Doctor Bernanke's Poison Prescription

Excerpts from Andy Xie's latest article in China International Business:

I recommend reading the full article here:  Drinking Poison to Quench Thirst

Financial markets didn't wait for the smoke to clear from the Dubai debt crisis before jumping back into the happy days of shorting the dollar and piling into everything else. After the massive government bailouts in the last crisis, the markets don't have any doubt that there would be bailouts the next time. This no-downside psychology is making each market correction shorter and shallower.

The zero-interest rate environment and rapid monetary growth are scaring conservative savers into becoming budding speculators. By threatening to destroy the value of cash and by subsidizing speculation with low interest rates and bailouts, good guys really finish last.

The Dubai crisis wasn't even the most important event last month. The confirmation of Ben Bernanke and Obama's announcement of the surge-and-withdraw decision for the Afghan War were both more important. Both indicate that the most important decisions in the world are focused on sustaining existing trends despite catastrophic consequences in the long term.

Senators expressed huge frustration during Bernanke's confirmation hearing. They all sense the existing system is wrong. After all, the last crisis happened for a reason. Throwing around so much money to stabilize the financial system didn't cure anything.

If you listen to how Bernanke is justifying what he has done and is doing, it sounds just like Greenspan. It is about decisions made on marginal considerations, not on the soundness of the system. The most powerful consideration is put on how the decisions impact GDP and employment in the short term. There is a Chinese saying that one could quench ones thirst by drinking poison. Bernanke seems to be prescribing exactly this to the US economy. He talks about interest rates being kept low because the unemployment rate is high, but he doesn't talk about how low it should be. He is confusing people between levels and marginal changes.

Governments throwing around trillions of dollars restore stability temporarily, but this strategy is too expensive to last. Only massive structural changes can bring the global economy into self-sustaining balance and lay the foundation for another growth cycle. The problem is that structural reforms would bring pain first and gain later. Politicians, wherever they are and whatever parties they belong to, seem incapable of talking about accepting pain. The policy consensus to prop up the global economy with stimulus will continue until inflation takes off or governments are broke.

When the next crisis hits, the cost will materialize. The financial recovery that governments are touting is really a sham; it is just another robbery.

Asset inflation is making a significant contribution to global growth, mainly in emerging economies and in the housing, auto and commodity sectors. The perceived robust growth in emerging economies is mainly an asset inflation story, which is fed by the weak dollar-driven hot money. What's occurring is similar to what happened in 1995. Then the emerging economies had robust growth amidst asset inflation while the dollar was making a historical low.

Inflation will likely drive the next crisis. The normal lag between money creation and inflation is one year and a half – though it is probably longer now due to globalization.

The next crisis will essentially be a continuation of the last one. Out of political concerns governments and central banks have thrown trillions of dollars towards preventing necessary economic adjustments, believing that stimulus will bring back growth. The money is buying some time, but the costs are (1) that the governments won't have enough money to cushion the pain during the coming economic restructuring and (2) that inflation will increase misery in an economic downturn.

The whole world is drinking poison to quench its thirst. It may feel like relief now, but the sickness will strike in 2012.


Another outstanding article by Andy Xie.  The recovery is a sham.  Depending on how deep government pockets are, we could end up in an inflationary scenario through enormous money printing.  Alternatively, we could be in a deflationary collapse triggered by another credit crisis. 
How this will play out depends on the reaction of central bankers and policy makers.  From the actions to correct the structural problems that we have seen to date, optimism is in short supply.