Is the United States Making the Emerging Nations Stronger?

Why is the rate of inflation so low in the United States when the government has pumped huge amounts of debt into the country and the Federal Reserve has loaded the financial system with large amounts of liquidity?

The same question was asked in the 1990s. Where was the United States inflation?

The answer for the 1990s…and for the present time period…is that the United States has exported inflation to the rest of the world…more specifically…Asia. As the accompanying chart shows, inflation seems to be heading up in Asia…as it is also heading up in many other emerging nations.

As reported in the LEX column of the Financial Times yesterday, global inflation has seemingly bifurcated. In the developed countries the current inflation rate is below 2 percent (Australia and the UK are exceptions). Morgan Stanley expects a 1.5 percent rate of growth for the wealthier countries in 2010. “By contrast, the emerging market inflation rate is about three times higher—expected at 5.4 percent in 2010…” (http://www.ft.com/cms/s/3/0c01f5a4-fb0d-11df-b576-00144feab49a.html#axzz16h9jdCiK)

The post-financial crisis stimulus is now feeding the inflation in the emerging countries. “A significant portion of the river of cheap money flowed into commodity markets. The initial price recovery caused no problems, but the trend now threatens to create a vicious circle.”

There is also the “carry trade” which takes United States dollars throughout the world seeking higher interest rates. This flow is certainly not insignificant.

In these days, it seems like it is very difficult to contain the international flows of capital. Maybe policy makers need to give this a little more weight in their policy discussions.

There is an argument that central banks, in some Asian countries, kept their interest rates “appropriately low” over the past year or so because of “concerns about the strength in their developed-market trading partners” especially the United States. Now, with inflation threatening to get out-of-hand in the emerging nations, these same central banks are faced with the need to raise their domestic interest rates higher and higher. (See “Emerging Wild Card: Inflation”: http://www.ft.com/cms/s/3/0c01f5a4-fb0d-11df-b576-00144feab49a.html#axzz16h9jdCiK.)

The article continues: “One conundrum for investors is how more aggressive tightening would play out in the currency markets. Most investors have been operating on the assumption that with the Fed keeping interest rates at zero for the foreseeable future, any moves by emerging-market countries to raise interest rates would attract even more money from yield-hungry investors.”

This seems to reflect a cumulative problem. By keeping interest rates low in the United States, dollars are flowing out into the rest of the world. This out-flow is threatening to bring about greater amounts of inflation in the emerging nations of the world. In order to combat this rising level of inflation, the central banks in emerging nations are raising interest rates. But, in raising interest rates, more United States dollars flow to these emerging nations.

And the flow of money into dollars from Europe as a “safe haven” has kept the value of the dollar stronger than it otherwise would be in such a situation which just enhances the return to investors from moving into the interest rates in the emerging countries.

So, the Federal Reserve continues to inject large amounts of reserves into the banking system, hoping to get the United States economy going again. But, individuals, families, and small businesses do not seem to want to be borrowing. Only large, healthy companies seem to be borrowing and piling up cash reserves. The money the Fed is printing seems to be going off-shore.

Therefore, instead of stimulating the United States economy, the Federal Reserve seems to be stimulating the emerging countries of the world. The two results of this seem to be that the United States is not getting stronger, but it is helping the rest of the world to get relatively stronger. The rest of the world needs to keep inflation under control, but the emerging nations feel the relative shift in power within the world and are taking more and more advantage of this increased power. See reports on the recent G-20 meeting. (http://seekingalpha.com/article/236430-release-from-the-g20-what-more-needs-to-be-said)
Only strong, self-disciplined countries come out on top. Right now, the United States is anything but self-disciplined and it is finding that its relative strength is slipping away. The unfortunate thing is that in its lack of self-discipline, the United States is feeding the rising relative strength of the emerging nations in the world. This is our fault, not the fault of other nations within the world.

Are There Bubbles All Around?

One thing we learned in the 1990s and the 2000s is that there can be asset bubbles in the economy without growth in either money stock variables or increases in consumer (flow expenditure) price inflation. The financial system seems to be flexible enough so that it can leverage up where it wants to even though monetary policy and consumer spending seem to be “in control”. This is the lesson of modern “financial engineering.”

However, the monetary statistics are not benign for most of the time period from January 1961 up to September 2008. During this time period, the monetary base which is supposedly under the control of the Federal Reserve System rose at a compound annual rate of slightly more than 6%. Total credit during this time period rose much more rapidly. Consequently, the United States experienced a period if “credit inflation” that dominated everything going on during this 47 years or so. This secular inflation drove the financial innovation that took place as the whole financial system took on more-and-more leverage and more-and-more risk.

