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PUBLISHED : Sunday, 25 September, 2011, 12:00am
UPDATED : Sunday, 25 September, 2011, 12:00am


Stocks slump to a 2-year low on Fed pledge

SCMP headline, September 23

Tug at your memory a bit and you may remember something called the Phillips Curve.

It's a 1960s theory named after New Zealand economist William Phillips stating there is a trade-off between unemployment and inflation. If you push down one, you get more of the other and vice versa.

Phillips himself made the effort to build a plexiglass machine with coloured water pouring from one tilting tray to another to show just how a choice could be made between the two. Policymakers loved it - a perfect prediction machine, the future under control at last - and they rushed to adopt it.

Being politicians, they were of course short-term-minded and concentrated on stimulating employment. It takes time for inflation to assert itself but jobless workers vote immediately.

The theory worked at first, with unemployment kept down. But then a strange thing happened. As inflation began to rise, so did jobless rates. By the late 1970s the US and Britain in particular were in a distinct fix: record unemployment and record inflation with economic growth in a serious slump. They called it stagflation.

Fortunately, both countries benefited from a new set of policymakers who got things roughly right. They concentrated instead on wringing inflation out of the monetary system, which encouraged economic growth and then generated much-needed jobs.

But it seems we have returned to the 1960s. The 'pledge' by the US Federal Reserve Board, to which our headline refers, has been given the name 'Operation Twist'. It refers (obscurely) to a similar Fed caper in 1961 of selling short-term obligations and buying long-term debt to force down long-term interest rates and thus stimulate demand and employment growth.

Fed chairman Ben Bernanke, also known as 'Helicopter Ben' for suggesting that you can always get an economy moving again by scattering money from a helicopter, has long argued that the proper antidote for deflation and recession is monetary stimulus. He conveniently ignores that on this occasion he has neither deflation nor recession.

But what of it? Election year is coming up and policymakers who refuse to sacrifice the health of the US economy to this beauty contest had best consider their personal future. America could ignore lessons learned in the school of hard knocks and go back 50 years into its past to try the Phillips Curve again.

World markets have understandably taken fright, knowing how successful this remedy is likely to be over any reasonable investment time frame. On this issue, you can safely side with the markets over anything politicians say - and Bernanke has made himself little more than a politician.

So here is what I see as the likely scenario: inflation in the US will continue to rise, as will unemployment, and the American economy will be in recession again within a year or so.

As growth is also likely to slow in Europe for reasons that are only superficially different, we are likely to see a slowdown in China's exports to its major markets and a consequent slowdown in China's economic growth, the severity of which will be determined by just how much bad news the banking system is really hiding on its books. It could be a good deal.

We in Hong Kong are generally well positioned for a bad spell, with both financial and fiscal systems solidly grounded. But we have the same weakness - an overheated property market - that we had in 1998. And any slowdown across the border will obviously hit us hard. We cannot hope to escape painlessly.

Over the last 20 years, there has been a close correlation between economic growth and stock market performance in Hong Kong. We are most likely headed down in terms of economic growth and share prices.

But these share prices have already seen the bad news coming and reacted downwards long before the economic figures showed a slump. Good, responsive financial markets have a way of doing this, which suggests that we are not looking over the brink of a precipice in the market.

And that's always been our market's way. Take your hit when it's coming to you because it will only get worse if you put it off. It won't go away. And those who won't learn from the past are condemned to repeat it.