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Home > Macroeconomic Issues Best Practice > The Globalization of Inflation

Macroeconomic Issues Best Practice

The Globalization of Inflation

by Diana Choyleva

Executive Summary

  • The past ten years saw the clash between China’s semi-command saver economy and the market economies of the West. Interaction between supply and demand for goods, services, factors of production, and assets has been polarized on a global scale. Inflation or deflation in the modern world has to be analyzed in the framework of the balance between global demand and supply.

  • The low-inflation decade that preceded the overheating of 2007 and early 2008 gave central bankers God-like status. But they fell seriously behind the curve by failing to grasp the profound global changes at play and their implications for economic, financial, and price developments. The central bankers’ mistakes could cost the world a dangerous lurch into deflation.

Introduction

The surge in global consumer price inflation in 2007 and most of 2008 caught many by surprise. The low-inflation decade that preceded this overheating had given central bankers God-like status. But improved monetary policy had at best a supporting role in the global Goldilocks story. The protagonist was the Eurasian savings glut. The setting was the process of globalization. Central bankers across the world fell seriously behind the curve by failing to grasp the profound global changes at play and their implications for economic, financial, and price developments. Their mistakes could cost the world a dangerous lurch into deflation.

The past ten years saw the global clash between China’s semi-command saver economy and the market economies of the West. China’s supersonic expansion turned it into the manufacturing hub of the world. But final demand for manufacturing goods came from the developed borrower countries. China provided the world with an endless supply of low-cost labor and mispriced, cheap capital. Developed countries provided most of the supply of real and financial assets. Interaction between supply and demand for goods, services, factors of production, and assets has been polarized on a global scale. Globalization did not alter the nature of inflation. But inflation in the context of the modern world has to be analyzed in the framework of the balance between global demand and supply.

The Impact of China’s Economic Expansion

China’s reawakening has transformed the global economy. For many centuries it was the world’s greatest. Chinese steel production in 1066, using blast furnaces, exceeded Britain’s in 1866. But China ignored the 18th and 19th century Industrial Revolution. It then failed to tackle its 20th century weakness, culminating in the 30-year economic catastrophe of Mao’s leadership. Since 1978, China has gone down the export-led, catch-up path pioneered by Japan and Korea, with a similar annual growth rate of almost 10%. Growth of GDP per capita at purchasing power parity averaged a huge 12%, meaning the standard of living doubled every six and a bit years. In 2007 China was the second largest manufacturer, after the United States. Much of China’s manufacturing is low value-added assembly, where China now dominates both global output and capacity.

While China was fast becoming the world’s manufacturing powerhouse, the emergence of the Chinese consumer remained a chimera. Final demand for manufacturing goods came from the developed, especially the borrower, economies. The reason is that China saves excessively out of its income, more than a half. This negates the possibility of a mass consumer market. Savings are high for structural reasons. These reasons include the lack of universal social security, pension provision, and poor health care; the one-child policy, which has destroyed family security; migration into cities, which has broken up families; and limited financial products to channel savings between the old and the young, or into the private corporate side of the economy.

Instead, China provided the world not only with what seemed like an endless supply of low-cost labor, but also with mispriced, cheap capital. China’s high savings cannot be invested profitably in the domestic economy. In a command economy they have no need to be. Profitability and return on capital are irrelevant. Instead, command economies are incredibly good at wasting savings through misallocating investment. China can waste its excess savings either domestically or abroad.

In the first half of this decade its excess savings went into a massive domestic investment boom. There was a huge buildup of excess capacity. The mainly state-owned banking system played an instrumental role in this. It has the bulk of the domestic savings, and the bulk of its lending goes to state firms and local governments. It is not done according to market principles and proper credit risk assessment. State banks are unwilling or unable to provide much finance to private firms or households. Access to cheap money gave state firms an unfair competitive advantage over private firms. But for private firms, China’s incorporation into the global economy, especially since its entry in the World Trade Organization (WTO) in 2001, was a boon, providing both the markets and a source of funds. Moreover, Beijing kept its exchange rate fixed to the dollar and the capital account closed.

