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Bernanke, inflation, China and the housing bubble

by Jerome a Paris Tue Nov 22nd, 2005 at 04:11:33 PM EST

The Financial Times published today a viciously critical piece on Bernanke's decision, in his position as Fed chairman nominee, to announce an inflation target. This gives me an opportunity to revisit and comment a great article in the Economist this summer about China's impact on our inflation and on other economic indicators at home.

Bernanke should rethink his monetary `Maginot Line'

It is hard to see why Mr Bernanke is devoting all his initial political capital to this issue [of setting an explicit inflation target]. Perhaps, like the Maginot Line, it is all about the last war. Inflation peaked in the US in 1982, under Paul Volcker, Mr Greenspan's predecessor. It is today well in check and although the gold price has been rising in recent days, the yield on 10-year US Treasury bonds has been falling. This is hardly a market panicked by the prospect of inflation.

The author, Peter Hartcher, an Australian commentator and the author of a soon-to-be-published book with the delicious title of Bubble Man: Alan Greenspan and the Missing Seven Trillion Dollars , continues:

The clue to what is driving Mr Bernanke may be found in a speech he gave in March 2003: "Credibility is not a permanent characteristic of a central bank; it must be continuously earned." In effect, an untested Fed chairman is seeking to establish through a formal arrangement the credibility that his two towering predecessors won through action. But in the meantime, as he builds this monetary fortress to protect his chairmanship from any doubt about his credentials, there are other defensive works left undone.

The experience of Japan in the 1980s, and the US in the 1990s until today, is that easy money no longer flows into traditional inflation, but into asset price inflation. While consumer price inflation stayed low, America blew up its economy with vast speculative asset price bubbles.


The US central bank, under Mr Greenspan and, shortly, Mr Bernanke, avoids focusing on [how to deal appropriately with bubbles]. The enemy has reformed, but the Fed's threat perception has not. In the meantime, the US has gone from one bubble - in stock prices - to another, in house prices. Right now, the housing bubble is starting to deflate. This is because the Fed is raising short-term rates, bringing them back to a neutral position. It just so happens that this tightening to head off any inflationary threat coincides with the need to deflate a potentially dangerous bubble in house prices.

(...) Under current Fed doctrine, the Fed would do what it did during dotcom mania - wait for the burst and the recession that follows. Is there a better way? This is the big new agenda item for central banks, but Mr Bernanke is preoccupied with the old agenda.

If you've been reading me here, you know that I am convinced that there is a massive asset bubble, and I am always pleased to see confirmation that others (in this case, most Western Central Banks except the Fed) agree. I usually go one step further and say that the bubble was caused by the Fed itself, which lowered interest rates too much.

The mysterious question is why these low interest rates, and the correspondingly frothy economies they have boosted, have not triggered inflation. That brings me to China, and one of the most comprehensive explanations provided for this, in the Economist last July.

Ironically, the article starts by expaining that the trade deficit with China, the most talked about item between the two countries, is probably the one thing that China is not responsible for. As I have argued, the Economist makes the point that it is the USA's lack of savings and over consumption that generate the deficit, which is not only with China:

But the article then goes to make a fundamental point:

China and the world economy - From T-shirts to T-bonds
(behind sub. wall - I'll email the article to anyone who requests it)

China's impact on the world economy can best be understood as what economists call a "positive supply-side shock". Richard Freeman, an economist at Harvard University, reckons that the entry into the world economy of China, India and the former Soviet Union has, in effect, doubled the global labour force (China accounts for more than half of this increase). This has increased the world's potential growth rate, helped to hold down inflation and triggered changes in the relative prices of labour, capital, goods and assets.

The new entrants to the global economy brought with them little capital of economic value. So, with twice as many workers and little change in the size of the global capital stock, the ratio of global capital to labour has fallen by almost half in a matter of years: probably the biggest such shift in history. And, since this ratio determines the relative returns to labour and capital, it goes a long way to explain recent trends in wages and profits.

The entry of China's vast army of cheap workers into the international system of production and trade has reduced the bargaining power of workers in developed economies. Although the absolute number of jobs outsourced from developed countries to China remains small, the threat that firms could produce offshore helps to keep a lid on wages. In most developed countries, wages as a proportion of total national income are currently close to their lowest level for decades.

The flip side is that profits are grabbing a bigger slice of the cake (see chart 4). Last year, America's after-tax profits rose to their highest as a proportion of GDP for 75 years; the shares of profit in the euro area and Japan are also close to their highest for at least 25 years. This is exactly what economic theory would predict. China's emergence into the world economy has made labour relatively abundant and capital relatively scarce, and so the relative return to capital has risen. It is ironic that western capitalists can thank the world's biggest communist country for their good fortune.

