Prevent The Worst Of All Worlds
Dominique Strauss-Kahn , on how rich and poor nations must work together to make sure commodities inflation doesn't snowball.
It is obvious why we should care about the rise in the price of some goods. Ask an ocean fisherman or a long-haul trucker about the rapid rise in oil prices. Ask a mother in Africa about soaring food costs that mean she can only afford one bowl of rice a day for her children. Recent increases in oil and food prices have hit many people hard, and the poorest people hardest.
But often when we read about inflation—a general increase in prices and wages—it seems like a more abstract problem and a less serious one. Some might say that a general increase in both prices and wages would help the poor by redistributing the pain of prices in food and fuel. Others say its more important to continue supporting growth, rather than fighting inflation. It's growth that will keep jobs safe and allow families in the developing world to escape from poverty.
In fact, allowing the current price increases in fuel and food products to be translated into a broader increase in inflation would be the worst of all worlds. It wouldn't help the trucker or the African mother. Oil and food prices have increased relative to other goods because demand for them has increased and supply hasn't. Solving that problem requires more food production, new sources of energy and greater energy efficiency. Inflation delays that adjustment: while high food and energy prices send a clear signal to producers to produce more, the signal is muffled by more general price increases.
It would also stunt growth. The foundation of growth is trust between savers and investors. Savers must be confident that their gains won't be wiped out by inflation. Otherwise they will demand a higher return, and investment and growth will fall.
Finally, it would hurt the poor. It's wage earners who lose most when the value of money falls. Millionaires are usually well protected against inflation.
We have seen this movie before, in the 1970s, when developed countries allowed oil-price increases to turn into general inflation. And we've seen the sequel too: the early 1980s, when it took years of high interest rates and recession to get rid of inflation. We need to learn from this history.
There are actions we can take to ease the pain of those hit hardest by food and fuel price rises. Well-targeted income support can ease the burden of relative price changes on the poorest citizens. Support from donors and multilateral institutions, including the IMF, which I head, can ease the burden on the poorest countries.
In time, high prices will stimulate development of new sources of supply to feed the world and power the global economy. The challenge for governments and multilateral institutions is to help people get through the current period of dislocation without resorting to policies that would produce inflation, and therefore undermine global stability and growth.
—Strauss-Kahnis managing director of the International Monetary Fund.
How The Doha Collapse Hurts
Pascal Lamy , fresh from the failed world trade negotiations, explains why less free trade will only exacerbate price increases.
Fighting the scourge of global inflation is primarily the responsibility of central bankers and finance ministers wielding monetary and fiscal tools to keep price rises in check. But trade can help too.
Trade can transmit price changes across borders, and while it is true that this can spread higher prices across countries, there is also evidence to suggest that opening trade can reduce price levels through greater competition among producers. Lowering tariffs has the potential to bring prices down, which is why in the current food crisis, more than 20 countries have unilaterally cut their import duties. Policies that distort trade, including tariff peaks and agriculture subsidies, can have consequences for price stability as well. Though subsidies may push down prices in the short term, in the longer term they drive producers from the market—especially in developing countries—while discouraging necessary investment and innovation in the agricultural sector.
In sectors where very little trade takes place price inflation can be acute. Take rice. Rice prices have risen by roughly 70 percent in the past year, yet the underlying supply-and-demand equilibrium has not been disrupted to any great degree. Rice is one of the most thinly traded commodities, with only about 7 percent of production being sold internationally in recent years. Such a thinly traded market means factors other than changes to supply and demand—such as speculation or hoarding—can lead to disproportionate volatility.
Policymakers had a chance last month to make a significant contribution by establishing a more equitable and modern global trading system, with its important benefits in fighting inflation. Unfortunately, the trade ministers meeting in Geneva failed to agree on the Doha package of reforms that would have sharply reduced barriers to trade in agriculture and industrial goods. At a time when inflation threatens our future prosperity, they let this opportunity slip through their fingers.
—Lamyis director-general of the World Trade Organization.
A Conundrum Made In China
Stephen Roach advises emerging market policy makers to learn from the mistakes of the past and fight stagflation before its too late.
It had to end sometime. the disinflation of the past 25 years—a progressive reduction in the global inflation rate—is over.
