Authors: Stephen D. King
Consider China.
As we have seen, in modern economic history China is the first economy to be both poor in per-capita terms but large in terms of its global influence.
China’s expansion has, to date, been very commodity-intensive.
China is now the second-biggest energy consumer in the world, behind the US but ahead of the European Union.
In 1980 it was an economic minnow, with its national income only 7 per cent of America’s in dollar terms and only 9 per cent using purchasing power parity.
Already, China’s expansion has had a huge impact on demand for basic materials.
In the early years of the new millennium, China absolutely dominated the consumption of metals, accounting for almost all the increase in global demand for tin and nickel and more than all the increase in global demand for lead and zinc.
For aluminium and copper, China accounted for around half of the increase in global consumption.
China was also responsible for 30 per cent of the increase in global demand for oil.
The story doesn’t end there.
China’s per-capita incomes may have risen rapidly in recent years but, at current levels, there’s a long way to go before the Chinese begin to enjoy living standards anywhere near those taken for granted in the developed world.
As China’s incomes rise, so its consumption of the world’s scarce resources will continue to increase.
As noted in Chapter 1, simple back-of-the-envelope calculations suggest that, at current growth rates, China would be attempting to consume the equivalent of all of the world’s current oil production by the middle of the twenty-first century.
As the IMF explained in the September 2006
World Economic Outlook
, ‘historical patterns suggest that consumption of metals typically grows together with income until about $15,000–$20,000 per capita (in purchasing power parity adjusted dollars) as countries go through a period of industrialization and infrastructure building … So far, China has generally tracked the patterns of Japan and Korea during their initial development phase.’
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Meanwhile, like other countries before it, China’s economic success is
prompting a shift to protein-based diets, which will have a major long-term effect on the demand for grain.
Perhaps China’s economic progress will moderate (or, as some pessimists would argue, come to a grinding halt).
Maybe someone will discover an alternative energy source which will, once again, liberate us from the Malthusian constraint.
In the absence of these outcomes, however, it seems likely that commodity prices will rise (indeed, higher energy prices may be necessary to encourage energy-saving innovations).
If they do, what happens to inflation?
The easy answer, one which you’ll hear from many central bankers, is ‘nothing’.
If inflation is merely a monetary phenomenon, there is no reason to believe that a rise in the price of one particular good or service will lead to an increase in the general price level.
In a fantasy world in which all prices are flexible, increases in some prices will be offset by declines in others, leaving overall inflation unchanged.
Returning to the real world, not all prices are fully flexible.
In particular, it’s typically easier for wages (which are, after all, the price of labour) to rise rather than fall, even allowing for greater ‘flexibility’ in recent years.
If, however, commodity prices are persistently rising, there is a problem.
To see why, we should think about inflation not so much from a price perspective but, instead, from the point of view of costs.
After all, the price of anything is, ultimately, a reflection of its production costs, whether they be labour costs, raw-materials costs or profits (which are the costs of capital).
If raw-materials prices start to rise rapidly, it follows that other costs will have to come down.
Try telling a population used to ever-rising living standards that, from now on, they can expect to experience wage and profit
squeezes – maybe even cuts in pay or in dividends – to make room for the demands coming from China, India and other fast-growing emerging economies.
It’s not very plausible.
If inflation targeting requires people to be made worse off ‘up front’, it’s going to find fewer and fewer supporters.
‘Making room’ for the economic demands of the Chinese and the populations of other emerging nations was never going to be easy, but inflation targeting highlights the immediate problems associated with the developed world’s loss of control over commodity prices.
Whether or not Western nations adhere to inflation targets in these circumstances may be a second-order question, given that rising commodity prices will make commodity-importing nations worse off, either through a squeeze on real spending power or through a return to 1970-style inflation accommodation.
Nevertheless, seen through the framework of inflation targeting, the issue is made particularly stark.
Commodity prices are increasingly affected by movements in demand in other, poorer, parts of the world, for better or worse.
In the first few years of the twenty-first century, emerging economies’ success contributed to rising commodity prices: in the last decade of the twentieth century, their failure contributed to collapsing commodity prices, primarily as the result of the Asian crisis beginning in 1997 and its broader ramifications for emerging economies more generally.
These waves of influence are hardly trivial.
In the late 1990s, both central bankers (notably Alan Greenspan, the then Chairman of the Federal Reserve) and economic commentators argued in favour of the so-called new economy, a view that undoubtedly contributed to large – and ultimately unsustainable – increases in equity prices, as observed in Chapter 4.
The new economy was being driven, apparently, by sweeping productivity gains that would lead to both elevated economic growth and ever higher stock prices.
In the late 1990s, there certainly was some evidence consistent with the ‘new economy’.
In the US, growth was unexpectedly strong and
inflation was unusually low.
But does this constitute proof?
Not necessarily.
First, although US economic growth was, indeed, exceptionally strong in the late 1990s, this strength came after a period of disappointing weakness in the first half of the 1990s.
If one takes the peak of the 1990s economic cycle and compares it with the previous peak, the US economy enjoyed growth through the 1990s as a whole of 3 per cent, no faster than the average through the 1980s economic cycle.
And, as the US entered the new millennium, the growth rate slowed down abruptly.