Now that's a pretty straightforward insight: as Chinese labor becomes available to the global economy, it puts a downwards pressure on the remuneration of labor everywhere - and this is indeed what we all see and feel. And China's compatition brings prices of goods down, and keeps wages down, thus preventing inflation.

A study by Dresdner Kleinwort Wasserstein reckons that China has knocked almost a full percentage-point off America's inflation rate in recent years.


As it is, China's reduction of inflationary pressures has allowed central banks to hold interest rates lower than they otherwise would be.

And this is where it gets interesting: with less inflation, Central Banks have kept interest rates low, thus fuelling the financial world with vast amounts of ultra cheap money. But, in a period of actually declining prices, Central Banks should not be targetting for low inflation, but tolerate some deflation (prices going down) to reflect improved productivity and allow the gains to pass on to consumers (andw thus workers who otherwise have stagnant wages).

in such circumstances, overall price stability might be the wrong policy goal. Instead, they argued, average prices should be allowed to fall to pass the productivity gains on to workers and consumers as higher real incomes. But just like today, monetary policy prevented prices from falling. And an overly loose policy then inflated the late-1920s stockmarket bubble.

(...)  The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a misallocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem.

This is compounded by China's decision to peg the yuan to the dollar, which it enforced by purchasing massive quantities of US Treasuries, thus also keeping long term interest rates at record low levels. The Economist notes that this Chinese policy has effectively eroded America's monetary sovereignty, as shown by the recent increases in the Fed's (short term) rates, which have not had their usual impact on long term rates.

America's sovereignty over its monetary policy has therefore been eroded, with a given rise in short-term rates producing much less monetary tightening than in the past. To that extent, global monetary policy is increasingly being set in Beijing as well as in Washington.

By helping to hold down interest rates in rich economies, China may have indirectly created a global liquidity bubble. Total global liquidity last year rose at its fastest pace in three decades after adjusting for inflation. This excess liquidity has not pushed up conventional inflation (thanks to cheap Chinese clothes and computers), but instead it has inflated a series of asset-price bubbles around the world. Thus, pushing this argument to its limit, it could be said that the global housing boom is indirectly "made in China". Not only has China played a role in holding down short-term interest rates, but the People's Bank of China has also supported America's mortgage market by buying vast amounts of mortgage-backed securities.

And the Economist thus concludes:

The fate of American house prices could thus be determined by unelected bureaucrats in Beijing rather than the unelected central bankers of the West.

This article has argued that global inflation, interest rates, bond yields, house prices, wages, profits and commodity prices are now being increasingly driven by decisions in China. This could be the most profound economic change in the world for at least half a century.

The important insight is that the link between interest rates and inflation has been broken, because of China's emergence on the world economy and its deflationary impact on consumer prices and wages. Thus cheap money has fed into asset prices - and created the massive housing bubble.

As a reminder, these few graphs:

Investment in the residential sector in the USA has almost doubled in the past 10 years, and increased by 50% since 2001. That's the sector where most of the current growth of the US economy is coming, and it's clearly finance generated, notably via home equity loans:

This has been compounded by Bush's reckless budgetary policies, which, as the graph below shows, are defined by an unprecedented scissor movement of increasing spending and reduced tax receipts:

So, at a time when deflation should have been tolerated and interest rates raised, hundreds of billions were given away to rich Americans in tax cuts and more to financial markets as cheap money, thus preventing consumer prices to go down at a time when wages were kept in check. The only thing that has given to many the illusion that all was dandy are the higher house prices and the debt fuelled consumption they make possible.

The result is artificial growth of the housing sector, massive debt for consumers, and no room for manoeuver on the budgetary side to fight the tighter monetary policies now imposed - finally - by higher oil prices (also caused by China). And no control over long term interest rates, willfully or not manipulated by big US Treasury holders/purchasers like China or the oil exporters.

Bush and Greenspan have given the keys of the house to China, and Bernanke is busily repainting the door. Nice job.

This is crossposted over at dailykos for your kind recommendations. This is your daily good deed to bring more traffic to ET.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Tue Nov 22nd, 2005 at 04:25:16 PM EST
(hopefully I might get to some more thoughtful comments tomorrow)

First, I'd love a copy of the article, I did have it on paper, but I seem to have mislaid it.

