Thursday, April 28, 2011

Chinese Inflation, and Next Recession Musings


Amidst news stories of Chinese truck drivers striking over the price of fuel, and 20% minimum wage rises, I wanted to see the actual data on Chinese inflation.   The above graph is from Trading Economics, and shows the Chinese CPI.  Looks like the economy there is indeed starting to overheat.  However, it's still rather below the 8% level reached in early 2008, before the great recession took the wind out of everyone's sails.  At historical rates of increase, it looks like that kind of level might be a year away.  So perhaps it will be a little while before something gives in the global economy.

In general, I'm thinking a lot about the following mental model for oil prices and recessions.  First of all, recessions are not linear phenomena.  They represent trend breaks in the general path of improving economic productivity.  I think of them as akin to a paradigm shift (in the Kuhnian sense) when global markets are forced to realize that some assumption they were implicitly making cannot continue to hold any longer.

We are in an era where the availability of natural resources is not sufficient to support the wealth levels that the developed world has grown accustomed to, along with the speed of growth with which the developing world is trying to approach those same levels.  So, this is represented by oil prices rising (along with food and other commodity prices more generally).  But the effect of this is not to place a uniform drag on growth, because the global mind has not accepted this truth yet.  Instead, the global economy keeps trying to grow in a way that is inconsistent with the resource constraints, and then some part of the system tears and gives way.

So, in 2007/2008 the sector that gave way was the American subprime consumer, along with a significant chunk of the financial system that was predicated on the idea that poor Americans could continue to take on more and more debt indefinitely.  Instead, rising gas and food prices eventually destabilized the finances of that sector of consumers, they started to default, then their lenders started to default, financial contagion set in, and the situation was only stabilized with massive extraordinary interventions by sovereign governments.  That worked, but left a lot of the sovereigns in significantly weaker condition than before.

Now poor Americans borrowing more and more to bid house prices higher and higher was always an unsustainable trend that was going to end in tears one way or another.  But the timing was likely determined by the oil/food price shock that ended in 2008.

So now, just three years later, here we are again with oil and food prices rising fast, and the question in my mind is this: what part of the global fabric tears next?  And when?

Clearly, we have had some smallish rips in recent months.  The instability in the Middle East this year has a similar character.  The people there have been living under nasty authoritarian regimes for a long time, and that's probably always been an unsustainable arrangement that was going to end badly some day.  But rising fuel/food prices were a trigger, at least in part.  But, so far, these events have not been sufficient to cause enough general distress and panic to get commodity prices to go lower.  Indeed, because the region is such a critical oil producer, prices have gone higher (with Libya in particular seeming not likely to resume much in the way of oil production in the immediate future).

Whether the events in the Middle East have run their course, or are just smoldering in out of the way places (Syria) waiting to burst into larger flames again, I am not sure.

Then there is the issue of European sovereign defaults.  The Greeks and the Irish, and maybe a few others, are not going to repay their debts in full.  At some point, this is going to have to be recognized and the consequences worked through.  Will this cause enough general panic and fear to get the global economy off track and lower commodity prices?  I have a hard time believing it, since the whole situation has been so obvious for so long and you'd think the various institutions at risk (eg the French and German Banks) would have had time to mitigate their risks (but then I would have said the same about the US housing bubble, and that was clearly not right).

In a way, whatever happens in the end to stop global growth and drop commodity prices almost has to come as a surprise, at least to most of the global mind.  It can't be something that's broadly accepted already.

A few other candidate issues:
  • China's authoritarian political system is probably not sustainable forever.  Major political unrest in China would obviously send massive tremors through the global economy.
  • The US government deficits are not sustainable forever.  Obviously, elite opinion is that the crisis is not imminent and so the proposals for dealing with this are mostly not very serious, but it is receiving some attention.
  • The US trade deficit is not sustainable.  At some point the dollar has to get a lot weaker relative to currencies that are currently pegged to it (like the Renminbi and the Riyal).
  • It's probably also worth mentioning the whole derivative market mess (with outstanding contract face values some humungous multiple of the size of the global economy).  I'm not sure that's a likely cause of rips in the global fabric, but it does perhaps have the potential to cause unexpected transmission paths from an initial shock to other parts of the system. 
So which of these gives first?  Or is it something else altogether?  I'm not sure.  But as long as the world is trying to grow at 4%+ a year on the current technological base, I think the strain will be getting worse.

