Half the World Lives With Double Digit Inflation

Globalization used to be all about making things cheaper. It's hard to think of much that didn't go down in price over the past few decades—cars, electronics, consumer goods of all kinds, services like banking and telecommunications—as the global movement of goods, labor and capital played out around the world, enriching developed countries and emerging markets alike. In fact, between 2003 and 2007, world GDP grew 5 percent per year—faster than it ever has—even as inflation remained under 4 percent. Freer trade, cheaper emerging-market labor, better technology and more plentiful capital all collided to make this early part of the century the most prosperous in the history of our planet.

This sea change in global opportunity and prosperity is a compelling story. So compelling, in fact, that until quite recently, consumers, policymakers and even the bankers financing it all seemed to have forgotten there was a downside. With this unprecedented growth has come greater global demand for things such as labor, food, and energy.

And now, for the first time in 35 years, the world is facing a serious, and synchronized, surge in inflation. The increasing interconnectedness of global trade and capital markets that fed the boom is now speeding the dark side of globalization around the world faster than ever before.

You've likely felt the pain—inflation has hit most nations in the past few months—at the gas pump, or in a restaurant, or while paying a heating bill. But in vast swaths of the developing world, hyperinflation is already causing hunger, riots and political instability. In Russia, consumers have gone back to stockpiling food, as they did in the days of chronic shortages under the Soviets. They are now hoarding enough staples like flour, pasta and oil to last for months, lest 15 percent inflation make them too dear. China is facing record power shortages, as soaring coal prices and government-set electricity tariffs have forced smaller power plants to shut down. A Morgan Stanley report released in late June summed it up: "Much to our own surprise, we find that 50 of the 190 or so countries in the world now have inflation running at double-digit rates," including most emerging markets. In other words, about half the world's population is already experiencing double-digit price increases.

Policymakers are finally sounding the warning bells. Only a few weeks ago, European Central Bank president Jean-Claude Trichet declared that rising inflation was threatening growth in Europe, warning that second-round effects like spiraling wage inflation are becoming more likely (already wages in Germany are taking off). In June, U.S. consumer prices posted their sharpest rise in 17 years, leading Fed chairman Ben Bernanke to tell Congress that bringing down inflation to an acceptable level was now "top priority." A July report from the Asian Development Bank urged policymakers to abandon their decades-old focus on growth and start fighting inflation lest they suffer a worse fate: stagflation. That crippling combination of low growth and high inflation immiserated the West three decades ago, and would represent a complete reversal of the golden age of globalization.

The comparisons to the '70s are rife these days (even Bernanke has made them), and some are apt. Then, as now, an increase in government spending, and irresponsibly loose monetary policy, encouraged inflation. But the differences matter more. Back then it was developed nations that were causing the pain, and feeling most of it: from the early '70s to the early '80s, the unemployment rate in OECD nations rose from 3 to 7.8 percent, as prices rose more than 10 percent per year. Now it's an emerging-market phenomenon. Nations like China are starting to export inflation as their explosive growth and voracious demand for resources push up world commodity prices. In the United States, food and oil now account for about half of inflation; the figure is around two thirds in Europe, and even higher in some developing nations.

The fact that today's inflation is almost entirely related to commodity spikes is another crucial difference from the 1970s. Back then, in the United States, for example, food and oil represented about 30 percent of total inflation. Core inflation—the sort that doesn't include food and oil—was spiraling; today, by contrast, it is relatively steady (at least in the rich world). The conventional wisdom was that inflation spikes in food and oil are not worrisome, because those prices tended to fall back to long-term averages. Now food and oil prices appear to be rising inexorably, due to the long-term rise in demand from emerging economic powers like India and Russia, slow productivity growth in agriculture and supply disruptions in the oil patch. Those trends make it "quite possible that overall inflation will stay higher than it has in the past," says Holger Schmieding, chief European economist of the Bank of America. With global inflation now nearly 6 percent, it looks unlikely to fall back to its 2007 level of about 4 percent—much less the 3.5 percent rate of earlier in the decade—any time soon.

Many firms are beginning to rethink their entire business models to cope with the new inflationary environment. Many airlines and automobile manufacturers are close to imploding. Restaurant chains are suffering; Starbucks just posted its first-ever quarterly loss, thanks to rising coffee prices and fewer people willing to shell out four bucks for a latte. Procter & Gamble just announced a rethinking of its global supply chain, with the aim of bringing production back from far-flung locales and closer to consumers to cut soaring shipping costs. Rubbermaid, the U.S. consumer-goods firm, has had to slash various lines of trash cans and storage bins because of the high cost of petroleum-based resins used to make them. The firm has also said it plans to raise prices on some existing items as much as 20 percent.

So far, many companies have simply eaten the higher costs and accepted lower profits, because consumers accustomed to the golden era of cheap global goods won't pay extra. But that may change. Surveys in both Europe and the United States now show consumers' expectations of inflation are at peaks not seen in years, and their willingness to pay extra is low. But for now, companies are taking the hit: airlines have seen their profit margins vanish entirely. The large California department store Mervyns recently filed for bankruptcy, in part because rising apparel costs couldn't be passed on to the consumer. "We can't quantify exactly how much emerging-market inflation is being exported to the West, but I suspect it's happening," says Morgan Stanley chief U.S. economist Richard Berner. He notes that shrinking profits have not yet produced a sharp drop in corporate spending, possibly due to one-time corporate tax breaks. Payback seems likely after those incentives expire late this year, he warns.