Second, thanks for this, I know I badgered you about it.

Third, does this structural change in the balance between capital and labour suggest that the Left is in trouble until the balance changes again? i.e. Rising inequality is guaranteed until that time?

by Metatone (metatone [a|t] gmail (dot) com) on Tue Nov 22nd, 2005 at 04:54:26 PM EST
Fascinating question.  People have been asking that for awhile.  First, it seems that people will not stay in the same job their whole lives.  For all of us below fifty, that seems obvious.  But it seems that unions have changed to reflect that.  Can we develop a system that allows for payments into a pension fund that is controlled by the union?  My father is a minister, paid into the denomination's pension fund his whole adult life and now has a pretty good pension.  This fund reflects the fact of a minister's life:  they never stay at the same church forever and no one takes responsibility for a pension anyway so they went and set one up for themselves.
Second, world conditions make it essential for the US to go to a single payer system.  Employer based health care cannot compete on a global basis.
Third, and to me most important, all of the industrial countries will need to ensure adequate housing.  This is important because if we move into a class-based economy, dependent on education level and the opportunities one has from birth, we will shrink the consumer base year after year and eventually have a stagnant economy.  Housing plays an important role because without it we have greater movement inside the country as well as country-to-country which, if grown to a large enough percentage, will destabilize everyone involved.  If people have decent, affordable housing, it becomes an equation of what can I do to raise my own standard of living in my community?  People will be empowered to seek greater education, to be more creative, and to pursue business opportunities that benefit the whole community.  At least, that's my idealistic view of it.  
These are some of the opportunities that I see the left as having with this kind of realignment.  And, as I read somewhere recently, China has historically been a very big part of the global wealth.  We may be moving back to that norm.
by red moon dog on Wed Nov 23rd, 2005 at 03:30:41 PM EST
[ Parent ]
...that the two articles you cite are arguing opposite sides?

The FT is saying that inflation is not a threat and that rates should be kept low.  The Economist says that inflation should be negative and therefore rates should be raised.

FWIW, I'm with the FT.  Raising rates does lower inflation, but at the cost of higher unemployment.  It might return a share of the pie to the wage sector, but at the cost of making the pie smaller.

The ultimate problem is that China's workers are paid much less than their productivity would justify, because China's millions of workers have no bargaining power and no independent unions.  Even Mexican workers (paid $1.50 an hour) can't compete with them.

by tyronen on Tue Nov 22nd, 2005 at 05:15:29 PM EST
The FT article (which, to be clear, is an Op-Ed by an outside writer) does say that inflation is not a threat - and in that it agrees with the Economist; and it also agrees that the danger is an asset price bubble. What it says additionally that the reasons for increasing interest rates today are not those used by the Fed - they should be raised to fight asset bubbles, not to fight inflation. It does not call explicitly for an interest rate hike, but comes damn close to it... so I find the two articles to be coherent.

In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Tue Nov 22nd, 2005 at 05:24:33 PM EST
[ Parent ]
As always, very interesting post Jerome. I'll pick up the FT on my way home tonight.

Question for you, and anyone else who cares to respond. In the event of such an asset bubble bursting in the US, what are your thoughts on what will happen to the Euro? and the European economy in general?

The Economist has also written several articles on a housing bubble throughout the globe. Australia, Britain, in Paris, and definitely the US. Some of their recent articles have alluded to a recent decline in UK prices as the beginning of a worldwide trend of lowering house prices... don't know exactly where this fits in, but from that perspective the asset bubble is not only in the US and thus could have depression points in other countries should it burst or begin to deflate...


by aden on Tue Nov 22nd, 2005 at 06:32:57 PM EST
Picked up FT this evening. Scratch comment on recent decline in UK housing prices -FT reporting 3.3% increase in UK housing prices.
by aden on Tue Nov 22nd, 2005 at 09:16:35 PM EST
[ Parent ]
Another really outstanding story Jerome.  I may post a few questions, or comments.  First,
(...)  The entry of China's army of cheap labour into the global economy has increased the worldwide return on capital. That, in turn, should imply an increase in the equilibrium level of real interest rates. But, instead, central banks are holding real rates at historically low levels. The result is a misallocation of capital, most obviously displayed at present in the shape of excessive mortgage borrowing and housing investment. If this analysis is correct, central banks, not China, are to blame for the excesses, but China's emergence is the root cause of the problem.
I wonder to what extent the central bankers really control this now, and maybe you are questioning that as well.  Your case is very strong for strong deflationary forces (not bad deflation, but deflation) due to this wonderful influx of people into the world's labor pool--I say wonderful because I think it will be good for them and everyone.  If that's the case, long term interest rates, which are more set by the market, than the central banks, will be low.  And in fact we see that today.  The US Fed is driving up their short term rates (now 4%, but the 10 year treasures are at 4.428%.  Two more rate hikes of 1/4 each and you may have an inverted yield curve.  You may have noticed the US market popped upon news that the fed chairmen are talking about not raising short term rates--good for stocks, I think.  