Today's oil shocks, together with surging prices of industrial materials and agricultural commodities, are strikingly reminiscent of those that sparked the Great Inflation of the 1970s. Meanwhile, growth in the major economies of the industrial world is most assuredly stagnating. The U.S. has been on the brink of recession for six months, and the growth outlook is deteriorating in Japan and, more recently, Europe.
But there is a critical difference between today's stagflation risks and those of the 1970s, which started in rich industrial countries. Policy mistakes and an insidious wage-price spiral led most people to expect that inflation would keep rising, which then became a self-fulfilling prophecy. Now, it's no longer common in developed economies to index wages to inflation, and wages are restrained by structural (global competition) and cyclical (recessionary) forces.
The new stagflation risk arises from the developing economies, which are making policy mistakes eerily reminiscent of those made by developed economies some 35 years ago.
First, there is a dangerous fixation on "core inflation." The idea here is that food and energy prices are exogenous (driven by external factors), and mean-reverting (tend to fall back to the long-term trend), and therefore of little consequence for monetary policy. The world's major central banks mistakenly targeted core inflation in the 1970s with disastrous results. And yet this blunder could be compounded in the current climate—because surging agricultural and energy prices are endogenous (driven by internal factors) to rapidly growing, commodity-and-food-intensive developing economies.
Second, policy interest rates in developing Asia—the world's most rapidly growing export sector—are currently being set at about one percentage point below the headline inflation rate. History tells us that such negative real, or inflation-adjusted, short-term interest rates only fuel an outbreak of inflation. The hope in developing nations is precisely what it was in the developed world in the 1970s—that mean reversion in food and energy will bring inflation back toward the "core" and take real short-term interest rates back into positive territory. Yet this is the sixth year in a row when food and energy prices have failed to revert to the mean.
Third, the developing world has a voracious appetite for hypergrowth as the principal means to alleviate poverty and raise per capita incomes. On one level, that bias is understandable: According to the World Bank, the number of poor people in Asia declined by more than 300 million over the 1990 to 2004 timeframe. Such impressive progress tempts policymakers to ignore the negative repercussions of hypergrowth—namely, inflation, pollution, environmental degradation, mounting income inequalities and periodic asset bubbles. Growth is viewed as the rising tide that obscures even the most jagged macro rocks.
All this tempers any enthusiasm for the adoption of anti-inflation policies by major developing economies. And yet, of course, in the end, inflation is the cruelest tax of all—especially for those at the lower end of the income distribution. This is a growing risk in the developing world and an increasingly tough problem for import-dependent economies in the developed world.
—Roachis chairman of Morgan Stanley Asia.
Keep Your Seatbelt Fastened
Mohamed El-Erian offers advice on how the world's economic leaders should navigate an especially challenging policy environment.
The global economy, still reeling from the U.S. financial crisis, has entered an even riskier phase on account of inflationary pressures. Inflation is particularly painful when it is driven, as it is now, by price increases on essential products like food and fuel. Governments and companies have to react even if they end up using blunt instruments that initially make the situation worse.
Today's situation is particularly complex, as a good part of the recent price rises were driven by these perverse second-round effects. This is evident on both the supply and the demand side where the immediate reactions of many market players to the food and oil price rises aggravated global supply-and-demand imbalances.
For example, rather than increase output in response to higher prices, some food producers imposed export bans in an attempt to safeguard supplies for their domestic populations. In the process, they cut supply to a fragile world market in which prices were already rising. In the energy market, some companies (including airlines) rushed to secure supplies by purchasing future contracts that, ironically, they deemed too expensive to buy at lower prices. That too fosters price increases.
This perverse dynamic is starting to reverse itself. Additional supply is beginning to hit the food and energy markets as other producers seek to capitalize on the significant price jumps. Also, part of the demand for these products is being destroyed as a growing number of consumers get priced out of markets.
But this reversal is not happening fast enough, especially when it comes to sheltering the segments hardest hit by inflation, such as the poor. This raises the pressure on policymakers to do something, if only to show that they care.
Certainly prompt policy action is needed, to moderate expectations of future price increases and prevent a protracted bout of inflation that is harmful to the well being of societies. And policymakers have reacted, placing heavy if not exclusive emphasis on monetary actions.
In emerging economies, central bankers have been raising interest rates and tightening credit growth, combating inflation by sacrificing some of today's growth. In industrial countries, central banks have increased their anti-inflationary rhetoric, causing markets to raise interest rates.
