Is the world stepping into a ‘crack-up boom’ minefield with QE2?

Posted on 07 November 2010 with 1 comment from readers

Stock markets are back to the level of two years ago despite the crisis being far from over in many major economies of the world. QE1 and Fed money pumped into the banks has inflated an equity bubble. The other main impact of money printing is runaway inflation in China and surging commodity prices, though let us not forget that China spent half its GDP on stimulus measures last year so is hardly blameless.

Welcome to the ‘crack-up boom’. For what do you expect to follow surging commodity prices? Look at what happened after oil hit $147 a barrel in July 2008. Higher commodity prices are bad for economies, not good, unless you happen to be an oil producer and even then life is only good until the party suddenly ends.

Food prices

Down on the streets if agricultural prices surge then in poorer countries people cannot eat. It is true in developed countries that people will also grumble at the supermarket till but they are less likely to go hungry.

But in places like China and India, which still have hundreds of millions living below the poverty line, this threatens social disruption. Workers will strike for higher pay and who can blame them? This is not the bloated BBC after a pension deal, this is about feeding families.

For economies like China that are puffed up into bubbles this risks bringing the boom down to earth with a thump. Profit margins have become wafer thin and balance sheets overstretched by a massive property boom. If this sounds like Dubai two years ago that is because it is the same phenomenon times a thousand to quote hedge fund manager Jim Chanos who is shorting China, and got shorting subprime right too.

‘Crack-up boom’

The risk in a ‘crack-up boom’ is of course a sudden stop, and reversal. The oil price in the second half of 2008 fell from $147 to $33 within six months.

No country has ever managed to inflate its way out of economic crisis by devaluing its currency. The danger is always that rival currency central banks do not stand idly by and let another country gain advantage, and so a competitive devaluation race emerges.

One thing financial markets hate more than anything is uncertainty. Right now the question is should you ride with the Fed and hang the consequences or wait on the sidelines until markets correct? Is the Fed going to get what it wants and create a ‘crack-up boom’ for the global economy, or will currency loosening be matched by tightening in other countries, effectively sterilizing QE2?

Policy split

Last week India and Australia raised interest rates to tighten policy, will others follow? Could such moves eventually force the Fed into reverse and push up US interest rates? That would surely be better for the global economy in the long-run.

For investors the question is whether the stock market is not ahead of itself, and if you consider this uncertainty then the answer is pretty obvious. And one of the lessons of 1929-33 that seems to have been forgotten is that no amount of Fed spending can counter a bear market when investors want to sell out. The Fed then also tried to direct market sentiment with vast interventions and failed completely.