Since September 2008, the Federal Reserve has caused the Monetary Base to increase explosively by more than 130%. However, the banking system is not lending and much of these funds seem to have ended up on the balance sheets of the banking system. Excess reserves in the banking system went from about $2 billion in August 2008 to almost $1.2 trillion in February 2010. Excess reserves for September 2010 averaged slightly below $1 trillion.

Even with all of these excess reserves, the current concern is whether or not the economy will go into a period where prices actually decline. That is, might the United States be headed for a period of deflation?

Everything mentioned above is true. Yet, there is more going on in the economy than just what we see here. In some areas, a lot is going on and in these areas we are seeing lots of upward price movement which leads one to ask whether or not these price movements are bubbles or indications of something else taking place. Certainly, the “bubbles” are not increasing employment, or capacity utilization, or getting the economy going again.

I have written about this before: “Where the Action is: The Bond Market”, http://seekingalpha.com/article/230048-where-the-action-is-the-bond-market. I wrote in this post:

“There is a lot of money in the financial markets…in the shadow banking system…and worldwide.
Where is the action taking place?
Well, for one, in the bond market. We have major companies issuing bonds at ridiculously low interest rates.”

Of course we know that government bond prices are inordinately high causing yields to be excessively low. But, this is also true in the market for high-grade corporate debt and for junk bonds. One could certainly argue that there might be “asset bubble” in the bond markets.

Thank you shadow banking system!

And, the cash continues to build up on the balance sheets of “healthy” large corporations. It also appears as if many hedge funds and private equity funds are attracting “large bunches” of new money.

But, capital is almost perfectly mobile in the modern world: it can escape almost everywhere.

Because of this, writers like Martin Wolf have argued that one of the goals of American leadership is to “inflate the world” in order to get United States economic growth going again.

So, are we seeing the results of this?

Well, we might be seeing this flow of capital going into world commodity markets and also into emerging markets. There is the possibility that bubbles may be occurring here.
The movement in commodities seems to be worldwide but repercussions are being felt domestically in the United States. (See “Dilemma Over Pricing: From Cereal to Helicopters, Commodity Costs Exert Pressure”, http://professional.wsj.com/article/SB10001424052702304741404575564400940917746.html?mod=ITP_marketplace_0&mg=reno-wsj.) This article indicates that, year-over-year, corn prices are up by 34%, wheat prices are up 34%, milk is up 32%, copper is up 30%, and oil is up 14%. It is also the case that sugar is up about 50% year-over-year.

The question many companies are facing is, “How can we raise prices to cover these costs when the economy is so weak?” A real dilemma!

Funds are also flowing into emerging markets. All one has to do is watch the stock exchanges in those countries. And, all indications are that large companies are looking to locate in many of these markets or acquire firms in these markets. We are also seeing the hedge funds and private equity funds looking in this direction. (See for example, “Buy-outs set to divide private equity”, http://www.ft.com/cms/s/0/726ce11e-dc6d-11df-a0b9-00144feabdc0.html.)

In a world where there is a fluid movement of capital, money is not going to stay at home if the home economy is not strong, structurally. The American economy is having major problems in its economy. Why would “big” money want to invest here? (See, for example, “Globalized Finance: Advantage China”, http://seekingalpha.com/article/229600-globalized-finance-advantage-china.)

The Federal Reserve, and the federal government, may need to change their economic models to include the fact that organizations other than domestically chartered commercial banks can create credit and can cause bubbles to occur anywhere in the world where an opportunity exists.

Modern finance with internationally mobile capital does not seem to exist in the models the leaders of the United States are using. This is one reason for my skepticism of all the new financial reform systems that are being constructed. (See my post “Banking at the Speed of Light”, http://seekingalpha.com/article/208513-banking-at-the-speed-of-light.) Money is becoming more and more fluid and hence less and less controllable.

The American banking system may currently be dormant, but there seems to be plenty of money and plenty of action, elsewhere.

Yes, there are bubbles all around.

China Is In The Game

China wants to play in the game. Yes, it would like to dominate the game, but that is for another time. For the present, China wants to be a player. I have written this constantly throughout my blogging career and I see no reason to change my opinion at this point.

China wants to play in the game and to do so its leaders realize that it must be a part of the game and not absent from it. But, remember two things: first, China will not do anything that it thinks might be harmful to itself in the long run; and second, China will always move in a way that “saves face.” Given these two conditions, China will be “in the game.”