13 comments:

bordoe said...

>It's probably also worth mentioning the whole derivative market mess (with outstanding contract face values some humungous multiple of the size of the global economy). I'm not sure that's a likely cause of rips in the global fabric, but it does perhaps have the potential to cause unexpected transmission paths from an initial shock to other parts of the system.

Keep on eye on:

http://online.wsj.com/article/BT-CO-20110419-715223.html

Especially the OCC as they deal in time based risk (as opposed to transaction settlement only of the rest of the DTCC structure).

These entities do not need to 'go down' to stop the market; merely a whiff that they MAY not function will cease all liquidity when a financial crisis takes down a major institutional trader.

No liquidity = No financial market.

Given our absurd reliance on promise shuffling to whip our cotton-candy economy ever higher, this will likely be a rather bad thing.

Also; please remember that risk cannot be 'untaken', it can only be offset. Last time it was CDS products from AIG/monolines (and others) that the risk was offloaded onto, then the US Treasury when they failed miserably.

So really, the loss (from a societal perspective) happens not when recognized, but when a bad loan is originated.

Burk Braun said...

Hi, Stuart-

Thanks for a provacative post. Gas prices may have been the straw, but the subprime (i.e. fraudulent and maliciously unregulated) lending was very much at the core of the bubble. Sane watchers were amazed that the bubble lasted as long as it did.

Sovereigns are in a weaker condition? They have all the power they need to spend paper money and raise demand to normal levels (as the Chinese are doing). They are very powerful... all-powerful, indeed. When inflation becomes a problem in the US, then we can talk!

For instance, the "derivative market mess" is an ongoing drag on growth, as financial firms continue to fill in holes, rather than making new investments. That is why growth is stagnant and will be for some time, given the weak fiscal response from the government.

The problem of resource depletion is a separate one from unemployment and distribution, and even aggregate demand. If more people find employment as farmers, or rickshaw drivers, or recyclers.. the economy keeps on chugging, distributing limited goods.

US government deficits do not need to be sustainable forever. Japan shows that they are sustainable for a very, very long time past where we are. But if we manage to improve economic conditions and put more people to work, and cancel the high-end tax cuts, the situation will quite naturally right itself.. that is the lesson of Keynes- that cutting in the middle of a recession is destructive on the long term, not just the short term.

The US trade deficit is certainly sustainable for just as long as people abroad like to save in dollars. That in turn depends on our political system not being given over to idiots and charlatans. The dollar will weaken with time, and that will be very good for our jobs picture, though less good for our ability to run deficits. When the renminbi takes over, we will, finally, have to think about lowering our federal deficit.

More broadly, I think your anthropomorphism of the world "trying" to grow at 4% is quite misleading. It is an impersonal and blind process, as we monetize more of our lives, create more things and ideas and services of value for each other, etc. The developing world is finally on a very good path to growth, and we should cheer them on, even as we use economic tools (like carbon prices) to make important public/external costs visible and economically relevant.

Nick G said...

"rising gas and food prices eventually destabilized the finances of that sector of consumers, they started to default, then their lenders started to default"

I've seen this said often on TOD, but I've seen no proof of it. As best I can tell, the housing bubble simply reached an unsustainable level and popped pretty much of it's own accord - at a certain point 1) it was not possible to find a "greater fool" to buy empty spec houses and 2) ARM resets revealed that home buyers could not afford their loans, regardless of minor changes in their gas and food expenses.

I'd like to see evidence for the idea that changes in gas and food expenses were large compared to housing expenses.

Gary said...

Burk, good discussion - especially "The problem of resource depletion is a separate one from unemployment and distribution, and even aggregate demand. If more people find employment as farmers, or rickshaw drivers, or recyclers.. the economy keeps on chugging, distributing limited goods."

