Stephen King: We must be cruel to be kind to save the world from a longer-term headache
Monday 16 June 2008
There is, I think, an answer to the world economy's growing problem with inflation. It does, however, require acts of bravery on behalf of the developed world's policymakers and acts of maturity on behalf of policymakers in the emerging world. The solution is fraught with risks but at least it would be a coherent response to a crisis which has been associated with inaction and lame excuses.
The developed world needs to see a revaluation of its currencies against the emerging world. This would be a huge volte-face relative to the accepted wisdom of recent years, during which western policymakers have typically argued in favour of stronger emerging market currencies to rid the world of global trade imbalances. A developed-world revaluation, however, would focus attention on the source of the global inflationary problem: overly loose monetary conditions in the emerging world.
Global inflation is high not because of nasty supply shocks akin to the oil price hikes of the 1970s. Inflation is high because demand is high. High demand, in turn, reflects overly stimulative monetary conditions in the emerging world. To date, though, many emerging market policymakers have been in a state of denial. For them, higher inflation is simply an external shock. Like every other country, emerging economies have to cope with the reality of ever-higher food and energy prices.
There is, though, an obvious problem with this argument. If all countries regard higher commodity prices as an external shock how, precisely, should the shock be explained? Have Martians arrived to drive up demand for metals? Are Mr Spock's fellow Vulcans responsible rising oil prices?
Those fond of conspiracy theories might warm to these ideas but for the rest of us, using some of Mr Spock's logic, the explanation for high commodity prices must lie with humankind.
The case for emerging markets being the source of higher global inflation rests on four key observations. First, emerging market growth has been persistently stronger than expected over the last three or four years, suggesting a rapid erosion of spare capacity. Second, emerging markets collectively are big: their total output is about the same as America's.
Third, the rise in global inflation had its origins in the emerging world: inflation was picking up rapidly in many emerging market countries last year, well ahead of the inflation problems that are now afflicting the US, the UK and the eurozone. Fourth, emerging economies still tie their monetary policies to those of the Federal Reserve – primarily by linking their currencies to the dollar – even though the credit crunch, housing collapse and sub-prime crises are mostly only US (and UK) problems.
Strong emerging market growth, rising inflation and overly loose monetary conditions feed directly into commodity prices. Higher commodity prices, in turn, help explain the return of inflationary pressures in the developed world. There's little in the way of wage pressure in the US, the eurozone or the UK: the inflation we're experiencing is, ultimately, a reflection of higher food, energy and metals prices. The advantage, then, of a revaluation of developed world currencies is that it directly lowers the price of commodities in dollar, euro or sterling terms. It is, then, a form of insulation. Moreover, a collective revaluation reduces the chances of inflation being redistributed within the developed world.
Ben Bernanke doesn't want the dollar to weaken against the European currencies but, then again, neither Jean-Claude Trichet nor Mervyn King is in the mood to see the euro or sterling falling in value at the moment.
A collective revaluation also makes it clear precisely who is responsible for the rise in global inflation. Until now, emerging market policymakers have preferred to wait and see. They hope that US weakness will eventually generate falling commodity prices, forgetting their own growing influence on raw materials costs.
They pretend that food and energy price increases aren't really inflation even though their poor citizens spend a disproportionate amount of their incomes on these basic necessities. They think revaluation is always an option if needed. They hide their inflation either through the use of, for example, fuel subsidies or, instead, manipulation of the consumer price data. And, as Turkey showed last week, they change their inflation targets when the going gets tough.
A G7 revaluation would force emerging markets to confront their own inflationary problems. Their own currencies would be weaker as a result – an appropriate response to signs of escalating inflationary pressures. Softer currencies would, in turn, remove the revaluation option which, until now, has been seen as a "get out of jail free" way of dealing with domestic overheating (an emerging market revaluation, other things equal, simply transfers inflationary pressures to the developed world). Most importantly, a G7 revaluation would force emerging markets to confront the imbalance between their increased economic maturity and their monetary youth and inexperience.
So how should the G7 nations deliver a collective revaluation? The answer, I'm afraid, lies in the delivery of a short, sharp, collective interest rate shock. The Federal Reserve, European Central Bank and Bank of England should all raise interest rates in the same week. They should argue that the rate increases are a collective response to the threat of commodity price inflation. They should also emphasise that they have a collective interest in currency revaluation and have no desire to enter a game of competitive, inflation-busting revaluations against each other.
For the emerging markets, G7 action of this kind would surely focus the mind. For those who want to tighten policy but have been unable to do so because of their currency links to a weakening US dollar, higher US rates would make it easier to tighten their own monetary conditions a notch or two because the dollar would, presumably, be a bit stronger. For those Micawbers always hoping for something to turn up, G7 rate increases might impress upon them that inflation is a home-grown emerging market affair and not the result of some kind of Vulcan conspiracy. And for those totally unwilling to act, inflationary dangers might quickly turn into balance of payments and currency crises. Nobody like to see that. But in the absence of any controls on domestic overheating, it will happen eventually whatever the G7 does.
For the developed world, there are some obvious dangers. I'm not convinced we've escaped the traumas of the credit crunch. House prices are still falling. Job markets are softening. The last thing these economies need, then, is higher interest rates. However, the trade-off between growth and inflation is rapidly deteriorating and we know from the experience of the 1970s that, eventually, policymakers might be forced to raise interest rates even with rapidly rising unemployment.
A co-ordinated action, though, might minimise the need for further rate increases and, through forcing the emerging countries to take their own inflationary pressures more seriously, might ultimately provide a better guarantee of price stability over the long term. Short-term pain, then, for potentially substantial long-term gain.
Stephen King is managing director of economics at HSBC
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