In normal times, the emphasis on monetary policy would be necessary and warranted. But conditions are far from normal in today's global economy. Pending progress in healing an injured financial system, especially in the U.S., such reactions are simply too blunt. Indeed, with the "transmission mechanism" largely inoperative, national authorities may legitimately pursue some well-intentioned policy objectives yet end up creating significant problems elsewhere. So, what should we expect in the coming weeks and months? I am afraid that the answer is more collateral damage to the global economy. This will occur through two distinct, but reinforcing channels.
First, tighter financial conditions, especially higher mortgage rates, will further undermine a U.S. housing market that is already collapsing under the weight of overvaluation, excessive inventories and growing foreclosures. The recent decision by the U.S. Congress to extend emergency assistance to mortgage holders and behemoth lenders (such as Freddie Mac and Fannie Mae) will only act as a short-term Band-Aid. In particular, it will prove inadequate to offset the headwinds facing American consumers who, for a number of years, constituted the "main" engine driving the global economy but are now struggling to overcome the combined impact of higher unemployment, declining living standards, and lower credit availability.
Second, growth in emerging economies will also decline as policymakers there realign their domestic priorities. For the global economy, this means slowing the "other" engines that, particularly in the past year, have accounted for a growing share of the increase in world GDP, thereby effectively compensating for the more sluggish U.S. economy.
Where does this leave us? The bottom line is that policymakers have no choice but to react to the food and energy price spikes. But in relaying overwhelmingly on tighter monetary policy, and in failing to aggressively pursue enhanced production and distribution channels for food and energy, they risk weakening global demand too much, thereby being potentially forced into a sudden reversal. The rest of us should keep our seat belts fastened as the global economy continues to navigate an even bumpier phase, as weakening growth impulses aggravate the impact of the credit crunch.
—El-Erianis co-CEO and co-CIO of PIMCO, and author of"When Markets Collide: Investment Strategies for a World of Global Economic Change"(McGraw Hill).
Unleash The World
Chris Anderson believes that the price-cutting power of technology can still bring nations relief if only bureacrats will allow it to.
Technology can be a powerful deflationary force. Thanks to Moore's Law (the remarkable ability of computer technology to double in power for the same price, or halve in price for the same power, every 18 months) if you want a 50 percent discount on an electronic gadget, just wait 18 months. Or turn a service into software, and it's just a matter of time before it is free.
But technology has been unable to offset some of the crucial supply issues around energy and food, both of which are at the core of today's inflationary quandary. Nuclear power was supposed to bring electricity too cheap to meter, but our electricity bills have never been higher. The green revolution was supposed to bring an endlessly bountiful harvest, making hunger a thing of the past, but we now have rice shortages and corn nearly tripled in price over the past year. And for all of our virtual connection via cell phones, video-conferencing and e-mail, we've increased our driving and flying to such an extent that we've outstripped global oil-production capacity, driving energy prices to all-time highs.
What happened? Were we wrong to think that technology would deliver us from rising prices? Well, yes, but it's not technology's fault. We mostly have ourselves to blame for standing in its way.
Why are agricultural yields not keeping up with population growth? In large part because the European Union essentially banned genetically modified crops both on its own soil and in imports, thus exporting its technology-blocking regulations to trade partners in Africa and elsewhere.
Another reason food is so expensive is that fertilizer prices are also near all-time highs. That's because the feedstock for much fertilizer is natural gas, and we don't have enough of that, either. Not because we can't get it out of the ground using high-tech tools, but because we can't get it where it's needed. Of the last 53 applications to build liquefied natural gas (LNG) ports and processing facilities in the United States, 50 were denied because of objections from the communities near where they would be located. Meanwhile we haven't built a natural-gas pipeline from Alaska in part because of similar environmental concerns.
The shortage of natural-gas-transportation infrastructure is also in part responsible for our high electricity prices, as is the multidecade virtual moratorium on new nuclear power plants after Three Mile Island. Meanwhile, policies putting high import tariffs on foreign ethanol (to protect American corn farmers) have raised the price of gas, while a refusal to follow California's lead on car efficiency standards has allowed national gas demand to grow faster than supply.
