Inflation has taken root again, in China as in much of the rest of the world. Blame pig disease, snow storms or OPEC if you will, but the underlying fact is that the US, China and others have been joint promoters of a fundamental folly. This can be summed up in the assumption that a rise in prices of assets such as shares and real estate is “good,” while rises in prices of consumables like rice, coal and cotton are “bad.”
For several years, they have been able to sustain the illusion that constant rises in asset prices were compatible with long-term low inflation, that inflation as a problem had been defeated and that if there was a global problem it was more likely to be deflation caused by a shift of manufacturing to low-cost countries such as China.
The answer to any hint of a setback was simple: Just print more money and lower real interest rates. That way, demand could be sustained and asset price rises would continue to underpin consumer as well as investor confidence. It worked for a while.
But now the very people who thought they had discovered this fast track to endless prosperity are faced with a 180-degree reversal. Slowing economies are not bringing lower inflation that would justify lower interest rates.
There is talk of the return of “stagflation,” the 1970s phenomenon where inflation continues even as economies stagnate. At the very least, it has already brought dramatic declines in asset prices just as goods prices, particularly those with a high commodity content, are soaring.
Central bankers like asset inflation because it gives people the illusion of greater wealth and suggests that an economy is strong. Goods price inflation is upsetting because it disturbs income distribution and invites negative public sentiment. But from a longer term view, any rise in asset prices without a corresponding rise in the rate of return on those assets damages the interests of savers and investors as surely as a rise in the price of pork hurts more consumers than it pleases pig farmers.
Almost every central bank has contributed to this money illusion to a greater or lesser extent, paying little attention to asset price inflation as a consequence of the rapid credit creation they have permitted.
The US of course is especially culpable. Its credit growth has been the source of a long-lasting consumer boom which has driven the US current account deficit to the US$700 billion-a-year level. This has, in turn, inflated the reserves of many other countries. Global forex reserves rose at double the rate of world nominal GDP growth in the five years to 2006 before hitting 27% in the 12 months to September 2007.
In China and India, money supply has been vastly outstripping the capacity of even these dynamic economies to grow. Hence, easy money has had a double impact on goods prices – driving up real demand and creating a liquidity pool that once went into stocks and property but is now taking refuge in commodities as a hedge against inflation.
Furthermore, the consumer price index in both countries is much more geared to food and raw materials than is the case in service-oriented developed nations. Thus, rising prices will have to be balanced out by salary hikes that greatly exceed productivity gains.
China in particular is not helping itself by keeping interest rates at near zero in real terms as it attempts to stem capital inflows. Beijing’s massive pile of US dollar assets has contributed to excessive domestic monetary growth, but now these holdings are declining in value just as inflated stock prices have turned sour on many private investors.
The situation will turn around eventually. Tighter credit in the West, driven by subprime and related debacles, will slow credit growth everywhere. The US consumer, faced with higher food prices and declining house prices, will consume less. Imports will fall, the US deficit will decline, global growth will slow and, in time, commodity prices will stabilize and wage pressure will ease.
But don’t expect this to happen in 2008. Inflation is entrenched and policies to try to avert recession in the West and much slower growth in the East will likely prolong the problems. Instead of a short, very sharp Asia crisis-style recession there will be slow, Japan-style adjustment, but with inflation rather than deflation.