Unsurprisingly, overinvestment and a pegged currency led to falling global manufacturing goods prices. Meanwhile, energy and commodity prices surged on the world market as China’s production was extremely energy-inefficient. But this was not reflected in the price of manufacturing goods because Beijing does not allow domestic energy prices to be set by the market. Ultimately, China could not escape the business cycle. By mid-2004 it had run into severe energy and transport shortages, which curbed its investment frenzy. Over the next two years domestic demand growth slowed significantly. China was still saving excessively, but now it had to find another channel to waste the savings—this time exporting them to the Americans. The yuan–dollar peg had also forced the Tigers and Japan, which had excess savings for their own reasons, to do the same.

China’s current account surplus surged. Beijing was investing its huge savings in low-risk, low-yield dollar assets, and so did most of the other Asians. Globally this led to a collapse in real yields. But while China was providing the world with the excess savings, developed countries provided most of the supply of real and financial assets. In simplistic terms, when the huge population of China was bolted onto the global economy, the demand for assets shot up. Naturally, the supply of assets shot up in response. The booms in real estate and in mergers and acquisitions in the borrower economies were an expression of that. They were also the source of yet another boom—that of a purely financial type of asset: the asset-backed security and its derivatives.

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Further reading

Books:

  • Congdon, T. Keynes, the Keynesians and Monetarism. Cheltenham, UK: Edward Elgar Publishing, 2007.
  • Dumas, C. China and America: A Time of Reckoning. London: Profile Books, 2008.
  • Dumas, C., and D. Choyleva. The Bill from the China Shop: How Asia’s Savings Glut Threatens the World Economy. London: Profile Books, 2006.
  • Pepper, G., and M. Oliver. The Liquidity Theory of Asset Prices. Chichester, UK: Wiley, 2006.

Report:

  • Beyer, A., and L. Reichlin (eds). “The role of money—Money and monetary policy in the twenty-first century.” Fourth ECB Central Banking Conference, November 2006. Frankfurt am Main, Germany: European Central Bank, 2008. Online at: www.ecb.int/press/pr/date/2008/html/pr080225.en.html

Articles:

  • Ball, L. M. “Has globalization changed inflation?” NBER working paper 12687, 2006. Online at: ideas.repec.org/p/nbr/nberwo/12687.html
  • Borio, C. E. V., and A. Filardo. “Globalization and inflation: New cross-country evidence on the global determinants of domestic inflation.” Bank for International Settlements working paper 227, 2007. Online at: ideas.repec.org/p/bis/biswps/227.html
  • Choyleva, D. “US liquidity crunch—The slow motion crisis.” Lombard Street Research Monthly Review 219 (August 2007).
  • Choyleva, D. “The globalisation of inflation.” Lombard Street Research Monthly Review 234 (October 2008).
  • Congdon, T. “Money and asset prices in boom and bust.” Institute of Economic Affairs, 2005. Online at: accessible.iea.org.uk/record.jsp?type=book&ID=291
  • Guilloux, S., and E. Kharroubi. “Some preliminary evidence on the globalization-inflation nexus.” Federal Reserve Bank of Dallas, Globalization and Monetary Policy Institute working paper 18, 2008. Online at: www.dallasfed.org/institute/wpapers/2008/0018.pdf
  • International Monetary Fund. “How has globalization changed inflation?” IMF World Economic Outlook, Chapter III, April 2006: 97–134. Online at: imf.org/external/pubs/ft/weo/2006/01/pdf/c3.pdf
  • Loungani, P., and A. Razin. “Globalization and disinflation: The efficiency channel.” CEPR discussion paper 4895, 2005. Online at: ideas.repec.org/p/cpr/ceprdp/4895.html
  • Pain, N., I. Koske, and M. Sollie. “Globalization and inflation in the OECD economies.” OECD Economics Department working paper 524, November 2006. Online at: ideas.repec.org/p/oec/ecoaaa/524-en.html
  • Rogoff, K. “Globalization and global disinflation.” Paper presented at Federal Reserve Bank of Kansas City conference on “Monetary policy and uncertainty: Adapting to a changing economy.” August 2003. Online at: www.kc.frb.org/publicat/sympos/2003/pdf/Rogoff.0910.2003.pdf
  • Wynne, M. A., and G. R. Solomon. “Obstacles to measuring global output gaps.” Federal Reserve Bank of Dallas Economic Letter 2:3 (March 2007). Online at: www.dallasfed.org/research/eclett/2007/el0703.html

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