All this said, I believe today's inflation will ultimately speed the adoption of technologies that can fight it. The higher prices get in the atoms economy, where things get more expensive every year, the more incentive there is to move goods and services to the bits economy, where things get cheaper. How high will airfares have to get (think they're high now? Just wait for new carbon taxes to kick in) before you invest in good videoconference gear and skip the flight altogether? How high will gas prices get before you decide to work a few more days a week from your fully wired home office, or skip the mall and shop online from home? The best way to lower energy prices is to cut demand.
In a world where seemingly everything is getting more expensive, the price of digital technology continues to fall and the differences between those two economies are growing. If getting rich was the incentive to go digital a decade ago, saving money may be an even stronger motivation this time.
—Anderson is editor in chief of wired magazine.
No Time To Be Tight-Fisted
Robert Hormats and Jeffrey Currieon why our long-term underinvestment is at the root of oil and food inflation.
There are several causes of the current outbreak of worldwide inflationary pressures. Of these the most visible and powerful is the surge in oil and food prices. Most press accounts focus on rapidly rising demand in emerging economies as the primary reason for this surge, but a deeper and longer standing problem is the sluggish growth in the capacity to produce more energy.
In many countries, insufficient sums of money have been devoted to expanding energy production capacity, and in numerous cases government-imposed barriers inhibit the flow of capital and expertise to areas where they could reduce energy supply constraints. Meanwhile, farm land is increasingly used to produce fuel, rather than food, which drives up agricultural commodity prices, and government subsidies promote inefficient energy use.
In the U.S., the mid-1970s oil crisis led to a striking increase in the efficiency of oil use and sizable investments in new capacity. This was followed by a series of crises in the early 1980s and more conservation. Then, as prices fell, Americans became complacent about gasoline use and developing energy alternatives—and major governmental initiatives petered out—even as dependence on foreign oil mounted.
In following years, enormous amounts of private capital went into innovative information technology, dwarfing the sums channeled into the search for alternative forms of energy or techniques to improve fuel efficiency. The federal government did not offer bold leadership to support technological breakthroughs on the supply or the demand side. Nor did it offer funding, better regulations or tax incentives to produce new fuels on a level commensurate with the urgent need to reverse the rapid escalation of the nation's energy dependence and to curb greenhouse-gas emissions.
The energy problem, of course, is worldwide in scope. American efforts alone would not have prevented rising prices or growing carbon emissions. But more powerful American measures would have limited U.S. demand growth and thus alleviated a portion of recent price pressures. More research and development could also have driven down the cost of alternative fuels and demand-reducing technology.
Now all Americans are paying a hefty "neglect" or "complacency tax"—in the form of high oil prices. This "neglect tax" is especially large, because of America's high per capita energy consumption and weak currency.
Americans can either continue paying the neglect tax or support bold conservation and production measures. American officials especially must take a hard look at policies and regulations that inhibit a more rapid supply response, including barriers to nuclear plants, windmills, solar collectors and transmission lines.
Governments elsewhere need to find ways to attract more capital and technology to boost fuel and food output. This exercise should include finding better ways to provide credit to small farmers in poor nations for seeds, fertilizer and irrigation, as well as to small entrepreneurs for distributed energy production.
Finally, a collective global effort is required to eliminate barriers to the flow of capital and expertise to areas where they can make a real difference in cleaner fuel and food output. Within each nation, and among them, in forums such as the World Bank, the U.N.'s Food and Agricultural Organization and the International Energy Agency, efforts must be made to eliminate the policy constraints and market distortions that impede fuel and food supply increases—and thus drive inflation.
—Hormats is vice chairman and Currie is head of commodity research at Goldman Sachs International.
Attack: The Case For Hard Money
Jeffrey Garten says central bankers must stop worrying about growth, and throw every weapon in their arsenal at inflation.
The most difficult decisions for government officials occur when all policy alternatives have unwanted and even painful repercussions. That's the situation facing finance ministers and central bankers now.
The dilemma is clear: should they give priority to fighting inflation or should they focus on avoiding deflation?
In the first category the U.S. Fed has signaled its concern about soaring food and fuel prices, reinforced by a weakening dollar and higher-priced imports, by saying that it is very unlikely to lower interest rates again. The European Central Bank has calculated inflation at 4 percent, the highest in a decade. A weighted average of inflation in the twenty largest emerging markets has increased to 6.9 percent this year, about 66 percent higher than a year ago.