Presently our expectations of what the economy should be providing are at odds with what it actually can provide. That shows up as high prices for energy and food. So we are forced to make an adjustment. The only question is if that adjustment needs to be another destabilizing collapse of some form, or if market forces will do the job with less disruption.

bordoe said...

Burk Braun>Japan shows that they are sustainable for a very, very long time past where we are.

Japan is and has been a net capital exporter that had a large private sector (corporate) debt overhang. Corporate sector debt has now worked itself off over 20 years into a nice cash position of JGBs.

Japanese government in turn has been able to buy hundreds of billions of US Treasuries with the 'excess' savings of the population, further propping up the US Treasury bubble.

But this is quite different from the US; which is a net capital IMPORTER and has a structural imbalance in both the balance of payments and fiscal balance.

Also, a consciously energy efficient economy mainly structured around manufacturing exports (also describes Germany) is quite different from an economy that has morphed into a combination of health care, education, hotels and prisons.

Nick G>I've seen this said often on TOD, but I've seen no proof of it. As best I can tell, the housing bubble simply reached an unsustainable level and popped pretty much of it's own accord...

Yes. I concur. Financial panics are not new to history and this just looks very much like a normal one. The fact that some commodity happened to reach a peak slightly after house prices is not any sort of indication of causation. For example; Japanese real estate prices peaked after stocks, by about a year. Does it prove anything? No. Just that different assets peak at different times during a bull phase.

Also; peak oilers (which I count myself as one) too readily ignore commodity cycles in history. Prices rise, prices fall, and often they dont 'mean' a thing.

--

But I wouldnt be surprised if a margin squeeze caused by high oil prices, along with the housing driver no longer in the economy, drove profitability down in some sectors to the point that letting go of workers made more sense.

And since wage labor income is the primary source of personal interest payments (on single family home mortgages especially) I could see that spiraling out of control.

Burk Braun said...

Hi, Bordoe-

"US Treasury bubble" .. These are serious words, and I think used in haste. The US can honor all its debts in perpetuity, just as Japan can. It prints the money. So the question is not one of a bubble or of insolvency, (unless our political actors decide for political reasons to renege on their obligations), but of inflation.

All this huffing and puffing about the US debt- its danger, its unsustainability, etc. is uninformed and unnecessary, though it may, through political suicide, become self-fulfilling. Inflation is now below target. Thus we need more money put into the system, not less. The idea that some magical thing may happen and drive us into hyperinflation next month or next year is simply not looking reality in the face. There would need to be a world-wide exit from the dollar in order for current trends to turn around and cause inflation. That would also mean that dollars are being spent buying US goods, which would be a very good thing in many respects.

Such a turn (out of the dollar, in rapid fashion) is something that could only happen for political reasons- if the country is run by the clowns we seem to be seeing line up on the right. In economic terms, it is certainly in China's long-term interest to start winding down its dollar assets to some small degree, or at least stop piling them up so high. But it is also in their interest to have this process happen very slowly.

Greg said...

I agree with nearly all of what Burk says, but I have to take issue with one point and nitpick another.

> The problem of resource depletion is a separate one from unemployment

Scarcity is relative. In the short run, if one set of inputs to production becomes scarce (as indicated by rising real price), then another set must become abundant. If physical commodities and energy are scarce, then labour is abundant. And therefore liable to be underutilised.

Labour will be underutilised, that is, until the capital structure adapts*. And that's my nit-pick. Yes, Stuart's language is dangerously anthropomorphic, but the point is still valid. By saying "... the economy trying to grow in a way that is inconsistent with resource constraints", Stuart is saying that existing capital was constructed in an era when physical resources were abundant, and it was designed accordingly. (From now on, it's likely that investments will be made in the light of resource scarcity. After a period of adaptation, new capital will be constructed to use different proportions of inputs.)

While I think the current US obsession with debt levels is over the line from rational, I will grant that we have had demonstrated to us that the ability of households to take on debt is another resource which has been somewhat depleted. Is it a renewable resource? Ordinarily, yes. With sustained downward pressure on wages, who knows?

