The force is extraordinary. The gravitational pull is almost irresistible. Yet our understanding of the black hole which threatens to upset all our best-laid economic plans is remarkably poor.
The black hole stems from the power now being unleashed by the emerging world, by countries like China, India, Russia and Brazil. For a while, we rather patronisingly thought these countries would simply produce cheap goods for the benefit of the western consumer. Now, we're discovering that their power and influence reaches much further. Mervyn King, the Governor of the Bank of England, will be writing a lot of letters to the Chancellor of the Exchequer in the months ahead explaining why inflation in the UK is so high. Mr King's focus should be on the emerging world.
Relative to the US, none of the emerging economies is, on its own, particularly large. Each of them has only a modest individual gravitational pull. That, though, is a bit like saying Texas, South Dakota or Wyoming is too small to count. The US economy as a whole, however, has a huge influence on the rest of us. The same conclusions apply to the countries in the emerging world. They're all growing rapidly. Their inflation rates are rising furiously. And, collectively, they're about the same economic size as the US.
Unlike the US, however, their policymaking institutions are immature. Most of them tie their monetary policies to those of the Federal Reserve through the use of currency pegs or managed floats against the US dollar. When, therefore, the US cuts interest rates – as it has been doing over the last few months – it is loosening monetary conditions not just in the US but also in many parts of the emerging world as well.
Emerging markets, though, aren't suffering from a sub-prime crisis. They're not wilting in the face of a credit crunch. They haven't seen their housing markets topple over. As a result, looser US monetary policy, while rescuing beleaguered US households and banks, is also lifting emerging world inflation.
If you don't believe me, imagine this. Tomorrow morning, Ben Bernanke is woken by a phone call from George Bush who informs the Fed chairman that, overnight, a new monetary union has been created involving the US and all the emerging economies. The Federal Reserve will no longer look after monetary policy for the US alone, but instead set interest rates for the good of the new monetary union. The new "one size fits all" approach would surely force Mr Bernanke to raise interest rates from where they are today because inflation in this imaginary monetary union is currently averaging about 6 per cent (and rising).
The western response to this problem is to demand that emerging economies should sever their ties against the dollar and allow their currencies to appreciate. Their inflation rates would then come down through a combination of cheaper imports (as a result of the higher exchange rate) and higher domestic interest rates (now released from the shackles of the dollar peg). There is, though, a major problem with this approach. Japan followed this policy in the late 1980s, and Brazil has followed a similar strategy over the last few years. In both cases, though, inflation pressures were only temporarily suppressed rather than removed altogether.
The dollar peg regimes worked well when the emerging markets were small and played an insignificant role on the global economic stage. Now they're big and need their own, independent, monetary regimes. But what should those regimes look like? Inflation targets won't work well because so much of the inflation in the emerging world comes from food and energy prices, which are all over the place from one year to the next. Money supply targets never worked well in the developed world and, with only rudimentary and sometimes unstable financial systems, emerging economies are unlikely to fare much better.
In this policy vacuum, emerging market policymakers have adopted what amounts to a very simple strategy. It's called "hope and pray". They're mostly taking the view that, with the US softening, their exports will slow. Commodity prices, meanwhile, will drop. Both effects should reduce inflation.
But emerging economies are now so big, why should a slowdown in the US lead to falling commodity prices? Increasingly, countries like China are global price setters. They determine the global price of oil, of metals and of food. Hoping that, somehow, a US slowdown will lead to diminished global inflationary pressures no longer rings true. The gravitational pull now comes from the emerging economies. And, in the absence of a decent nominal framework to control price pressures, there's no guarantee that inflation will abate.
This is a bit of a throwback to the 1970s. At the beginning of that decade, the Bretton Woods exchange rate system collapsed. For years afterwards, countries struggled to find an alternative monetary system and, in the process, lurched from one economic upheaval to the next.
This partly reflected an absence of political will. As Nigel Lawson said in his Mais lecture in 1984, "the post-war trend towards ever more ad hoc interference with free markets within a context of increasing financial indiscipline ... was the road that led to stagnation, unemployment – and above all accelerating inflation. That ... was the experiment that failed. But many of those who embarked on it did so ... because they had reached the conclusion that political and electoral pressures in a democracy gave them no option."
In other words, it's not easy to jettison one system and replace it, overnight, with another. We take for granted our world of inflation targeting and stable economic prospects, forgetting the strife that got us to this point. The emerging economies, like the rest of us, will have to go through growing pains. Like unruly teenagers, they'll need to make their own mistakes. That takes time.
Will our own institutions be able to cope? Increasingly, it looks as though inflation in the UK is made in the emerging world. Rising food and energy prices owe a lot to the extraordinary strength – and overly loose monetary conditions – in China, India and the rest. To meet its inflation target, the Bank of England needs to ensure that food and energy price increases have to be matched by price decreases elsewhere. Easier said than done.
I'll make two points. First, it's probably wrong to assume that food and energy prices will come down anytime soon. Indeed, if the emerging economies adhere to their "hope and pray" strategies, there's a good chance that food and energy prices will continue to rise. Second, higher food and energy prices can be regarded also as higher food and energy costs. If these costs are rising, other costs will have to fall. In a UK context, that means lower wages and profits. To deliver this, monetary policy may have to remain tight even in the light of a housing market collapse.
This is not good news. Our inflation targeting regime implies that mistakes made in other parts of the world will have to be paid for domestically in the form of a major squeeze on spending power. Will the voters accept this view? Will they be prepared to make sacrifices to cope with the failures of other countries to achieve price stability?
That, after all, is what the Bank of England is asking of us. In a speech in Winchester in October 2006, the Governor said "we cannot insulate ourselves from the real economic consequences of the extraordinary changes taking place thousands of miles away from our own island ... but to say that we are exposed to changes in the rest of the world is a far cry from saying that monetary policy is impotent to control inflation.". Maybe, but can we insulate ourselves without political upheaval from the consequences of those monetary policy decisions?
Stephen King is managing director of economics at HSBCReuse content