On the other hand, the global financial system is exceptionally weak and the growth of global trade is decelerating. In America and parts of Europe, housing prices continue to fall and consumer spending is declining. Unemployment in the OECD area is expected to increase by 3 million people over the 2008 to 2009 period, a 9 percent increase over 2007. The Bank for International Settlements believes the global economy could be on the brink of a serious recession.
My vote is to attack inflation first, foremost and decisively. Ultimately uncontrolled price increases will fall hardest on the poor and vulnerable, and soaring prices will only create a situation in which the ultimate medicine will be even more painful that it would be today. Moreover, it is crucial to head off inflation before the expectation of price increases becomes a self-fulfilling prophecy for companies pricing their products and workers pushing for raises.
The inflation problem is a global problem. Thus, it is imperative that the G-7 and key emerging-market nations such as China, India and Brazil collaborate so that the cumulative impact of policies neither falls too short of the mark, or vastly overshoots it. It's a tall order for countries to work together this way. But nothing less will do.
—Garten, the Juan Trippe Professor of international trade and finance at the Yale School of Management, held economic and foreign policy positions in the Nixon, Ford, Carter and Clinton administrations.
The world economy may be heading for a rerun of the 1970s "Great Inflation," this time maybe more severe as it is coinciding with a credit crunch and asset deflation in several advanced economies. Though high oil and commodity prices, housing busts, declining wealth and tighter credit have already crimped the developed-world demand. Meanwhile, the developing-country boom over the past few years has now been followed by the negative supply shocks from rising oil and commodity prices, poor weather, trade barriers and tighter environmental regulations, all of which have helped contribute to inflation.
The forces behind the Great Moderation (stable growth and low inflation), such as better inventory management, inflation-targeting, globalization and financial innovation, are losing their power to lower and stabilize inflation. Import prices are rising thanks to higher production and transportation costs, tighter inventories keep commodity prices high and volatile, and monetary policymakers have their hands tied as downside risk to growth (that require lower policy rates) are constrained by rising inflation (that requires higher policy rates).
As in the early 1970s, loose monetary policy in the U.S. together with the dollar-fixed or heavily managed exchange-rate policies of many emerging economies has led to excessive growth and liquidity in these countries, further feeding the commodities boom, and inflation. Emerging markets that explicitly or implicitly peg their currencies to the dollar severely undercut their ability to fight inflation through currency appreciation.
The U.S. has not yet resorted to Nixonian price and wage controls, but price controls and subsidies in developing countries allow at least half the world population to pay less than the world price for fuel and food, distorting the market and undermining the demand destruction that would ultimately help bring prices down. Now, some producers are beginning to pass on price increases to consumers: a string of steel producers recently announced steel price hikes due to the doubling cost of their inputs, coal and iron ore. Those increases will eventually trickle down, raising prices on consumer goods like cars and appliances. Unlike in the 1970s, no wage-price spiral has taken hold yet on a widespread basis, with exceptions in some emerging markets and parts of Europe. Without this key ingredient of wage inflation, many economists believe high inflation is a temporary phenomenon. The lack of wage inflation is a double-edge sword however, as stagnant wages amid rising prices for goods and services cut consumer purchasing power. This, in turn, can push up inflation expectations if consumers believe their income will buy increasingly less in the future. Second-round effects have begun to appear in parts of Europe and the developing world. Generally, inflation is still lower than it was in the 1970s and core inflation trends remain moderate. Comparisons with the 1970s aside though, several factors point to persistently higher inflation despite a global demand slowdown. Most of the world's population already suffers from double-digit consumer inflation. Consumer inflation in developed countries remains in the single digits, but is high after a long period of disinflation in the 1980s and 1990s.
Unfortunately, there is little that individual rate hikes in the developed world could do to stem the rise of commodity prices in the face of strong emerging-market demand. Emerging markets should raise policy rates more significantly before a sharp upward shift in inflation expectations triggers a wage-price spiral. But more likely these economies—where the commodity price shock is breeding social turmoil—will be unwilling to tighten monetary policy enough and let their currency appreciate enough to control inflation. The slowdown in domestic growth that such deflationary policies would imply would compound the growth slowdown due to the G7 economic slump. The result may be a policy mistake that will lead to a rise in global inflation.
—Roubini is a professor of economics at the Stern School of Business at New York University and chairman of RGEMonitor.com; Pineda is an analyst at RGEMonitor.com.