If the Fed is Looking to Inflate Away Problems, What Should Asia Do?

I would be especially interested to hear the views of NC’s Asian readers on this post because Japan and China are usually considered antagonists with a long and sordid past.

Andy Xie thinks the Fed is on an inflationary path.  Last month, he wrote an article in Caijing which says that ‘stagflation lite’ is the Federal Reserve’s preferred outcome. What’s interesting is his recent article about the need for China and Japan to join forces under an ASEAN umbrella, rejecting the APEC umbrella shared with the U.S.

In last month’s article, Xie said:

The bottom line is that, regardless what central banks say and do, the world will be awash in a lot more money after the crisis than before — money that will lead to inflation. Even though all central banks talk about being tough on inflation now, they are unlikely to act tough. After a debt bubble bursts, there are two effective options for deleveraging: bankruptcy or inflation. Government actions over the past year show they cannot accept the first option. The second is likely.

Hyperinflation was used in Germany in the 1920s and Russia in late 1990s to wipe slates clean. The technique was essentially mass default by debtors. But robbing savers en masse has serious political consequences. Existing governments, at least, will fall. Most governments would rather find another way out. Mild stagflation is probably the best one can hope for after a debt bubble. A benefit is that stagflation can spread the pain over many years. A downside is that the pain lingers.

If a central bank can keep real interest rates at zero, and real growth rates at 2.5 percent, leverage could be decreased 22 percent in a decade. If real interest rates can be kept at minus 1 percent, leverage could drop 30 percent in a decade. The cost is probably a 5 percent inflation rate. It works, but slowly.

If stagflation is the goal, why might central banks such as the Fed talk tough about inflation now? The purpose is to persuade bondholders to accept low bond yields. The Fed is effectively influencing mortgage interest rates by buying Fannie Mae bonds. This is the most important aspect of the Fed’s stimulus policy. It effectively limits Treasury yields, too. The Fed would be in no position to buy if all Treasury holders decide to sell, and high Treasury yields would push down the property market once again.

I certainly agree with him. You don’t have to be in the hyperinflation camp like Marc Faber to think the Fed takes Ken Rogoff’s suggestions about 6% inflation seriously. In a May post, I said:

Basically, the Fed wants to inflate our way out of this depression – that’s the dirty little secret.  There is really no other policy choice because the mountain of debt in the United States is immense.  And I think Bernanke, Geithner and Summers have proven they are willing to do anything to reflate this economy and avoid debt deflation dynamics.

And when I say anything, I mean create asset bubbles that are being given intellectual cover by the likes of Frederic Mishkin. This is a policy of economic weakness.

So what should the Asians do?  China is desperate to employ its tens of millions of countryside transplants cruising its cities in search of urban employment. That’s a major reason it keeps its exchange rate fixed to a plummeting dollar, making not just Americans but Europeans irate?  Japan has been in a modern day depression for twenty years. Its sovereign debt-to GDP is now over 200%, risking a downgrade.

Xie says the two should join forces – in part as a rejection of the U.S., which he basically calls a fading power (although the paragraph above points to serious weaknesses in China and Japan as well).

Here is an excerpt of Xie’s article:

Yet the fundamental case for Japan to increase integration with the rest of Asia and away from the United States grows stronger every day. Despite high per capita income, Japan remains an export-oriented economy, having missed an opportunity to develop a consumption-led economy in the 1980s and ’90s. In the foolish belief that rising property prices would spread wealth beyond the industrial heartland in the Tokyo-Osaka corridor, the government of former Prime Minister Kakuei Tanaka pursued a high-price land policy, discouraging the middle class from pursuing a consumer lifestyle as they saved for property purchases…

The point is that Japan has a strong and genuine case that favors more integration with East Asia. The United States is unlikely to recover soon and with enough strength to feed Japan’s export machine again. There is no more room for fiscal stimulus. Devaluing the yen to gain market share is not an option as long as Washington pursues a weak dollar policy. Without a new source of trade, Japan’s economy is doomed. Closer integration with East Asia is the only way out…

Five years ago, I wrote an op-ed piece for the Financial Times entitled China and Japan: Natural Partners. At the time, a prevailing sentiment was that China and Japan were antithetical: Both were still manufacturing export-led economies and could only gain at the other’s expense. I saw complementary demographics and capital: Japan had a declining labor force and China needed to employ tens of millions of youths migrating to cities from the countryside. China needed capital and Japan had surplus capital. And their trade relations indeed tightened, as Japan had increased the Chinese share of its overall trade to 17.4 percent in 2008 from 10.4 percent in ‘04.

Today, the situation has changed. China has a capital surplus rather than a shortage. Demographic complementarity is still good and could last another decade. As China shifts its development model from resource intensive to environmentally friendly, a new complementarity is emerging. Japan has already made the transition, and its technologies that supported the transition need a new market such as China’s. So even without a new trade agreement, bilateral trade will continue growing.

An FTA between China and Japan would significantly accelerate their trade, resulting in an efficiency gain of more than US$ 1 trillion. Japan’s aging population lends urgency to increasing the investment returns. On the other hand, as China prepares to make a numerical commitment to limiting greenhouse gas emissions at the upcoming Copenhagen summit on global warming, heavy investment and rapid restructuring are needed for its economy. Japanese technology could come in quite handy.

An FTA involving Japan and China would be a serious threat to American economic power. You can imagine that policy makers in Washington are opposed to this idea.  Let’s watch to see what kind of rhetoric comes out of Barack Obama’s China trip to see if this issue is discussed.

