America's all right Jack – too bad about Russia

When the US embarked on its QE experiment and zero interest rate policy, the rest of the world had little choice but to follow suit. As America prepares to turn off the money tap, emerging markets will be hit hard.

Reserve Bank of Australia Governor Glenn Stevens’ hand-wringing speech yesterday about the limitations of monetary policy ironically came just a week after his American counterpart, Janet Yellen, declared monetary policy’s victory.

The head of the US Federal Reserve warned that if the labour market stays as strong as it is, rates will rise sooner than anyone expects.

And in a speech two days later a member of her voting committee and St Louis Fed chief James Bullard confirmed it: “normalization … may need to begin sooner rather than later”, he said.

The bell has been rung for the final lap; American central bankers are preparing for their appearance on the podium, garlanded with flowers.

The Fed has printed the most money in the shortest period in world history, flooding global markets with $US4 trillion while turning capitalism on its head by overriding the market pricing of credit and keeping interest rates effectively at zero for closing on six years. As a result, as Glenn Stevens pointed out yesterday, Ben Bernanke prevented the Great Depression Mark II.

America is now adding 230,000 jobs a month and unemployment has fallen to 6.1 per cent. The US labour market is not without problems -- income growth is feeble and average unemployment duration still very high -- but aggregate hours worked per week is back to where it was before the 2008 crisis. In fact US firms are now reporting labour shortages.

And this has happened during a ferocious fiscal tightening that has seen the US budget deficit collapse from 12.3 per cent of GDP in 2009 to 2.8 per cent this year, the same as Australia’s.

Limitations of monetary policy? Well, it didn’t happen overnight, but it did happen, to quote a certain TV commercial. Now America’s great money tap is about to be turned off, and the great dollar squeeze is about to begin.

And that’s the real next problem the world must face, not the failure of animal spirits that Glenn Steven discussed yesterday.

America’s QE and ZIRP (quantitative easing and zero interest rate policy) forced the rest of the world to choose between asset bubbles and a job-crushing rise in the exchange rate.

Most, including Australia and especially emerging countries, chose the former, unsurprisingly, and are now facing the reverse choice – asset bust from a sudden yanking up of interest rates, or a run on the currency.

Emerging markets were hit with a thundering capital outflow during last year’s “taper tantrum”, when the Fed first foreshadowed the end of QE. The Fed’s language changed and the crisis ended, but worse may be yet to come.

The International Monetary Fund’s global financial stability report last October estimated that cumulative capital inflows into emerging market economies since 2008 have totaled $US470 billion, or more than 5 per cent of their total GDP.

This amounts to the “hot money” that has flowed into emerging economies directly as a result of the Fed’s policies. No one knows how much will flow out again once those policies end.

Russia especially is in a difficult spot, having unwisely stumbled into a fight with the West that will mean its capital outflow starts early and gets bigger than anyone else’s, at the same time as export income probably falls off a cliff because of sanctions. The 12 per cent fall in its sharemarket in three weeks could be just the beginning of Russia’s misery.

But China’s total external debt is now estimated at close to 250 per cent of GDP – more even than Japan’s – other countries like Brazil, Indonesia, Turkey, India and South Africa are all facing an increase in borrowing costs with high debt and vulnerable economies.

As for Australia, the good news is that Glenn Steven’s prediction of a rapid decline in the exchange rate will soon come true. US interest rates are about to start rising as inflation moves higher, and as a result the US dollar will begin a major cyclical recovery.

But there’s no reason to expect a disorderly Australian dollar run or a current account crisis. Interest rates will eventually rise here, but not as much as in those countries that have been bathing in hot money for five years and for which the bathplug is about to be pulled out.

And, remember, this all comes down to the fact Ben Bernanke succeeded. Not only did he prevent another Great Depression, but also by keeping the printing presses running and rates at zero, he has returned the US economy to health (although some of the credit for that must go to cheap energy from oil and gas fracking). His successor’s job will be to carefully turn off the tap that he left running.

But Bernanke succeeded for the country that paid his salary, while destabilising the rest of the world with dollars that couldn’t be easily absorbed.

America and Australia should be all right, Jack, and China and India could attract enough investment capital to offset the coming Great Repatriation of dollars back to America.

Not sure about Mr Putin’s Russia and a few others though.