Oct 23, 2010 11:41 am


Stimulus emerged as a dirty word in this election cycle. Democratic Keynesians argue that it saved the US and what is needed is more of the same. 2/3 of American polled, consider it a waste of money. They may not know the reason the Keynesian recipe no longer works but they can see that it not only does not work but that it is making the sick American economy sicker. But why have American efforts to stimulate the economy fail so miserably while Chinese efforts have succeed so well? Because in the US (though not in China) demand is local but supply is global, points out Andy Xie.

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. . . .

Despite trillions of dollars in stimulus and a sharp one-year rebound in the global economy from the middle of 2009, the developed economies have virtually seen no employment growth. The consequences of the financial crisis have eaten away quite a big chunk of the stimulus. It is, however, not the full explanation. We are seeing overheating in emerging economies. The stimulus is just working somewhere else.

For the stimulus to work in developed economies, it needs to inflate costs in emerging economies so much that the multinationals want to add additional capacity in the developed economies. That is unlikely. The average wage in developed economies is about ten times the average level in emerging economies. And there are five people in emerging economies for each one in developed economies. The math just wouldn't work out for this approach.

Xie wrote the article in August and went on to predict a rise in oil prices and gold:

The stimulus policy is more likely to end with inflation. Inflation is a monetary phenomenon. The massive growth in the money supply in the U.S. and other developed economies is not causing inflation for three special reasons. First, the financial crisis has crippled their banking system. Before it is fully repaired, it will slow down money velocity, equivalent to a reduction in money supply in the short term. Second, weak demand is forcing suppliers to refrain from raising prices. Third, as discussed before, multinational companies are investing in emerging economies.

The first two factors are temporary. When the two factors are removed, many argue that the central banks will have time to withdraw money before inflation happens. This is a bold assumption. The amount of money that has been injected into the global economy is so massive that removing it would be extremely hard. The odds are that the central banks won't be able to.

Before the first two factors are removed, inflation still can happen via the emerging economies. The price of oil is above US$ 80 per barrel, even though the global economy and the demand for oil are depressed. It has more than doubled from the lows during the 2008 crisis. One could argue that the shortage in supply is the reason. I seriously doubt it. Inflation expectations are likely the critical driver. Today, oil producers are less willing to extract oil from under the ground in exchange for paper currency. Ceteris paribus, the price needs to be higher to motivate them to produce the same amount of oil. Unfortunately, the oil price goes up with further loosening in monetary policy.

Financial capital is turbo-charging the oil price both due to speculation and inflation hedging. Speculators are trying to anticipate the producers' willingness to supply and the demand from inflation hedges. Such motivations don't necessarily cause bubbles. But, when there are too many speculators, the price loses its normal signaling functions and just reflects speculative demand. When interest rates are near zero, speculators mushroom. If the Fed does pursue"QE 2," oil prices are very likely to rise above US$ 100 again.

Many analysts think that gold is in a bubble now. Quite a lot of money has been pulled out of gold lately. I think that the gold price just reflects how loose the monetary environment is now. If the Fed does a"QE 2," gold prices could rise above US$ 1,500 per ounce quickly and may move much higher afterwards.

So far, he seems right. Oil prices are rising as so is the price of gold. He also predicts continued high unemployment. The bright spot? High corporate earnings.

So what should be done to end the hemorrhaging of US public and private wealth? Xie recommends ending attempts to stimulate the economy. In other words, stop digging. I would like to see cuts in public spending and saving indexing to encourage private savings as is done in other countries.

Unfortunately, we may continue digging: G-20 ministers to decide on economic stimulus measures. The G-20 includes many developing countries who benefit from continuing to supply artificially increased American demand.

Update: The Economist argues that what is needed is more of the same: False expectations The historic infrastructure investment that wasn’t

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