Xie’s article in its entirety is at the link below.


Andy Xie: Why China and Japan Need an East Asia Bloc – Caijing

Originally published at Naked Capitalism and reproduced here with the author’s permission.

5 Responses to "If the Fed is Looking to Inflate Away Problems, What Should Asia Do?"

  1. Anonymous   November 12, 2009 at 10:07 am

    I don’t see any plan that will be implemented over a ‘decade’ timescale. Simply is not possible with the current accepted mindset.Long term plans are now on the order of a year.

  2. Anonymous ibid.   November 13, 2009 at 8:21 pm

    I think this misses the point. All Asia needs to let currencies strengthen so that the standard of living can rise. Until now, the competition between them has prevented this from happening. They need to let the exchange rates rise in concert so that export prices rise in concert.As for a China-Japan union, the Chinese are ferocious imperialists, and have been for thousands of years. The Japanese have learned their lesson from the late unpleasantness. But the Chinese actually believe in Manifest Destiny, and with a fervor that puts American jingos to shame. They have learned that war is an inefficient way to accomplish their goals. And give them credit. They have created an incredible civilization.Japan knows that in any such relationship, it is the fly and China is the spider.

  3. Anonymous   November 13, 2009 at 9:54 pm

    China is imperialist? Far from it. China could have colonized the world in the 1400’s. Instead they turned inward and isolationist leading to their backward state today. The Japanese on the other hand have shown their imperialistic tendencies with their invasions of China (rape of Nanking) and Korea. Over 8 million Chinese were murdered in the worst possible way by the Japanese, but no one seems to remember that part.

  4. Anonymous   November 14, 2009 at 11:34 am

    Let currencies strengthen so that the standard of living can rise……..imperial china…..unfortunately at some point, thank to the education system, this great country got filled with people, with no knowledge of history, or any other real knowledge, no common sense, and no ability to think. Asians can not let their currencies strengthen because, they still export labor intensive products, and most of trade they do in between ends us here as a final product. Wal-Mart sells them, and their only competitive advantage is price. Their standard of living depends on internal consumption, how they supply and finance it. Your doormen does not get a higher standard of living when he wants to raise his paycheck. You replace him. All Asia manufacturing base is positioned for people who make $25,000 / year on average and most of them no where near there; so they have to keep exporting and they have to keep prices low.

  5. Anonymous ibid.   November 14, 2009 at 5:48 pm

    Anonymous on 2009-11-13 21:54:40 says, “China is imperialist? Far from it.”The Vietnamese and the Tibetans would probably not agree. Or ask the Uighurs, who are currently being brutalized.But, as I said, the Chinese long ago shifted away from using warfare and direct occupation to cultural imperialism. There are large Chinese emigre communities that influence events abroad, for example. They have a significant effect throughout most of Asia. Chinese history and culture draws people to them.I have not forgotten and do not in any way minimize the Japanese invasion of Asia in the 1930s-40s. I know that many Japanese are still in denial over the terrible deeds they did. But they are realistic. They know that the nation is far too small and dependent on natural resources from abroad to be able to control anything much beyond their borders. In a nuclear exchange, Japan as a nation would be erased, while China would suffer terrible casualties but still remain a viable nation. Realism constrains any military dreams.______________________Anonymous on 2009-11-14 11:34:51 says “this great country got filled with people, with no knowledge of history, or any other real knowledge, no common sense, and no ability to think.”I believe this may be aimed at me rather than at all 300 million Americans.You might be surprised who you are speaking to, my friend.You say, “Asians can not let their currencies strengthen because, they still export labor intensive products…”The yen was once 300 to the dollar. As recently as the mid-80s, it was 180 to the dollar. Now it is half of that. And yet the Japanese standard of living has not collapsed. It has risen. Similarly, China has allowed the yuan to strengthen and yet living standards continue to rise. So, what you are saying is clearly false.What you mean to say is that there is a trade-off between export-dependent jobs and the strength of a currency. But if you would please read Harrison’s posting, Andy Xie makes the case that China needs to develop an internal, consumer-led economy so that it is not so dependent on exports. As he says, Japan “missed an opportunity to develop a consumption-led economy in the 1980s and ’90s.” The great wealth generated in that period led to an asset bubble in land/housing instead of providing people what they wanted (less stress through: retirement and unemployment security, better healthcare, more leisure, more education and opportunity, a cleaner environment, consumer goods, etc.)Here’s a simple way to understand the issue of currency appreciation. Suppose we have an economy size 100 units (call them kibbles). 50 kibbles are derived from exports, and 50 are derived internally. Each kibble represents 1 person employed. If the currency appreciates 2%, suppose that employment declines 1%. So, if the currency goes up 20% (say, from 5 kibbles/dollar to 6 kibbles/dollar), 5 people become unemployed, and exports fall from 50 nominal kibbles to 45 nominal kibbles. However, the value of money made from exports also rises by 20%, so those 45 kibbles are worth 54 old kibbles. Export income actually rises! And so anyone who loses a job can be hired at higher wages for the domestic economy.Naturally, the details of this depend on how elastic demand is to price and on whether government actually delivers on making sure those who lose jobs get new ones. But the labor component of the cost of Chinese exports is so low that I believe that wages could rise substantially while improving both employment and the standard of living– if Asia can revalue in concert. If they try to revalue separately, then of course customers will simply move elsewhere.