Global Economy on a Slow Summer Burn

Here It Comes

One can't see an easy way to avoid the slowdown. Interest rates are already too low. The ECB is raising interest rates to maintain its own credibility as an inflation fighter. The Fed for now is talking down the possibility of a new round of quantitative easing, or QE 3. Most governments are cutting budget deficits, and it seems there will be no more stimulus.

The slowdown's main impact has been to delay monetary tightening around the world. Central banks haven't faced such a combination of rising inflation and falling growth since the 1970s. Since policymakers including central banks remain biased toward growth, their tightening pace will be slowed. The new mainstream may be to stay behind the curve. That means more inflation.

While the Fed talks down QE 3 for now, it may change its mind, possibly within three months. A U.S. unemployment crisis is creating political pressure. The Fed has several options: It could maintain its balance sheet but shift into other assets from government bonds, perhaps by purchasing corporate bonds, mortgage-backed assets, or bank loans.

The Fed is trying to get consumption going in the United States, but there's no income to support it. Real wages are declining along with employment growth, while the household sector remains over-levered. The Fed may look for a rescue through the wealth effect. But since the property market obviously is not working, the stock market offers the Fed's only possibility, at least in the short term.

Juicing up the stock market may bring temporary relief but will not solve problems. The Fed doesn't have the Midas touch anymore.

And as long as we're talking about Greece and Greek metaphors, let's touch on President Barack Obama's Achille's heel as he vies for re-election in 2012. His prospects have recently changed for the worse as unemployment rises – hitting 9 percent in June. No sitting president in modern times has been re-elected at a time when unemployment is so high.

The U.S. workforce shrank by about 6 million between June 2008 and June 2011, even while its working-age population grew by 6 million. U.S. government labor statistics mask the extent of the problem because so many people have stopped looking for jobs. The actual U.S. unemployment rate is around 13 percent.

Why is unemployment rising? The Republicans blame government regulation and uncertainty over tax policy, while Democrats point to the George W. Bush legacy. Some economists blame insufficient stimulus, and everyone at least partially blames China.

President Obama made a big mistake when he listened to economists who advised big stimulus to get the economy and employment going again after the 2008 crisis. It would have been better to let the economy land where it would, and then recover on more solid ground in time for the 2012 election.

That's what Ronald Reagan experienced when he was president in the 1980s. Then-Fed Chairman Paul Volker raised interest rates aggressively to tame inflation and the economy crashed. But recovery came by the time Reagan was seeking re-election in 1984. He won. By then, the economy had cleaned out most of the dirt that accumulated during the high-interest rate period.

In hopes of winning the election, Obama may add to his previous mistake by piling more stimulus, providing a temporary fix but setting the stage for another crash later.

Another byproduct of Obama's mistaken policy is a new round of declines for property prices. Based on historical data, U.S. housing prices should have been cut in half after the 2008 crisis, but the government stimulus and the Fed's QE 2 gave property owners hope for recovery. So they hesitated, and the market recovered a bit last year, only to deflate hopes again. That led to the current wave of defaults, triggering another price decline.

In Japan, the world expected a speedy recovery after the earthquake and tsunami. Many trusted the Japanese government's ability to mobilize resources and coordinate reconstruction. Now, it seems my less sanguine predictions of a slow recovery are playing out. The disaster reconstruction minister, Ryu Matsumoto, recently resigned, reflecting the country's dysfunctional political system at the root of Japan's two decade-long decline.

Global trade suffered partly due to the disaster in Japan, where manufacturing has been slowed by an electricity shortage. Auto parts and electronic components are prominent examples of Japan's influence on the global economy, and overseas companies tied to Japanese production have themselves had to cut production.

Shortly after the earthquake, I predicted a weaker yen, noting that the Bank of Japan would have to provide post-disaster funding. My call came too early, though, because I failed to account for the country's incredibly slow administrative process. Funds will be needed when reconstruction begins, but that has barely started. Thus, for now, BoJ hasn't had to provide financing.

The need for funding will come later, and that's when the yen's value will decline. Thus, Japan's economy is likely to be weak through 2012, while the nation's financing problems will worsen.

Government finance is also at the root of China's inflation problems. Essentially, household savers are being taxed to fund government projects.

A lot of analysts and government officials in China are portraying inflation as a technical issue. They say price increases can be resolved through government-directed expansions on the supply side. But, again, they're playing a mind game – tricking people into accepting losses in the middle of a great summer slowdown.

Andy Xie is a board member of Rosetta Stone Advisors Limited