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FT.com / Columnists / Wolfgang Munchau - Inflation and the lessons of the 1970s

It seem that everyone’s speculating about the US economy today. Recession or no recession, that is the question. The economy has even surpassed the Iraq War as the number one issue in the US presidential race! John McCain, who has publicly admitted that economics is not his strong suit, may just find himself in trouble in a general election where the most important concern among voters is the economic situation.

So what IS that situation, anyway? Is the US in a recession? In other words, has real gross domestic, or total output in the US economy, actually declined over the last six months? Technically, the answer is no. My fellow blogger, Steve Latter, explains this clearly here. What is true, on the other hand, is that the current situation shares many similarities to the global economic slowdown that did occur in the 1970s.

In 1973 OPEC, the newly formed oil cartel consisting at the time of only Arab states, reduced its output of oil and cut off exports to the United States in response to US support of Israel in the Yom Kippur War, in which the Israelis officially occupied the Palestinian territories of the West Bank and Gaza and seized the Golan Heights from the sovereign nation of Syria. To punish the US for its position on this conflict, OPEC cut off supplies of oil to the west, driving gas and energy prices upwards by 70%, triggering a supply shock characterized by a decline in total output and an increase in both unemployment and inflation, a phenomenon known as stagflation: a macroeconomic policy maker’s worst nightmare.

Recently the world has seen a similar (albeit of a different cause) rise in the price of oil and energy prices. Today the rise in energy prices is driven primarily by rising demand, rather than reduced supply (since the 1970s the OPEC cartel has grown to include many non-Arab nations, making it harder to achieve collusion to restrict output and drive up oil prices). Global demand for oil has risen steadily, driven ever higher due to rapid growth in China and other developing nations, and exacerbated by the falling value of the dollar, the currency in which oil prices are denominated.

The supply shocks of today have combined with falling aggregate demand in the US due to weak consumer spending to slow real growth rates to nearlry 0%. So technically, the US has avoided a recession, but the effect on American workers and consumers may be just as painful as the real recession of the 1970s. In order to prevent the “r” word from becoming a reality today, central banks (including the US Fed) have eased money supplies, lowering interest rates, fueling even greater increases in the price level.

…the global weighted average inflation rate will be 5.4 per cent this year, while the global money market interest rate is currently only 4.3 per cent. This means that global short-term real interest rates are negative – at a time when inflation is rapidly accelerating. As monetary policy has been excessively accommodating for more than a decade, inflationary pressures have built up in the global economy.

Central bankers like Ben Bernanke have to make tough decisions sometimes, weighing the trade-off between unemployment and inflation, and determining their monetary policies based on whatever they deem to be the “lesser of two evils”. Rising energy prices have forced firms to cut either cut back their production and raise the price of their products, both actions that result in less overall spending and output in the economy. Falling house prices have led consumers to cut back their own spending, further reducing demand for firms’ output. These factors have all pushed the unemployment rate from around 4.8% a year ago to 5.1% today, which combined with an estimated additional 3-5% of American workers having dropped out of the workforce, (referred to by the Department of Labor as “discouraged workers”) paints a pretty ugly picture of the reality for the American worker today.

The harsh reality of the weak labor market has led Mr. Bernanke and the Fed to pursue an expansionary monetary policy aimed at avoiding further increases in the unemployment rate and decreases in the GDP growth rate. Expansionary monetary policy means lower interest rates, with the goal being increased consumption and investment, both factors that could worsen the inflation problem already experienced thanks to the global supply shock. Evidence indicates that the inflation problem, even in the US where slow growth usually leads to lower price levels, is not going away:

In the US, a survey-based measure of inflationary expectations recently showed an increase to more than 5 per cent. I would estimate there are now several hundred basis points of difference between the current Fed funds rate and an interest rate that would be consistent with price stability in the medium term.

…meaning the Fed, in its attempt to avoid recession and rising unemployment, has created a condition where real interest rates are actually negative, a highly inflationary condition. All this wouldn’t be so bad if wages in the US were rising along with the price level. This however, does not appear to be happening:

The main difference between the situation in the 1970s and now is today’s absence of wage inflation, which explains why absolute inflation rates are a little more moderate. I guess this is probably because of some combination of deregulated labour markets and globalisation. But the lack of wage-push inflation is not necessarily good news. Falling real wages mean falling disposable income and tighter credit conditions mean less borrowing for consumption.

Rising prices for energy, transportation and food have put American households in a tough situation. In the past, periods of inflation have often been characterized by rising wages, meaning the full brunt of nominal price level increases was not entirely born by the American worker. Today, on the other hand, a recession has thus far been avoided, but the combination of record numbers of “discouraged workers”, rising unemployment and inflation may make the pain of our current economic situation just as real as recessions of the past.

