Xie Says West’s Stimulus Stoking Emerging Market Inflation
Here’s Andy Xie spinning his inflation tale of woe. He thinks western stimulus is not creating demand or inflation in the west but stoking inflation in emerging markets, causing them to overheat. Take a look.
I have made a similar argument about emerging market asset bubbles in the 1990s.
For Greenspan, the Fed cannot stop bubbles; it can only ease the pain in the aftermath. Witness Greenspan’s comments in the Wall Street Journal from December 11, 2007.
As a result, the Fed has acted like a one-trick pony ever since. Greenspan pulled us from the jaws of recession in 1995 and again in 1998 by lowering interest rates and increasing the money supply. From the very beginning, the excess liquidity created by the U.S. Federal Reserve created an excess supply of money, which repeatedly found its way through hot money flows to a mis-allocation of investment capital and an asset bubble somewhere in the global economy. In my opinion, the global economy continued to grow above trend through to the new millennium because these hot money flows created bubbles only in less central parts of the global economy (Mexico in 1994-95, Thailand and southeast Asia in 1997, Russia and Brazil in 1998, and Argentina, Uruguay, and Brazil in 2001-03). But, this growth was unsustainable as the global imbalances mounted.
Emerging markets are certainly overheating – and that’s a world of difference to what’s happening in the States.
If emerging economies had floating exchange rates lower interest rates in the west would cause their currencies to become strong and they would have less inflation and smaller trade surpluses. The west would have higher inflation because of a higher cost for imported goods and smaller trade deficits.
The smaller trade deficits would mean more demand in the west and higher GDP and less unemployment.
If emerging markets have fixed exchange rates than lower interest rates in the west mean lower interest rates in emerging markets. This increases demand in emerging markets. This should increase the demand for western goods.
If emerging markets are at full employment at start with then the increase in demand will increase prices and make emerging markets less competitive and further reduce their trade deficits increasing demand in the west even more.
Therefore, in the long run from the west’s point of view the effect is the same. Lowering interest rates will decrease their trade deficits, increase aggregate demand, lower unemployment, and result in an increase in inflation.
The only difference for the west is that this will take longer if there are fixed exchange rates because it will take time for emerging economies to overheat and for the inflation to appear.
If you assume that emerging economies are already at full employment then they should allow their currencies to appreciate to avoid the unnecessary inflation. If the emerging economies are below full employment then the increased demand caused by the west is a good thing for them.
Xie is wrong to think this is bad except as he thinks emerging economies are incapable of acting in their own interest. Even in that case it is not clear it is the responsibility of western countries to suffer unnecessary employment because emerging country governments cannot act in their best interests.
@dk, your basic assumption at the outset seems to be that free-floating exchange rates would greatly diminish current account imbalances. I am not sure this is a good assumption looking at countries like Germany which has a free-floating exchange rate. For example, the Euro was at 1.60 to the US dollar at one point. Yet, the imbalances persisted.
My point: we should not expect exchange rates to cure the imbalances – much of it has to do with differences in domestic surpluses and deficits in savings over investment.
I think you are right, Ed. Consider Japan in the mid-1980s. The yen
appreciated from around 300 to the dollar to 100 (even higher in 1995) and the
current account surpluses exploded during that period.
And a government can’t simply wave a magic wand one day and decide it wants
to devalue its currency, if the currency is unpegged. Once the decision
is made to let the currency float, it’s subject to the vagaries of private
portfolio preference shifts, which are notoriously hard to gauge (certainly
impossible to “model”, as economists love to do).
In a message dated 8/21/2010 07:41:39 Mountain Daylight Time,
Edward Harrison wrote, in response to dk (unregistered):
@dk, your basic assumption at the outset seems to be that free-floating
exchange rates would greatly diminish current account imbalances. I am not
sure this is a good assumption looking at countries like Germany which has a
free-floating exchange rate. For example, the Euro was at 1.60 to the US
dollar at one point. Yet, the imbalances persisted.
My point: we should not expect exchange rates to cure the imbalances –
much of it has to do with differences in domestic surpluses and deficits in
savings over investment.
Link to comment: https://disq.us/kxp80
I think that with either fixed or floating exchange rates a reduction in interest rates by the central banks of western countries will reduce their current account deficits. With floating exchange rates it will happen faster.
At full employment current account balances are 100% determined by the difference between savings and investment. Exchange rates, prices, and wages adjust to bring the economy into equilibrium.
When the economy is at less than than full employment – like now – a reduction in interest rates by one country acts as if that country increased its savings rate. Money flows out of the country either pushing its exchange rate down and making its exports more competitive or by lowering interest rates in other countries increasing demand there which increases their demand for imports and pushes their prices higher. This does not cause inflation in the short run in the home country because there are large amounts of utilized resources.
Once the home country has full employment again then there would be inflation in the home country to bring about a balance between savings and investment.
I certainly do not thing exchange rates are the only factor determining current account balances. For example I think the marginal propensity to consume in the US has gone down in the last couple of years. At the same exchange rate, all else being equal, I would expect the US to have smaller trade imbalances than before.
Most of the time economies are reasonably close to full employment so looking at long term tends in exchange rates is not very useful.
In Xie’s video I think his analysis is basically the same as mine. The only real difference is that he is focused on the short term where there is less benefit to western countries and so he focuses on the cost to emerging markets. In his analysis emerging countries only have to deal with the cost of inflation because they are unwilling to alter their exchange rates.
Money doesn’t “flow” any longer. It’s electronically debited and credited to different accounts. No “money” actually “flows” out of the country. That’s a relic of the gold standard era. If I decide to send $5000 dollars to Mexico, my account is debited and same amount appears in someone’s peso account in Mexico at the click of a keyboard. It’s hard to tell what actually causes currencies to “float” on a day to day basis.
Obviously, after several months, the national accounts will reflect changes in portfolio preferences, but that’s what drives it. I don’t think your explanation is borne out by empirical evidence, with all due respect.
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