Disorder & imbalances

“The years since the early 1970s are unprecedented in terms of the volatility in the prices of commodities, currencies, real estate and stocks, and the frequency and severity of financial crises.” Robert Alibert.

“The current financial crisis in the US is likely to be judged in retrospect as the most wrenching since the end of the second world war.” Alan Greenspan, Financial Times, March 16th 2008.

“Inflation is always and everywhere a monetary phenomenon. Milton Friedman.”

Two storms are simultaneously buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one. What explains this combination of a “credit crunch” in the US with soaring commodity prices and rising inflation across the globe? Are these unrelated events or part of a bigger picture?

The answer, I am going to suggest, is the latter: they are related. In particular, they are related via two phenomena – the global savings glut and the global “imbalances” or pattern of current account surpluses and deficits – that are themselves, at least in part, the result of a dysfunctional global monetary cum financial system.

Furthermore, I will argue, these imbalances are the result of a “fear of deficits”. This is itself the consequence of the failure of the global monetary cum financial system to transfer capital to emerging economies safely.

Revival of inflation

Inflation is a sustained rise in the price level: the result of too much money (or purchasing power) chasing too few goods and services. A one-off jump in commodity prices is, of course, not inflation. Nor need such a jump cause inflation. Yet a continuous rise in the relative price of commodities is a symptom of an inflationary process. Whenever excess demand hits, the goods whose prices rise first are those with flexible prices, of which commodities are the prime example. Commodity prices then are a pressure gauge. If we look at what has been happening in recent years, the gauge is showing red.

The Goldman Sachs index of commodity prices has doubled since early 2007. The upward movement in commodity prices has persisted for more than six years. It looks indeed as though too much extra demand is pressing on too little ability to increase global supply.

Inflation is the result of too much demand chasing too few goods and services: put simply, the world economy has been growing faster than, with present technology and resources, it can sustainably do. The ability to expand supply is, of course, a real phenomenon. The supply of energy is the most important of all real economic phenomena. Our industrial civilisation is, after all, based entirely on fossil fuel.

Since the end of 2001, the real price of oil has risen some six-fold. Today, it is higher than since the beginning of the previous century. As the World Bank notes in its Global Development Finance 2008, global oil supply stagnated in 2007. This, argues the report, “contributed to the large decline in stocks in the second half of 2007 and to sharply higher prices”. These increases may prove temporary, as happened after the spikes of the 1970s, permanent or, worst of all, ongoing. We do not yet know.

The result of the pressure of demand on supply has been unexpectedly big increases in overall inflation: the consensus for world consumer price inflation in 2008 has jumped from the 2.4 per cent forecast in February 2007 to the 4.3 per cent forecast in June 2008. The jumps in the inflation expected in 2008 are considerably bigger than this in the emerging economies, where the weight of food in consumption is particularly high.

Yet how can we have what seems to be incipient global inflationary process when the US economy and those of other significant high-income countries are slowing down? The proximate reason is that the latter matter less than they used to. The underlying explanation is to be found in the forces driving both global demand and supply.

On global demand, however, two big things are happening: convergence and the consequences of the imbalances. Under convergence comes the accelerated growth of emerging economies, above all of China and India. Under imbalances come the interventions in currency markets aimed at supporting competitiveness.

Charles Dumas of London-based Lombard Street Research notes that, at purchasing power parity, China now generates a little over a quarter of world economic growth in a normal year, while emerging and developing countries together generate 70 per cent. Even at market exchange rates, the growth of China’s gross domestic product is as big as that of the US, in normal years for both countries.

This is a fundamental transformation in the balance of the world economy. The emerging countries are also in a good position to keep on growing, largely because they have such strong external positions. The reason this is important for global inflation is twofold: first, the growth patterns of these economies are extremely resource-intensive – China, for example, uses almost as much energy as the US despite having an economy that is half the size at purchasing power parity and a quarter at market exchange rates; second, these economies are continuing to grow very fast, even though the US and, to a lesser extent, other high-income countries are slowing down.


About the savings glut and the role of imbalances, we need to understand two things that have happened.

First, as Ben Bernanke correctly argued, a global savings glut emerged over the last decade. The single best indicator of that glut has been the low real rate of interest at a time of fast global economic growth.

Behind this glut lie three phenomena – the savings surpluses or, more precisely, excess of retained profits over investment, of the corporate sectors of the advanced countries, the persistent savings surpluses of a number of mature economies, particularly Japan and post-post-unification Germany and, last but not least, the switch of the emerging economies into ever large current account surpluses. The latter, in turn, has had three elements: the shift of crisis-hit emerging countries from deficit into surplus, particularly after the Asian financial crisis, the rise of China as the world’s largest capital exporter, despite also being the world’s biggest investor and, more recently, the surpluses of the oil exporting countries. China’s current account surplus equals those of Germany and Japan combined.

In aggregate the forecast current account surpluses of the twenty largest surplus countries is forecast by the International Monetary Fund at about $1,700bn this year. My back of the envelope calculations suggest that these surpluses are equal to about a seventh of world gross saving and close to twice as large a share of the savings of the capital surplus countries themselves: these capital flows then are enormous.

What have been the consequences of the emergence of savings gluts concentrated so heavily in a relatively small group of countries? I will discuss just two.

First, it should go without saying that the world balance of payments or patterns of savings surpluses and deficits must add up to zero. This reality is sometimes forgotten even by economists who take pride in the frugality of their own country and condemn the profligacy of those who spend what their own citizens choose to save.

As Harvard’s Kenneth Rogoff has argued, this is just another emerging market crisis, but this time the emerging market was found inside the US. It also is another reminder of why large net capital flows have proved so destabilising: they only work if the borrowers are making investments able to service the loans. This is just as true if the borrowers are insie the US as if they are in emerging economies. In this case, unlike in emerging market economies in the 1980s and 1990s, there was no currency crisis. But there was a crisis in the domestic counterpart of the external capital flows.

Meanwhile, what has been going on in the providers of capital? In the case of the emerging economies, the answer is that they have been intervening in their currency markets on a simply enormous scale. Over the seven years to March 2008, global foreign currency reserves jumped by $4,900bn, with China’s reserves alone up by $1,500bn. Almost all of this increase was in emerging countries who have engaged in what is surely the biggest “self-insurance” programme in world economic history. Indeed, 70 per cent of today’s reserves have been accumulated over this period.

Why have they done this and what are the consequences? Ronald McKinnon would argue that the state is pursuing a rational policy of fixing exchange rates, as a monetary anchor, while the balance of payments surpluses are simply the result of excess savings. But many emerging economies have intervened in currency markets on a huge scale, principally in order to keep export competitiveness and current account surpluses up (or current account deficits down). “Never again,” said the emerging countries hit by crises in the 1980s and 1990s; “not even once,” said China.

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