Mar 31 2008

Politics, priorities, and the Phillips Curve

FT.com / Asia-Pacific / China – Weak dollar troubles Beijing

Inflation, with its erosive effects on wealth and income, has plagued China at increasing rates since mid-2007. In February it reached an annualized rate of 8.7%, threatening to undermine China’s GDP growth rate, which has been predicted in the 8% range for this year.

As we have discussed in our our AP Econ class here in Shanghai, China’s inflation is caused by a combination of demand and supply-side factors. On the demand-side, a growing middle class has driven consumer spending to record levels recently, surpassing investment as the largest component of China’s GDP in 2007. Of course, as always, high inflation (thus low real interest rates), optimism about rising consumption in the future, and a comparative advantage in labor-intensive manufacturing (albeit a diminishing one as wages continue to rise) all combine to keep investment extremely high. Furthermore, cheap exports have helped keep demand for China’s output from abroad strong. The combination of increasing consumption, strong investment, and its trade surplus have resulted in demand-pull inflation.

On the supply-side, China has encountered additional inflationary pressures of late. Rising energy prices (mostly due to coal and oil shortages) combined with record rises in food prices (24% increase in the last year), have driven costs to firms up, shifting the aggregate supply curve leftward, further fueling inflation.

Knowing the damaging effects inflation has on income and wealth, it might be assumed that Beijing would place the utmost emphasis on taming the country’s rising prices. This, however,is not at the top of the government’s macroeconomic goals, according to premier Wen Jiabao:

On the issue of whether he would sacrifice economic output to bring down inflation, at the risk of increasing unemployment, Mr Wen indicated that growth re­mained the overarching priority. “We must ensure that our economy will grow…in order to ensure employment,” he said. “China is a developing country with 1.3bn people. We have to maintain a certain degree of fast economic growth to provide enough jobs.

”He said China needed to add about 10m jobs a year for the next five years, a lower figure than in the past whenPC the aim was growth of 15m-20m jobs a year.

The tradeoff between inflation and unemployment to which Mr. Wen refers is a text book example of the challenges faced by macroeconomic policymakers everywhere. This trade-off is illustrated in the Phillips Curve model, which shows that in the short-run, there exists an inverse relationship between the price level and the unemployment rate.

In his words above, Mr. Wen demonstrates Beijing’s preference in the trade-off between inflation and unemployment: He’ll take inflation… Here’s why.

In case you haven’t heard, China is not a democracy. Nor is it a, ehem, “free” country. According to Alan Greenspan in his book “The Age of Turbulence”, democracy and freedom of speech act as “safety valves” in Western countries; in other words, in times of economic or political unrest, the right to gather in the streets, the right to vent frustrations through a free press and the opportunity to advocate political and economic change through the various media, all combine to prevent violent and revolutionary uprisings when times get tough economically.

Take the US for example. Times are certainly tough right now. Inflation’s approaching 4-5%, while nominal growth has nearly stagnated. Unemployment, while it has technically fallen recently, in reality has risen as hundreds of thousands of workers have given up searching for work. The bursting of the housing bubble represents one of the most massive losses of wealth in recent history. A weak dollar has meant that even cheap imports don’t seem so cheap anymore. Throw in the desperate war in Iraq, the nuclear threat from Iran, rising food prices, $110 oil and an incredibly unpopular national leader, and by some measures the country would appear ripe for revolution. However, a revolution is about the least likely thing to occur in America, because it enjoys the “safety valve” of democracy. Rather than overthrowing their government, Americans have the right to go to the pole and vote for a new one, which in all likelihood will occur this November when it seems either Barrack or Hillary stand the greatest chance and winning the White House.

Now let’s look at China. The picture’s not quite so gloomy for the Chinese right now. Yes, inflation is high, as in the US. But unlike America, China is still growing at a very healthy pace, unemployment is probably still below its natural level, the real estate markets in China’s cities are still booming, meaning the middle class residents there are experiencing leaps and bounds in terms of personal wealth. Demand for its exports remains strong, and ever more poor Chinese are finding jobs in high paying factories across the country. Investments in capital, infrastructure and education point towards a bright future of continued growth for the foreseeable future.

But wait, 8.4% is something to worry about, especially when we take into account the 24% increase in food prices. Shouldn’t Wen and Beijing be taking drastic steps to reign in this high rate of inflation? In short, NO, they shouldn’t. Because as can be seen in the Phillips Curve, to reduce inflation could result in another, far more serious problem for Beijing; rising unemployment.

