By Charles Dumas – An undervalued country within a fixed-currency will tend to inflation, an overvalued country to deflation. Within the dollar fixed-currency zone, “Chimerica”, China is undervalued, America overvalued.
America controls the currency issuance, though the Chinese have been no slouches themselves: nominal GDP is up 33% in nine quarters from its pre-crash peak, but broad money is up 61%. America was drifting into deflation before QE2. The 12-month “core” CPI gain, only 0.6%, is the lowest in 50 years. It has declined at one percentage-point a year for two years. US QE2 was designed to avert deflation – and, combined with substantial fiscal stimulus, may succeed for a while. But the inflation it is alleged to threaten is happening in the undervalued portion of Chimerica, China. Liquidity flows downhill to the undervalued portion of the economy.
On top of its gross domestic overheating, China now has to cope with major escalation of food, energy and metal costs, measured in dollars. Its refusal to cut the yuan loose from the dollar seemed like a cost-free exercise in sucking demand out of the rest of the world. Now it is no longer. CPI inflation reached 30% in China in February, 1989, just before Tiananmen – and again in 1993, whereupon the yuan was pegged to the dollar to achieve stability. But now Chinese stability is destabilising the rest of the world, and the US “empire” has struck back – if unwittingly!
The other country pursuing a “beggar-my-neighbour” fixed-rate policy is Germany. Its undervaluation has yielded food and energy price inflation above America’s. Its export growth will fade as China grapples – too little, too late, but then for too long – with its inflation, and non-German Europe succumbs to fiscally induced stagnation or recession. Frau Schmidt will not be happy: as well as having to finance the bail-out of Club Med and Ireland, she will suffer unnecessary inflation as the price of Germany’s artificial cost competitiveness within the euro. So much for hoped-for German consumer growth.
Keynes despaired of getting a handle on persistent surplus, savings-glut countries and their likely spawn: global deflation. But America seems to have found a way of imposing the needed pain on them – “Print plenty of dollars”, inflate them, Mr Bernanke! But nobody can pretend this is more than a second-best solution. For a healthy world recovery from the crisis, the lead has to come from domestic demand in the surplus countries, notably China and Germany, since Japan has reached a near-terminal stage of economic impotence. Why is this needed? Because in America, Britain, Spain, and all the other deficit nations with two much debt, only with an economy able to increase its national savings rate at the same time as growing can reduction of unemployment be combined with lesser government deficit and private sector debt reduction. In the absence of domestic demand stimulus in the surplus countries the deficit countries can only grow while cutting their deficits if they devalue. But devalue is precisely what Club Med countries are not able to do, owing to euro membership, and the US is equally prevented by its chief exchange rate being set in Beijing – the yuan-dollar peg.
Now that the undervalued surplus economies of China and Germany are getting the inflation that is the natural price of too low an exchange rate, the likelihood of their raising their domestic demand is even less. Quite the contrary – refusing to appreciate their currencies (or in the German case jump out of the euro), the least painful cure for excessive inflation in a competitive economy, they feel obliged by the resultant inflation to cut back domestic demand to reduce inflationary overheating of the economy. In the German case, much restraint may not be needed. Frau Schmidt is well known to hate inflation, and will probably help snuff it out by cutting her own spending.
None of this may seem to matter too much in 2011. The US tax cuts put through as part of the two-year Bush tax cut extension should support strong consumer spending in early 2011. The 100% first-year depreciation allowed for 2011 only could yield a capital spending boom toward the end of this year. But much of that spending will be simply bunched forward from 2012, to take advantage of the 100% tax allowance. In early 2012 there will be a corresponding sharp fall in capital spending. And the 2011 tax also only lasts for one year, so taxes will in effect be going up too. On top of which the Republican majority in the House of Representatives may well be cutting federal spending by then. So 2011’s boom could be followed by 2012’s bust. And it’s a US election year, so expect plenty of finger-pointing.
There is no relief for China in this likely 2011 boom – it merely worsens its inflation problem. And by the end of the year, just when China has started serious slashing of its own excesses, the US relapse is likely to be getting under way. Stock markets are buoyant now, given good growth, strong margins and cash flow. But this looks like a year to ride it up – and then “sell in May and go away”!
Charles Dumas is Chairman of Lombard Street Research Ltd
This article first appeared in the Spring 2011 edition of the Channel Islands Stock Exchange Bulletin Board