The US expanded at a rate of only 2.5 per cent per year.
Not a big difference from one year to the next, perhaps, but, over a number of years, the compound effect becomes very large.
A decade of growth at 3 per cent leaves income levels almost 5 per cent higher than a decade of growth at 2.5 per cent.
On a per-capita basis, the numbers are even less impressive: after twenty years of per-capita income growth averaging 2 per cent per annum, the economic cycle in the early years of the twenty-first century generated per-capita gains of only 1.4 per cent per year.
Second, while technology innovations can improve productivity growth and, hence, allow an economy to grow more quickly without bumping into an inflationary constraint, commodity-price declines create a very similar effect, at least for commodity-consuming nations.
It’s easy to be seduced by the idea that economic success comes from technological improvements or wise policy decisions.
As perceptions about the new economy began to pick up in the late 1990s, Alan Greenspan, who had famously warned of ‘irrational exuberance’ in 1996,
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seemed happy to jump on the new economy bandwagon later in the decade.
His case was helped by the improving split between growth and inflation.
But was he right?
When the Asian crisis struck in 1997, triggered by a collapse in the value of the Thai baht, many argued that the end of the economic
world was nigh.
The Asian tigers had, apparently, been the main engines of global growth for a number of years.
Their collapse, it seemed, would prompt a worldwide economic crisis.
For a short while, economists busily slashed their forecasts for growth in the US and other developed markets, reasoning that a drop in Asian demand would, inevitably, feed through into lower world trade growth and, hence, a global recession.
The economists were largely wrong.
World trade certainly did collapse, but the US economy boomed.
A couple of years later, the European economy followed suit.
How was it that, faced with a collapse in demand in Asia and other emerging markets, the Western developed markets could perform so well?
There are two reasons.
First, as explained in Chapter 4, capital that had been attracted to Asia in pursuit of high local returns went home.
This provided a spur to equity markets in the US and Europe.
Second, because Asia had become an important source of demand for commodities, its collapse led to much lower commodity prices.
This proved to be very good news for commodity-importing nations (the US and Europe) and very bad news for commodity-producing nations (Russia and Brazil).
The Asian crisis thereby triggered a massive redistribution of income away from commodity-producing nations towards commodity- importing nations.
For a short period the commodity-importing nations were made better off.
Rather than accepting their temporary good fortune, however, they thought they’d discovered the elixir of ever-rising riches.
No longer, it seemed, was there a constraint on growth because no longer did there seem to be a major problem with inflation.
In response, they were able to keep interest rates lower than might otherwise have been the case.
This was a major mistake.
Inflation was low, but that was more a matter of luck than good monetary judgement.
In a world of already robust asset-price gains, keeping interest rates low just encouraged investors to borrow even more
money, driving equity prices in particular up to ever-higher levels.
Inflation might have been well behaved, but its good behaviour said little about whether central bankers were getting their monetary policies right.
The downward shift in inflation rates was a sign of changing real economic phenomena, which led to the creation of new winners and losers in the global economy.
It didn’t necessarily need a monetary response.
While it seems reasonable for central banks to safeguard the value of the currency – which is effectively what price stability implies – it is becoming increasingly difficult to decide whether that goal is being achieved from one month to the next.
If there’s a late 1990s-type emerging-market collapse, inflation in the US and Europe is likely to come in lower than expected.
Does this require lower interest rates?
Probably not.
After all, a fall in commodity prices would leave prices of goods in the developed world lower in relation to both wages and profits.
Real spending power is, therefore, boosted.
Why add to this beneficial effect by offering to cut interest rates?
Similarly, persistently higher emerging-market demand might raise commodity prices.
Other things equal, prices of goods will rise in relation to wages and profits.
People in the developed world are genuinely worse off through, for example, higher petrol prices.
Does their misery need to be compounded by a tightening of the monetary screws?
In the first decade of the twenty-first century, ahead of the 2007/8 credit crunch, this was precisely the dilemma central banks were faced with.
Remarkably enough, faced with an identical shock, they responded in very different ways.
The US couldn’t fully come to terms with the idea that commodity price movements were no longer determined by developments in the world’s biggest economy.
Oil, metals and other commodity prices soared, even though the US economy moved along at only a very modest pace by its own high standards.
The Federal Reserve took the optimistic view that increases in commodity prices in any one year
would be followed by declines in subsequent years.
In other words, it ignored movements in commodity prices altogether, focusing purely on so-called core inflation, excluding food and energy.
By doing so, it left interest rates low enough to help stimulate a housing boom and the sub-prime crisis that followed.
The European Central Bank, at the opposite extreme, thought that commodity prices might persistently rise, reflecting high structural growth in the emerging economies and, perhaps, the emerging economies’ overly loose monetary policies.
Unlike the Federal Reserve, it chose to focus on headline inflation.
By doing so, it provided a more ‘hair-shirt’ approach to monetary policy.
It worried that ‘this year’s’ higher headline inflation might feed through to inflation expectations, making ‘next year’s’ core inflation more difficult to manage.
The Bank of England attempted to navigate a middle course, admitting that there had been a structural increase in commodity prices as a result of strong demand stemming from emerging markets, but arguing that this was a ‘one-off’ that would not add to inflationary pressures in the longer term.