Anyone who has been trying to determine the status and the direction of the global economy cannot help but be confused -- especially when it comes to the world’s two largest economies, China and America.
Some believe that the Chinese economy is where the American economy was back in the late 1940s, building institutions--like AIIB--that will help it lead the emerging global economy.
Others believe that the Chinese economy is where the American economy was in 2008, or worse, back in 1929 when American households were heavily indebted.
We all know what happened then.
That’s certainly very confusing, even for the true believers in the Chinese economic miracle.
As of the US economy, things look even more confusing. The Federal Reserve believes that the US economy is in a “new normal,” an ideal state whereby both inflation and unemployment are very close to goals.
That’s why Fed officials are reluctant to depart from their long-standing ultra-low interest rate policy.
Wall Street bulls that have been benefiting from the ultra-low interest rates share the Fed’s view. And so does the Obama Administration, which takes part of the credit for a strong economy, as evidenced by a selective host of macroeconomic indicators.
Mired in a land where interest rates have remained too low for too long, economic indicators do not have the meaning they used to have, because markets have in a sense succumbed to the central planning economy created by the Fed.
Simply put, in regimes such as these, macroeconomic indicators become elusive—they no longer reflect the collective actions of market participants, but rather the deliberate actions of policy makers in a self-re-inforcing process.
Excess capacity — a frequently cited indicator by the Fed as a justification for the several rounds of QE — is a case in point.
Excess capacity is the consequence of the Fed’s prolonged monetary easing. That’s what new evidence about industrial capacity utilization and nominal interest rates confirms.
Since 1970, US capacity utilization has followed a well-known cyclical pattern: it declines sharply in recessions and recovers as sharply in economic expansions.
Recent research by the Federal Reserve , however, indicates that the secular decline in nominal interest rates matches a long-term downward trend in capacity utilization in the industrial sector, from 82% in the early 1980s to less than 70% following the Great Recession.
And there is a good explanation for this pattern: On the supply side, ultra-low interest rates encourage overinvestment—adding to the economy’s capacity. On the demand side, ultra-low interest rates “steal” consumption from the future.
The rest is history--the more the Fed cut s rates, the larger the gap between capacity and demand.
The bottom line: Investors should be very skeptical of all sorts of stories that justify populist policies that introduce elements of central planning into the functioning of free markets. We all know how these policies end.
