Asia can expect
inflation to be more than a passing problem of energy and grain
prices. You do not have to be a monetarist to understand that while
the relationship between money growth and inflation is erratic and
imprecise, at the end of the day when the supply of money has
persistently been growing faster than potential output, prices will
However virtuous the
policies of Asian countries may appear to be – trade surpluses,
firm currencies, positive real interest rates, low or negative budget
deficits – they cannot escape the wider world phenomenon. That
phenomenon has its roots firmly in the United States. That is not
because of some innate US evil. It is the direct result of a
combination of US dollar dominance of the world financial system and
the willingness of the rest of the world to soak up US trade
deficits, believing that their own surpluses reflect some sort of
US profligacy and the
short-sightedness of others, notably in Asia, created the phenomenon
of massive expansion of international reserves. In the period
2000-2005 they doubled at a time when trade grew by 66 percent and
global GDP by just 40 percent. Since then they have accelerated even
faster, rising an enormous 27 percent in the 12 months ending
Some of the increase
can be attributed to the natural desire of countries to build higher
reserves after seeing the devastation of the Asian crisis – and
the Russian one the following year. Some may be attributable to the
emergence of the euro, whose share of reserves has been rising.
However most is a direct result of US deficits. The dollar share of
global reserves is still 65 percent, which though lower than in 2000
is still well above the 59 percent level in 1995. Indeed, the recent
fall in the dollar component is due not to a slower rate of expansion
of dollar supply but the decline of the dollar against the euro.
This dollar deluge has
had several consequences. One was to expand base money in the surplus
countries, pushing their own overall rates of monetary expansion
above desirable target levels. Central banks were unable to respond
with sufficiently strong measures to curtail growth, either because
they lacked the instruments, or because they would require rapid
currency appreciation that was contrary to their ingrained belief
that export-led growth was virtuous. (In China’s case both
Another impact of the
dollar surfeit was to spur foreign direct investment, particularly in
China, but also in other developing economies. This had the temporary
effect of capping output prices of many manufactures, taking
advantage of lower cost labor, but the longer-term impact was to
increase domestic demand in those countries as low-cost manufactures
became available and urban employment boomed. It is just that surge
in domestic demand that has helped create global shortages of raw
Yet a third impact has
been to enable some advanced countries, notably Australia and the UK,
to easily finance their own excess consumption, reflected in current
account deficits in the same league as the US itself.
But is the phenomenon
not coming to an end as a result of the credit crisis in the west, a
crisis whose roots were the need to find ever-more sophisticated ways
of selling US household debt to the rest of the world?
Surely energy prices
are not going to go on increasing. Surely wheat, rice and soybean
prices are now close to their peaks so that the main drivers of
inflation of the past two years will no longer be around?
That looks simplistic.
For sure the US is probably going into recession despite the best
efforts of the Federal Reserve and the politicians (all of them
except Michael Bloomberg) to delay the inevitable by making money
cheaper than ever and further increasing the government’s
deficit. Eventually the US current account deficit, now contracting
only very slowly, will shrink dramatically as consumers wake up to
their lack of savings and as the dollar’s decline against Asian
currencies in particular takes its toll.
But none of this is
going to happen overnight, which means that global money supply will
keep expanding much faster than output for quite awhile yet. Quite
where the excess will flow is debatable but given low or negative
real interest rates almost everywhere now, and the volatility of
stock markets, it is a fair guess that money will continue to pile
into commodities, or at least the non-industrial ones like grains,
vegetable oils and gold.
The real underlying
demand for crops, boosted by bio-fuels, rising incomes and
diminishing global rises in both land productivity and land under
cultivation, should ensure that prices remain stubbornly high.
Meanwhile now that the gilt is off the Chinese and Indian stock
markets and interest rates are negligible one can expect a rising
proportion of excess household savings to go into gold.
Many countries, among
them such key ones as India, China, Russia, Malaysia and Indonesia
are trying to prevent global price rises flowing through to domestic
prices. At best they can only delay the inevitable or distort their
economies in ways which encourage consumption, retard production and
generally prolong the period of tight supplies.
countries, food and fuel play a much bigger role in consumer prices
than they do in developed ones where services and mortgage costs are
more significant. That inevitably means that consumer prices will
have to be compensated by rising wages – at rates almost
certain to be in excess of productivity gains. What began as a
narrowly based increase in commodity prices eventually translates
into generalized price increases.
That would be very
similar to what happened to the world after the dramatic oil price
rises of the early 1970s. This time the energy component is far less
threatening than then, so there is no needed to expect the double
digit inflation of that era. But a global average 5 percent looks on
the cards, driven in the US by a weak currency and rising prices for
Asian imports due to both wages and raw materials, and in Asia by the
flow-through from commodities to wages and other costs such as rents.
Do not imagine that Asian workers, accustomed to regular rises in
real wages, will put up with reductions just to help exporters.
The only way out is
either much higher interest rates, which would kill off US
consumption. That is not going to happen partly because it is
politically unpalatable and partly because it suits the US, as debtor
nation, to see its real debt eroded by inflation. Or much more rapid
currency appreciation, which Asian governments will resist.
Maybe in time the US
will recognize its own follies, particularly that while devaluing its
debt may be desirable, discouragement of savings is not. In which
case a new Fed chairman might, like Paul Volcker in the early 80s, be
prepared to use draconian interest rates (bond yields in double
digits!) to squeeze inflation out of the system.
But even if we supposed
that the US is capable of kicking its easy money habits, any such
move is more than a year away – after the installation of a
successor to George W. Bush. By then the US net investment position
with the rest of the world is likely to have deteriorated by another
US$600 billion or so to some US$3 trillion, mostly accounted for by