Economic & Market Commentary, December 2010

When the world financial crisis began, all economies acted, more or less, in unison to inject liquidity into the system, both to bolster the banks and to increase demand. Now we see divergent policies around the globe. Western Europe is imposing fiscal discipline. China and Australia have been increasing interest rates to stem inflation. The United States is alone in continuing additional expansionary monetary and fiscal policies. Brazil and other emerging economies have expressed concerns about ‘currency wars’ or devaluations for competitive advantage.

Why is the United States the sole economy with ongoing and aggressive expansionist programs in place? The answer may be simply, “Because it can.” Europe was forced to confront reality fairly early. Greece threatened default, and although its situation was supposedly stabilized, people there are expressing their displeasure by rioting and violent demonstrations. Ireland is undergoing a painful retrenchment. And, as concerns spread to Spain and Portugal, Moody’s is threatening to downgrade France’s debt. The Euro is under stress, and there is talk of possible bond defaults. The market has a way of imposing discipline.

The most intriguing divergence is with China. A year and a half ago, inflation was negative in both China and the United States. The Chinese and US currencies move together in close approximation. And large flows of capital and goods move between the two countries. One would think that inflation and monetary policy in one country would affect inflation and monetary policy in the other. With inflation now running 4.4% in China and 1.2% in the US, and monetary policy working in opposite directions, there must be some effect on financial markets.

Since the announcement of a new round of quantitative easing late last summer, the US stock market has improved nicely. However, given dollar weakness, a foreign view of the US stock market would be more muted. Although long-term bond yields have backed up and mortgage interest rates have moved off their historic lows, the Federal Reserve has been partially successful in lifting asset prices as part of its strategy to increase economic activity. Improving “animal spirits” (from the recent book by George Akerlof and Robert Schiller, who expanded upon the term coined by John Maynard Keynes) are reflected in retail sales. Time will tell, though, which economic policy will provide the better lasting effect.

The early Chinese reflation policy was perhaps too successful, and they are now backing away strenuously. On the one side, China holds $900 billion in US Treasuries and $2.0 trillion in total US fixed income securities. The US has to bring in $32.0 billion a month to cover the current account deficit. On the other side, the Federal Reserve is buying $75.0 billion in financial assets each month. And there is an unsustainable amount of government spending compared to revenues (the federal government is spending $1.60 for every $1.00 tax collected). It seems natural that measures taken in China would have some bearing on financial assets in the US.

At some point, there will be a market trigger that will impose discipline on US economic authorities and additional hardship on the people. In the meantime, do we follow the old adage, “Don’t fight the Fed” or do we entertain, “Don’t fight the Peoples Bank of China”?