Global Economy on a Slow Summer Burn

Financial markets lately have been predicting a peak for China's inflation rate. This is a psychological trick designed to embolden investors, in hopes more will focus on a (probably manufactured) trend that disregards real price levels and the big picture.

Actually, China is just beginning a major struggle with inflation. The government is raising interest rates but quite slowly – so slowly, in fact, that instability will mark the nation's inflation rate trend through 2012.

There's also a big risk that certain developments designed to cool overall inflation will give Chinese policymakers an excuse to switch to loose from the current tight monetary policy. These developments may include reduced import duties, highway toll rollbacks and declining oil prices. But any easing is sure to be followed by another inflation spike.

China's price struggle is just one of many signs of this summer's increasingly apparent global economic slowdown. The signs are obvious in the developed world. High unemployment and falling house prices are battering the United States, a sovereign debt crisis is spreading in the euro zone, and Japan is trying to recover from the earthquake-tsunami disaster.

It's clearer than ever that the economic "recovery" reported in the wake of the 2008 financial crisis was built on an unstable foundation. Governments used economic stimulus programs to hide from the headwinds tied to structural problems. This year's summer slowdown reflects the fact that stimulus benefits were short-lived, and structural problems remain unresolved.

Thus, the slowdown should be viewed as a lasting phenomenon rather than a temporary soft patch.

Dominant Gloom

There isn't much good news for the global economy right now. True, oil prices have fallen for the Europeans and Americans, with West Texas Intermediate crude recently trading at US$ 20 less per barrel than Brent crude. WTI barrels usually trade higher, but the United States and its allies recently released 60 million barrels from strategic reserves to hold down WTI, influencing the price spread. Weaker demand is also keeping prices in check in the West.

Stock markets around the world have recovered somewhat over the past month, as valuations have stabilized. But stocks are vulnerable. The precarious macroeconomic environment has not prevented the big bubble for Internet stocks. Actually, it's been amazing to watch confidence in the stock market grow relative to the environment. This confidence would be good news if not for the storm to come.

Government bonds are overvalued, although for now the environment still favors bonds. Loose monetary policy and low investment demand led to excess liquidity available for financial assets, and bonds benefit when stocks lose favor. But government bonds are so overvalued that they are bound for a sharp correction after investors wake up to inflation, which is poised to roar, maybe starting in the second half 2012.

It appears euro zone countries have managed to keep Greece afloat for the time being by providing cash assistance and getting bondholders, mainly West Europe banks, to accept a "voluntary" rollover. This deal merely kicks the can down the road. When the next wave of Greek bonds comes due, we'll see the drama repeated. Rolling over debt doesn't make the debt good, and even a rookie analyst can see that Greece can't pay its debt.

The economy in Greece is only 2 percent of the European Union's. Its national debt is 340 billion euros, less than 2 percent of total EU credit outstanding. So, in theory, a Greek bankruptcy would be no worse than that for a major corporation – painful but manageable. Besides, bankruptcy is inevitable unless someone else pays a national debt level equal to around 80,000 euros for each of Greece's 4.4 million citizens.

Why are European governments trying so hard to delay the Greek bankruptcy? Because the nation's finances are linked to the wider banking system, with two-thirds of the money owed to western banks and other foreign investors. Hence, France and Germany in particular are trying to delay it.

But the delay is just an accounting gimmick. Investors have obviously lost money, and it's sad to see European governments engage in this self-deception. Greek bonds are already pricing in bankruptcy by trading at massive discounts to par. If banks with bonds mark to market, they'd have to recapitalize immediately.

Three big rating agencies are challenging European practices by noting that the debt rollover is de facto bankruptcy. Their opinion matters because the European Central Bank can't hold bankrupt government bonds as collateral. U.S. banks pledged worthless subprime paper to the Federal Reserve to secure loans during the 2008 crisis, and now European banks are doing the same to the ECB.

Right after France and Germany orchestrated a temporary bailout for Greece, Moody's downgraded Portugal's credit rating to junk status. That kept alive the panic over Europe's sovereign debt, guaranteeing that worries will last all summer long.
 
Meanwhile, Europe's stall on debt is casting a long shadow over the global economy. Companies and investors worry what might happen when the inevitable takes place. This uncertainty is likely to deter investment and consumption, dragging down the global economy.

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