A s economies begin to expand again, policymakers are doubtless expressing a collective sigh of relief. They can now go off to the beach, with bucket, spade, sun tan lotion and dodgy economic model in hand, happy in the knowledge that their worst fears – a return to a 1930s-style Depression – have proved unfounded. When they return to their post-holiday desks and computer screens, they will perhaps find themselves having to deal with an unexpected threat. Inflation will be on the rise. Until now, inflation has been quiescent, helped by a decline in global commodity prices, particularly for oil. Yet, over the past months, oil prices have been heading up.
As the credit crunch took hold, oil prices collapsed. It seems a long time ago but, in the middle of 2008, oil prices had threatened to top $150 per barrel. They then dropped, three times bouncing below $40 per barrel. Now, they are $70 per barrel. Is this a sign that the global economy is returning to renewed health and vigour as earlier worries over depression and deflation begin to fade? Or are these renewed oil price rises a threat to lasting economic prosperity?
The answer depends mostly on where you live. In the US, Europe and the UK, signs of economic stabilisation are encouraging but, at present, the level of demand in these economies remains depressed. To understand why oil prices have risen so much, you have to look at other parts, most obviously Asia. China has given a shot in the arm to global economic activity via the stimulus package pushed through over the past few months. Its renewed strength has been a key reason behind the return to much higher oil prices.
Other Asian economies are also beginning to contribute. Indeed, Asia may be retuning to the buoyant economic conditions last seen in the early parts of this decade. To understand why, it's worth thinking about how policymakers in these countries tend to conduct monetary policy. As with many other emerging nations, countries in Asia tend to link their currencies, formally or otherwise, to the dollar. So when the Federal Reserve decides on interest rates suitable for the US economy, it is also, inadvertently, setting interest rates for many other countries. Of course, those countries could detach their currencies from the US dollar and plough their own monetary furrows, but there is a considerable reluctance to do so.
If you're an American Congressman, this reluctance stems from the blind pursuit of mercantilist trade policies by the Chinese and others. If you're Chinese, the tie to the dollar creates a useful external anchor for monetary policy given the lack of a properly developed domestic financial system. In these circumstances, a currency target is often preferred to a domestic inflation target.
The US sets interest rates for a big chunk of the world economy. If the US has a nasty credit crunch, but other countries do not, those other countries are likely to end up with interest rates which are too low. As a result, their economies expand, their credit systems go into overdrive and their financial markets boom, a point made forcibly by Fred Neumann, my colleague in Hong Kong, in a recent paper, Blowing Bubbles.
Rising oil and other raw materials prices are not good news for commodity-importing nations. So-called "headline" inflation – which includes the volatile bits and pieces such as food and energy – is likely to be moving up again later in the year, seemingly putting paid to earlier worries about deflation. Stronger Asian demand will boost US and European exports to that part of the world but, despite Asia's immense regional power, its economies have yet to replicate successfully the US consumer's role on the world stage: Asian countries are full of savers, not borrowers. My guess is that the impact of higher commodity prices will swamp the effect of stronger Asian demand for developed-world exports, creating a new set of questions about economic recovery in the developed world.
The picture I've painted is one in which the developed world will increasingly have to make room for the strength of demand from Asia and other parts of the emerging world. Rising oil prices are part do not threaten 1970s-style inflation, where prices and wages went up in leaps and bounds. Instead, they make people in the developed world worse off.
Janet Henry, another colleague at HSBC, has just written a paper, Delving Beneath the Surface, examining the likely dynamics of inflation in Europe in response to higher commodity prices. Her conclusions make for uncomfortable reading. In the UK, for example, inflation will be back above 2 per cent in months. Yet, with huge amounts of spare capacity, even allowing for a permanent drop in productive potential associated with the lasting effects of the credit crunch, the chances are that wage growth will be, at best, desultory. Real spending power will be under tremendous downward pressure.
In the good old days, we'd have borrowed our way out of these difficulties. If incomes were being squeezed, we could have relied upon credit markets to allow consumption and investment to continue rising. But the credit crunch has put paid to this. The only borrower left is the government, and few governments will be either willing or able to keep borrowing at the pace seen over the past year.
The credit crunch has created a pivot in the world economy. The debt-driven attempts at continued expansion in the developed world have unravelled uncomfortably quickly. Lower interest rates will provide part of the solution, but they are working more to stimulate demand in Asia than in the developed world. Asia is a lot bigger economically than it used to be, at a resource-dependent stage of its development and is helping driving energy prices back up again. Those increases, in turn, threaten to constrain the pace of economic recovery in the west by eating away at our real disposable incomes.
This is why a debate over fiscal consolidation is ultimately so important. Keynes wasn't wrong. The fiscal pump-priming we've seen over the past 12 months prevented a far worse economic meltdown. But, by increasing government debts, we have increased the tax burden on future generations. That's fine if we can look forward to strong and sustained growth. But, as the global economy pivots, that becomes less likely for the developed world. At some point, we will have to accept a string of years in which the key word will be "austerity".