The weekend news about China’s move on its currency is a case in point. The move was taken at China’s initiative. It seemed to catch the rest of the world by surprise. The move followed weeks of discussion about the possibility that China would not change the value of its currency in the near term.

China timed its move according to its dictates and not those of other nations.

Furthermore, the move pre-empts any discussion or actions by members of the G-20 at its June 26-27 meeting to highlight China’s unwillingness to play ball with the other major nations that will be in attendance. Now, the rest of the G-20 must re-boot their strategies relative to the agenda of the upcoming meeting.

China must see this as beneficial to itself and believe that moving at this time “saves face” because the news was done on its terms and not those of other countries in the world. It is keeping itself in the game.

However, China does not want events to get ahead of its plans. Although the announcement came on Saturday, when the market opened on Monday the value of the yuan was approximately 6.83 yuan to the dollar, roughly the same as it closed on Friday. By Monday afternoon, however, the yuan was trading around 6.8015 to the dollar, the highest level it has been in the modern era.

The point here is that China wants any appreciation in the value of the yuan to be incremental and not discrete. That is, movements in the yuan will tend to be more like a slow crawl and not like a discrete jump or leap. The leaders in China do not want to encourage speculators or huge currency inflows.

The signal to investors is that the value of the yuan may change but don’t expect wide swings. This is just not the way the Chinese do business.

But, I think, there is a bigger story going on here. The bigger story includes Russia and India…so we have three of the four BRIC nations as a part of what is going on. President Obama and his administration are making a concerted effort to be a part of the trajectory taking these countries into a prominent position in the world. All three of these countries are engaging each other, and talking with each other, visiting each other, and doing things with each other.

Chinese leaders have come to America and American leaders have gone to China.

New contacts with Russia show promise. Last year, President Obama called for a reset in relations with Russia. The countries have now signed a nuclear arms reduction treaty, agreed to increase cooperation in Afghanistan, and Russia has supported United States sanctions against Iran. This week President Medvedev comes to Washington to discuss business and then will visit Silicon Valley to meet with leaders in the technology field. Medvedev would like to encourage technology areas similar to Silicon Valley in Russia.

Leaders in India also are responding to invitations from the Obama administration to engage in dialogue and improved communications between India and the United States. Of these three BRIC nations, India has the longest solid ties with the United States and the greatest personal bond to see that these ties become stronger.

Not only are these three countries becoming relatively stronger in the world pecking order, but are the important reason why discussions about world business and foreign trade need to work in the larger Group of 20 nations rather than in the smaller groups that have been so prominent in the past.

Add on top of this the economic weaknesses experienced in the United States and Europe which have allowed these three, China, Russia, and India, to gain relative to “the West” faster than they would have if the financial collapse in these former areas had not occurred. These three nations are not going to back off their ascent in the world power scramble just because the United States and Europe are facing some “uncomfortable” economic weaknesses.

Furthermore, Europe has its own internal contradictions to deal with. Leadership in Europe is close to zero and the political problems that must be resolved there are almost overwhelming. And, while Europe attempts to get its house in order…the rest of the world moves on.

Brazil, the other BRIC, seems to be laying bricks lately. The current president, Luiz Inảcio Lula da Silva seems more interested in playing around with the leaders of countries at odds with the United States rather than entering into more mature relationships with the rest of the emerging world. Enough said.

What is vitally important for world trade and finance is to have these major countries talking with one another and learning about how they can work together to create a world in which all can prosper. World trade will not exist if it just benefits one or two countries.

The emerging nations are doing just that…emerging. These countries must be an important part of the world of the future. Keeping these nations down and causing resentments in a world where there are no channels for communication is not the way to build a richer and more vibrant world to live in.

The crucial thing is learning how to deal with each other. As I mentioned above, the Chinese will not make moves that will harm themselves in the long run and when they move they will do so in a way that does not make them look bad. Can we in the United States accept these two behavioral traits that seem so important to the Chinese or will we become so impatient and try and impose our self-importance on them?

Certainly, leaders in the United States cannot become “doormats” that others can just walk over. But, the time seems right for talking, for keeping channels open, for cooperation within the competitive framework, and for learning how to work with each other, accepting the quirks and psychological needs of others.

China will not always internally do the things we in the United States think that they should do…especially in some areas like human rights. We should not be silent on these things. But, I believe the world still has more to gain by building cooperation over the longer run than it does by breaking off ties. I believe that the recent economic moves by China confirm this. I believe that the leaders of China truly want to be in the game and will act accordingly.