The end of the low-inflation age was entirely foreseeable, in retrospect. After the bursting of the tech bubble in 2001, Western central banks, led by the Fed, slashed interest rates to prop up battered markets. Many big emerging nations like China, with exchange rates pegged to the dollar, were forced to follow, though the cuts weren't needed in their high-growth economies. The result of rock-bottom interest rates was a flood of cheap money, the seeds of the current mess. Inflation was already rising when the credit crisis hit last year, prompting central banks to cut rates again, adding more cheap money to the fire. This time "inflation has traveled faster around the world" than it did in the 1970s, says Morgan Stanley Global economist Joachim Fels. "The global inflation rate is amplifying national results in a way that it didn't in the past."

The global forces that once restrained inflation are proving less strong, or more complicated, than people thought. Cheap goods made in China are still cheap in renminbi, but the weakening dollar has made them more expensive for Americans. And while the Internet is still a powerful tool for comparison shoppers and hagglers, it is not powerful enough to stem the tide of rising global demand. Harvard economist Dale Jorgensen says that since the mid-1990s, when the spread of information technology started to raise U.S. productivity dramatically, it has typically lowered the annual U.S. inflation rate by about .5 percent. That was a big cut when inflation was running about 2 percent, but much less significant now that it's topping 5 percent. "The Internet is helping, but it can't combat the threat of $200 oil, or spiraling food prices," says Jorgensen.

What's more, according to the Conference Board's chief economist Bart van Ark, the growth of a global knowledge economy is actually contributing to what may become permanent wage inflation at the top of the economic heap. "We always thought globalization would depress wages, but in fact, for highly skilled people it's inflating them," he says, noting that in places like China, IT salaries (already among the top) are rising fastest.

In fact, wages are skyrocketing across the board in much of the developing world: most Persian Gulf nations, along with other nations such as India, Egypt, South Africa, Argentina, Venezuela, Russia, Turkey, Indonesia, Pakistan, Hungary, Latvia and many more, have seen double-digit wage increases this year. Meanwhile, euro-zone wage inflation has accelerated to 3.3 percent in early 2008, the highest rate in four years.

Will such increases lead to a broader, 1970s-style wage-price spiral? Some say yes. Companies like U. S. Steel are soaring right now, because rising transport costs are making Chinese rivals less competitive in the U.S. market. As a similar shock hits industries from batteries to furniture, bringing production home, it will lead to demands for higher wages from U.S. and European workers, says CIBC World Markets chief economist Jeff Rubin. "Inflation is going to make the world rounder," he says. Others are not so sure, in large part because the declining clout of Western labor unions makes them less powerful advocates for higher wages. "Expectations are completely different today than in the 1970s, when left-wing policies were in ascendance," says Schmieding, who attributes recent European wage increases to lower unemployment, not union power.

There is also an opposite argument: that in the West, at least, recession fears will help curb a wage-price spiral. Normally, the dynamic of a spiral is that consumers expect higher prices, so they buy more today to beat the increases, and demand higher wages to cover the prices. Now, however, consumer spending in both the United States and Europe is way down, and certain retail surveys show that people are actually beginning to haggle, Third World style, over goods at their local markets. Meanwhile, a toughening economy makes it difficult for workers to reasonably ask for raises.

It's not clear how inflation will affect global growth, but it won't be pretty. Seminal studies by Stanley Fischer and Robert Barro suggest that the impact really starts to kick in after inflation rises above the range of 5 to 7 percent, and again, the global average is now 5.5 percent. The IMF is predicting that global growth this year will be about 4 percent, a full point lower than last, in large part because of inflationary effects.

All this underscores just how complex the new economic order is. The demand stoked by globalization has created a new class of emerging-market rich who have in turn fueled a new era of global inflation, one with which we must all cope. The way out won't be easy. Already, the tougher global environment is pushing protectionism and insularity. Emerging economies in particular will have to make painful choices between growth and security, decoupling their monetary policies from the West, and cutting back on the massive subsidies that help their people buy food and fuel but distort markets and further stoke global inflation. Some, like Turkey, South Africa and India—countries with dismal public finances, difficult politics and little commodities wealth—may be hit hard by stagflation, which could result in civil unrest.

Many others will simply enter a more volatile and uncertain period of growth. All will have to step carefully to avoid the policy mistakes that led the West to its painful '70s stagflation. One tip: forget the easy-money advice of Alan Greenspan and reread the words of Paul Volcker, the more conservative Fed chief who eventually tamed double-digit inflation in the United States. "What emerging markets need," says Morgan Stanley's Fels, "is their own Volcker to create a recession," and correct the inflationary buildup before things really spiral out of control. So, then, what's needed is thoughtful and measured economic leadership. In that, perhaps, things aren't that much different than they were 30 years ago.