence. Their idea is to keep the “Means of Production”, like the S&P, healthy and let the magical effects trickle down to the worker bees.

  7. murrayv says:

    quote “monetary easing alone will not increase investment at home, which leads to employment growth.”
    end quote – and this is precisely the reason why QE will not generate inflation in developed countries. Demand remains below supply capacity, and cheap money makes it very inexpensive to maintain excess capacity – thus no inflation. Murray

  8. mdanda says:

    Excellent, except for one point mentioned in comments above:

    How can you have inflation when incomes are falling?

  9. 4whatitsworth says:

    I enjoy articles like this they make you think even if you do not agree with the premise.

    I agree with your statement that slowing monetary velocity is a very serious problem I do not believe it is the caused by a dysfunctional financial system. I believe that slowing monetary velocity it is caused by a dysfunctional political system creating a constant state of uncertainty, and too much government intervention and regulation. The Fed is just one element in this movement.

    Today the populous wants growing government and greater government regulation. In the business world this creates a “what the hell is the government going to do next” mentality and uncertainty factor. This environment has not just slowed money velocity is has slowed the velocity of nearly everything. Transportation is slowed down by high security theater; construction projects are slowed down by environmental regulation, and now take a look at what is happening with health care system.

    This environment of big government and high regulation has been absolutely devastated blue collar employment the only decent work available for tradesman these days is building houses. In the old United States there where infrastructure projects that made a difference for society, these were done at a fraction of the cost and time line of today’s projects. The empire state building took just over a year to build, the Alaskan pipeline was built in about two years and the golden gate bridge was built in four years. Today these events on the original time line would be impossible.

    In my view the Fed is the only thing that makes this all work. Since the populous has spoken we should all hope that the Fed continues do its best and the housing sector comes back. If you do truly believe that government is the answer remember lower interest rates mean less money to sustain the debt, higher inflation means more assets to tax, and an expanding monetary base means that the rest of the world believes in our Ponzi scheme.

  10. oldbluejeans says:

    I believe Mr Xie has a great record identifying bubbles. But the problem with “Bubble Identification” as a career is that you can be correct in WHAT is a bubble but getting the WHEN part is nearly impossible as bubbles usually go on much longer than anyone thinks possible.

    I love this research note, although what seems to be missing is exactly what to do to protect yourself. What to invest in? Stocks – no, bonds – no, property – no, gold could be in a bubble as well. So what?

    Seems to my tired old eyes that Jimmy Carter got stuck as the guy that let inflation get out of hand. I think that whoever is president when the s**t hits the fan from all this Fed mumbo jumbo will also get the blame. Thinking back, it was a young Alan Greenspan that was Nixon’s Chairman of the Council of Economic Advisers who advocated and then implemented price controls, which didn’t work, followed by Ford’s “WIN” buttons, which didn’t work, followed by the guy who ultimately had to solve the crisis: Paul Volker.

    It will take more than a Volker when one of these super bubbles bursts.

  11. Pantmaker says:

    Bond yields are higher than when QE started. The Fed is a toothless tiger and the illusion that they are actually “doing” something could evaporate in an instant. Everything else is beside the point.