It appears that Beijing’s greatest fear is a population out of work. Its goal of creating 10 million new jobs is ambitious, but in the eye’s of the government, necessary. The Chinese people do not enjoy the “safety valve” of democracy through which economic frustrations and hardships can be channeled were the country to experience a slowdown in growth and an increase in unemployment. The last time the economy faced high inflation AND high unemployment, students, workers, soldiers and tanks all gathered for an afternoon of urban warfare under Mao’s somber gaze in Beijing. To avoid such massive revolutionary movements in the future, Beijing must do all it can to insure job creation continues and growth remains strong, even if the trade-off is record high inflation.

This one passage spoken by Wen Jiabao, China’s premier, tells a vivid story about the reality of Communist dictatorship in China. Sound economic policy may go on the back burner in times of political uncertainty. Price controls, such as those on petrol in Shanghai (speaking of, the long lines at gas stations are back!), were a microeconomic example of bad economics; Beijings hesitance to seriously tackle inflation is a macroeconomic example. Holding on to power seems to be more important than stabilizing prices, at least for now.

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

8 responses so far

8 Responses to “Politics, priorities, and the Phillips Curve”

  1. yunqimokon 04 Apr 2008 at 1:38 pm

    While it is true that China should be concerned about the unemployment levels, it should be wary of what occurs in the long run. The tradeoff between unemployment and inflation is in the short run, but once the long run Phillips curve kicks in, the only that will happen is crazy inflation, and decreases in AS. However, I think Wen Jia Bao is employing the correct policy at this moment. Even if prices are soaring, less unemployment will mean a better distribution of wealth, which is an important economic growth. Furthermore, the state will have less of a burden to help the unemployed, and can focus its fund on improving infrastructure, or other public goods.

  2. Angel Liuon 07 Apr 2008 at 9:56 pm

    The power of a communist government is quite scary. I was wondering why Chinese laborers would be willing to work at a real wage rate below the inflation rate cause then they would be losing money the more they worked. But since people had no right to express free thoughts, they must keep working if the government commands its labor force to work for diminishing wages. In a democracy, the government cannot simply ignore inflation over employment.

  3. Jack Loon 07 Apr 2008 at 10:20 pm

    This is an example of where politics and economics cross paths. Although these sky high inflation rates will probably erode all of the wages away, the Chinese people will keep working. We humans are more than economic beings. We're not stupid enough to stop working just because an economic model shows that they're actually losing money by working. The Chinese government ain't stupid. They've seen what high unemployment can cause – a revolution. That's why the government is choosing to keep unemployment low rather than keep inflation low.

  4. kevinchiuon 09 Apr 2008 at 1:22 pm

    Hmm.. if excessive inflation occurs in the long run, as Yun Qi stated, isn't that what China wants? Increasing inflation at a faster rate than other nations makes the RMB less valued than other currencies right? (Not a rhetorical question, I actually don't know). I mean, if the RMB's value lessens, China's exports seem more cheap and more foriegn nations will continue investing, hence providing more job opportunities in China for workers. Is inflation really that bad if the nominal wage increases at a similar rate?

  5. howard linon 10 Apr 2008 at 9:22 pm

    Holding on to price levels only assures a little bit more time staying in authority. However…is that really good for the public?! It would just create shortages like the scene outside the gas stations around november…and holding on to rice price might result in shortages ( caused by rise in input cost – however, a price celing, -> reduce in Q produced ) and may eventually cause starvation.

  6. alicesuon 10 Apr 2008 at 11:19 pm

    The effects of making the trade-off between inflation and unemployment are sure to create problems in this case with the issue of soaring inflation. However, I believe that choosing to prevent unemployment rather than curb inflation is the correct choice in this case, at least for the time being; what's harder, trying to deal with rice that's too expensive, or realizing that you don't even have any job income to buy rice in the first place? True, inflation is a problem that needs to be dealt with, but in any case the political issue of maintaining the nation's security comes first and foremost before any economic philosophy.

  7. Jessicaon 13 Apr 2008 at 11:24 pm

    I guess it makes sense to choose employment over inflation. If Wen decided to take the middle class and to try to reduce inflation while also trying to reduce unemployment, he would be overwhelmed and who knows what the results would be. The inflation created now is definitely both demand pull and cost push. With so many Chinese people who are getting richer, the demand for goods is increasing exponentially. Also, the prices of gas and oil are HIGHHH now. Reducing unemployment means that people will at least have some money and will be able to scrape by. If Wen had decided to deal with inflation instead, then prices would be lower but half the country would still not have the money to buy the goods.

  8. mina.songon 15 Apr 2008 at 3:51 am

    May be… I think …. this is the one thing that I saw what chinese government is doing right. as we studied unemployment rate has relation with inflation. even though there will be some high inflation rate, this will lower the unemployment rate.