And doesn't it also seem that the rising returns to capital are almost inevitable as well--labor needing relatively scarce capital to become more and more productive--also good for the equity markets, I think.

I share your concern regarding wages.  With these strong two headwinds, and competing labor overseas, that in Asia will become better and better educated, can we drive real wages up?  One positive thing in the states is that 50% of households now own stocks, so they can participate in this.  But there is the other 50%, who Bush wanted to give an option to invest in stocks through social security--but that is a two edged sword.

So I think I share your view of these trends, and also your concerns.  I'm going to read again tomorrow and may have more.  Thanks very much for this.

by wchurchill on Tue Nov 22nd, 2005 at 06:41:29 PM EST
Oboy, an inflation target is not even enough anymore. Now we need a deflation target?

I'll ask the question I always ask . . . interest rate hikes will slow economic growth, increase unemployment, put more downward pressure on wages. Why do workers always have to pay for the mistakes of the bankers?

by TGeraghty on Tue Nov 22nd, 2005 at 08:43:32 PM EST
Well, interest rate hikes avoid irrational exuberance and misallocation of capital. Better to do them a little bit early than too late. Better to do them a little late than a little early, possibly, but now we are waaayy too late.

Or do you consider the current debt binge fuelled "growth" sound?

The point about deflation is that lower consumer good prices at a time of stagnant wages is the only way to compensate workers for that situation. Otherwise they lose on everything, so it's not a totally silly point.

Now the other cosnequences of deflation (the possible vicious circle of waiting, lower growth, and further price drops) may make this idea a bad one, but the argument should not be dismissed without serious consideration.

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Nov 23rd, 2005 at 05:58:50 AM EST
[ Parent ]
I've never seen (or had time to read in detail about) widespread deflation so I don't know how the effects play out.

Do price drops imply wage drops as companies seek to remain competitive, particularly since energy costs may rise, whilst Chinese labour costs remain below ours?

by Metatone (metatone [a|t] gmail (dot) com) on Wed Nov 23rd, 2005 at 06:04:01 AM EST
[ Parent ]
My understanding is that the suggested course in the articles I quote was to let consumer prices go down, but not wages. I suppose that in the past "deflation" also included falling wages, thus its vicious circle effects.

Here's a paper on the Japanese deflation of the 90s, from the BIS. It's pretty technical, so I don't know if there are any useful insights there...


In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Wed Nov 23rd, 2005 at 06:40:28 AM EST
[ Parent ]
No, of course the bubble economy is not a sound path to economic growth.

I would just like to see central bankers have additional regulatory tools to prick these bubbles other than just raising interest rates.

For example:

One measure for promoting both stability and fairness is a small sales tax on all financial transactions-that is on the sale of all stocks, bonds, derivatives and foreign currencies. . . . The idea behind the financial transaction sales tax-whether it applies to foreign currency transactions or to stocks, bonds, or other instruments-is that it raises the costs of speculative trading and therefore discourages the types of excesses that occurred in the U.S. stock market in the 1990s, since the tax would have to be paid every time a trade takes place. The tax will not discourage investors who intend to hold onto their assets for a longer time period, since, unlike the speculators, they will be trading infrequently.

A second type of measure that would be important for promoting both stability and fairness in the financial system is what are called asset-based reserve requirements. These are regulations that require financial institutions to maintain a supply of cash as a reserve fund in proportion to the other, riskier assets they hold in their portfolios. Such requirements  can serve both to discourage financial market investors from holding an excessive amount of risky assets, and as a cash cushion for the investors to draw upon when market downturns occur. One example of an asset-based reserve requirement that is already in operation is the so-called margin requirements on stocks purchased with borrowed funds. As we have discussed, Alan Greenspan acknowledged in September 1996 that he could have prevented the speculative market bubble at that time by raising margin requirements. A simple proposal would therefore be for Greenspan or his successors to actually make use of this policy tool as the next incipient bubble begins to form.

by TGeraghty on Wed Nov 23rd, 2005 at 01:49:07 PM EST
[ Parent ]

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