Stephen King: Emerging economies are repeating our old mistakes
Monday 25 February 2008
So you think we've got an inflation problem? You may be right, but the West's inflation difficulties are nothing compared with the problems now facing many of the so-called "emerging" economies. China now has an inflation rate of 7.1 per cent. Saudi Arabia's inflation rate is 9.0 per cent. Russia's stands at 11.9 per cent. Argentina's inflation rate is, officially, a more modest 8.2 per cent, although many people, including those who work at the IMF, think the true inflation rate is a lot higher.
Apart from Argentina's rather dubious claims, these numbers are all a lot more elevated than they used to be. China's experience is grabbing the most headlines. In 2006, inflation was only 1.5 per cent, a rate low enough to put a smile on the face of even the most conservative of central bankers. Saudi Arabia's inflation rate was a touch higher, at 2.3 per cent, but hardly at a level to cause panic within the central banking community. What, then, has gone wrong? Why are the emerging economies' inflation rates now so high? And what do they mean for the rest of us?
Broadly, there are two competing explanations for the rise in emerging market inflation. The first is what I'd call the "bad luck" explanation. Those living in emerging markets have, on average, lower per capita incomes than those who live in the developed world. Proportionately, more of their income is spent on basic items such as fuel and food. The prices of these "basics" tend to move around in volatile fashion in response to bad harvests, occasional wars or the onset of disease. As a result, inflation rates within emerging economies move up and down a lot more than their equivalents in the developed world. High inflation in one year could easily be followed by low inflation the next year.
The second explanation is monetary in nature. Inflation is rising because monetary conditions are simply too loose. And because people in emerging markets spend most of their income on the basics, it's no great surprise that the prices of fuel, food and other essentials go up. This is not a case of bad luck. It is, instead, the outcome (perhaps unintended) of a series of earlier monetary policy decisions.
For those of a certain age, this debate will seem rather familiar. It's a throwback to the 1970s when, in addition to flares and Donna Summer, inflation in the western world was all the rage. Back then, neither economists nor anyone else could convince themselves that inflation was a monetary phenomenon. Many thought "bad luck" was the culprit. Inflation had nothing to do with money. Instead, it was going up because of high oil prices (thanks to the Yom Kippur War), wage pressures (thanks to greedy unions) and big price increases (thanks to myopic businessmen). Monetary policy was, apparently, of no great relevance (for those interested in this sort of thing, it's worth having a read of The Great Inflation of the Seventies: What Really Happened? by Edward Nelson, published by the St Louis Fed and available at http://research.stlouisfed.org/wp/2004/2004-001.pdf).
This approach led to all sorts of, by now, well-documented problems. Monetary policy was aimed not at the control of inflation but, instead, at the achievement of maximum growth. To keep inflation in check, governments were forced to use incomes policies, price controls, voluntary wage restraints and other market-distorting techniques. This, though, was a bit of a disaster. The controls wouldn't stick. Those with industrial muscle managed to push through wage and price increases. Meanwhile, market mechanisms broke down. The invisible hand went missing and economic growth fell flat on its face.
Now back to the present day. I'm sure that, for some emerging economies, there has been a bit of bad luck. But given that inflationary pressures are building in the vast majority of emerging economies at the same time, it seems more likely that monetary conditions are playing a significant role.
Many emerging market policymakers have deliberately controlled the value of their exchange rates in recent years, particularly vis-à-vis the US dollar. Partly, they've done so for good, old-fashioned, mercantilist reasons, based on the traditional Asian model of export-led growth. They've also, though, shadowed the dollar in an attempt to piggy-back off the Federal Reserve's anti-inflation credibility (in much the same way that the UK chose to link sterling to the Deutsche Mark, either informally or through the European Exchange Rate Mechanism, in the late 1980s and early 1990s). Seen this way, a dollar target is a useful device to prevent domestic monetary conditions from getting out of control.
The problem with this approach, however, is its failure ultimately to deal with underlying economic realities. Fast-developing economies cannot help but experience upward pressure on their exchange rates. As they become more productive, so their buying power over foreign goods improves. In other words, their terms of trade get better. A rising exchange rate secures this outcome by making foreign imports cheaper.
What, though, if the authorities prevent the nominal exchange rate from rising? In these circumstances, the only other option, ultimately, is a rise in the so-called real exchange rate via a higher domestic inflation rate relative to inflation rates in other countries. Suppose, for example, that Chinese domestic prices and wages are rising 10 per cent per year whereas British prices and wages are rising at around 4 per cent per year. Under these circumstances, the Chinese worker's buying power over the rest of the world's output will be improving over time relative to the British worker's (through Chinese eyes, British goods will appear cheaper and cheaper).
This outcome, though, presents two difficulties. The first one is a problem for the emerging world. By preventing their exchange rates from rising, emerging economies will inevitably experience rising inflation. However, rising inflation can easily lead to an unfair redistribution of income. Some will end up a lot better off. Others will be a lot worse off. The social tensions associated with this process can easily lead to political turmoil. Inevitably, politicians try to keep the lid on this pressure cooker by imposing price and wage controls, but then, of course, they're heading straight back to the 1970s.
The second difficulty is for the rest of us. For a while, the emerging economies' buying power was suppressed. Policymakers managed simultaneously to control their exchange rates and their inflation rates. They no longer seem able to do so. With inflation rising – and, hence, emerging wages rising relative to wages in the developed world – the emerging economies' buying power is on the rise. That means the rest of us have to pay more for our energy, our food and countless other items. These higher prices all add to price pressures and help to explain why, even in the midst of a nasty credit crunch, inflation has yet to subside.
This, in turn, means we're facing a much more difficult economic landscape. Even if growth slows a bit, there's no guarantee that inflation will come down particularly quickly. Indeed, higher inflation is part of the process of economic retrenchment. If we end up paying more for raw materials, yet are unable to achieve compensating pay increases, our spending power will dwindle. Inflation made "over there" is increasingly having an impact on economic wellbeing "over here".
Stephen King is managing director of economics at HSBC; firstname.lastname@example.org
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