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 rise.
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 moral superiority.
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 September 2007.
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 factors operate).
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 materials.
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.
For developing 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 Treasury debt.