One final observation. There have been several changes of the financial "centre of gravity" in recent European history (since, say, 1300 CE). When a change occurs it tends to be quite sudden, and the former centre suffers grievously. The things that Stuart lists point to a switch away from New York and the USD, sometime in the next few decades.

--------------------------
* or possibly permanently. In pre-industrial Europe, peasant labour was quite underutilized. There were about 100 Holy Days in England in mediaeval times. There was a large class of seasonal labourers, and another set of seasonal migrants who lived in the mountains and marshes and also worked seasonally, but not every year. Nowadays, we're approaching a time when self-directed machines could do much human-equivalent work.

bordoe said...

>"US Treasury bubble" .. These are serious words, and I think used in haste. The US can honor all its debts in perpetuity, just as Japan can. It prints the money. So the question is not one of a bubble or of insolvency, (unless our political actors decide for political reasons to renege on their obligations), but of inflation.

All this huffing and puffing about the US debt- its danger, its unsustainability, etc. is uninformed and unnecessary, though it may, through political suicide, become self-fulfilling. Inflation is now below target. Thus we need more money put into the system, not less. The idea that some magical thing may happen and drive us into hyperinflation next month or next year is simply not looking reality in the face.

-=-

Maybe serious but totally meaning it. US is now a heavily levered country without any obvious source of domestic savings to fund a massive fiscal imbalance.

The government is insolvent (which merely means that it has revenues that cant match liabilities) and it cant reasonably bring itself back into solvency through taxes (would have to go up tremendously to make that happen, precipitating capital flight for sure) OR through spending cuts, since the US domestic economy is INCREASINGLY 'Federally' backed sectors like health, education and various contractors. Cut that and our domestic tax base probably takes a tremendous hit, making the situation worse.

Printing money is no solution. If it was, the world wouldnt have most of the problems it has.

Your understanding of the debt markets, especially when you mentioned (in a previous post's comment) that the bond market 'always' funds US Treasury, is simply incorrect.

US Treasury has been 'golden' credit since it didnt officially default (it did go off the gold standard, which is a type of default) during the Great Depression when European countries did by in large defaulted. For a very brief period during 1932-1934, you'll see that Federal Credit was trading at a PREMIUM yield to the best private corporate credits and large municipal bonds.

This only happened because at that time, and it may happen again, it seemed that private sector was a better preserver of capital than the Federal government.

TiradeFaction said...

So Stuart, it seems you've gotten fairly pessimistic as of late. Are you coming more around to the luddite doomer's POV? Just curious.

Stuart Staniford said...

Tirade:

No, I haven't become any more of a doomer. I have about the same view of peak oil I've had for a few years: it's more likely than not that we'll adapt to it, but it's likely to be a painful process involving a series of recessions. There is some risk of it being worse than that, with that risk being social rather than technical.

As to Luddite, not altogether, but I do have very strong concerns about certain directions of innovation, as discussed here.

TiradeFaction said...

Thank you for the timely response Stuart.

If I may ask, what technological base (or direction) do you find more palatable (and desirable)? My guess is you diverge greatly than the "ArchDruid" on this issue (as do I).

DPM said...

I could only find 1 source suggesting collapse of the housing market began in the outer suburbs and exburbs as a consequence of increasing gasoline price. I know a handful of studies observed this pattern and came to this conclusion.

http://www.npr.org/templates/story/story.php?storyId=89803663

DPM

FuturePundit said...

Stuart, You ask a good question:

what part of the global fabric tears next? And when?

The tears can take so many forms. While we tend to look at things from the perspective of Western middle class folks I wonder if the tears will come in places outside the West. Look at inflation in developing and poor countries due to commodity price rises. Aren't some of the tears already happening? Would Tunisia's revolt have happened if prices had stayed low? That led to Egypt, Libya, and now Syria.

So will the next round of tears come in specific countries rather than in the world economy?

Or look at Europe. Greece, Ireland. These are tears as well. The current oil price spike is worsening prospects for the PIIGS.