In the words of billionaire investor and economic sage Warren Buffett just today:

“I believe that we are already in a recession… Perhaps not in the sense as defined by economists. … But people are already feeling the effects of a recession.”

“It will be deeper and longer than what many think,” he added.

Discussion Questions:

1. What is the difference between nominal and real GDP? Which must decline in order for the economy to be in a recession?
2. What impact do rising energy prices have on the behavior of individual firms?
3. Why are low interest rates likely to make the inflation problem even worse?

Rising inflation in Asia stings in the West - International Herald Tribune

I hate bad news. But this is bad news. Just as the US economy is about to officially enter its long-dreaded recession triggered by falling home prices and weak investment and consumption, it looks like inflation will continue to accelerate as wages and commodity prices skyrocket across Asia.

“Inflation is the major threat to Asian countries,” said Jong-Wha Lee, the head of the Asian Development Bank’s office of regional economic integration.
It is also a threat to Western consumers because Asian exporters, even in very poor countries, are passing their rising costs on to their customers.

Now Americans are in big trouble. While the dollar plummets, making imports more expensive, wages and input prices in Asia are climbing, leading to autonomous increases in the price levels overseas.

That puts American consumers in a double bind, paying at least some of producers’ higher costs for making their goods, and higher prices on top of that because the dollar buys less in those countries.

So where lies the hope for relief? Is there any? What are the possibilities that input costs will fall in Asia, offering relief to consumers in the West? Daniel Altman, the International Herald Tribune’s economics blogger, has this to say:

On the labor question, there is some precedent for relief. When wages rose in Japan and Korea, production of cheap consumer goods and electronics shifted to Hong Kong and Malaysia. When wages there rose, it moved to China and Vietnam. With higher wages in those countries, it could shift to poorer nations in Africa, Central Asia and Latin America - provided those nations are stable enough to do business with foreigners.

There is no relief in sight for energy and commodity prices, however. Demand is simply too great. New technology could provide some answers with time, though it’s not clear how it can solve problems like the lead and copper shortages. In the short term, we may simply have to accept that living standards, judged by our material consumption, will not rise as quickly as they have in the past couple of decades. It was a nice ride while it lasted, eh?

Globalization and free trade have led to huge improvements in access to affordable manufactured goods for Western consumers. The hope that cheap imports will drive our consumptive lifestyles into the future, however, is waning as the basic economic problem of scarcity rears its ugly head in labor and commodity markets.

Discussion Questions:

1. Is global inflation today primarily demand-pull or cost-push? How do you know?
2. What implications do rising wages in China have for less developed countries such as those in Africa and Latin America?
3. As commodity supplies dwindle, how can the world’s economies continue to grow? Can they? Will the world ever reach a point where continued growth is impossible and a period of contraction begins?

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Judging by today’s headlines, things aren’t looking too hot for the US economy:

• Job losses, unemployment both worse than forecast - Apr. 4, 2008
• Dollar slips against euro, yen on jobs - Apr. 4, 2008
• BBC NEWS | Business | Oil price edges up on Opec stance
• FT.com / Asia-Pacific / China - US economy is ‘down sharply’, Paulson says
• Bernanke Nods at Possibility of a Recession - New York Times

From the last article:

In his bleakest economic assessment to date, the Federal Reserve chairman, Ben S. Bernanke, said Wednesday that the American economy could contract in the first half of 2008, meeting the technical definition of a recession, and he encouraged Congress to help homeowners caught up in the mortgage crisis.

For the first time during his three years in the job, Bernanke has admitted we could be in a recession, defined as two consecutive quarters of negative GDP growth. By June, we could very well have experienced just such a decline in output; every central banker’s nightmare!

The source of America’s economic woes? Weak housing market. In fact, house prices have fallen around 10% nationwide over the last 12 months. To understand why, we need to recall the basic microeconomic principles of supply and demand. Quite simply, too many homes were built over the last decade, as low interest rates and optimism about the continued strenght of the housing market (rooted, of course, in the irrational exuberance about the economy as a whole) led builders to expand the suburban sprawl like never before, anticipating growing demand forever into the future. Problem was, demand couldn’t keep up with supply, and now the price is starting to reflect this basic economic principle.

To make things more complicated, many home buyers over the last seven years should never have been given loans based on their credit histories and household incomes. Many of these buyers were thus given “sup-prime” loans, many with adjustable interest rates, which means that today people who were too poor to get a normal loan four years ago are seeing their monthly payments increase just as the economy is slowing down. Rising unemployment puts downward pressure on wages, and inflation (caused by rising energy and commodity prices) forces poor homeowners to allocate more of their wages towards food and electricity, making it doubly hard to make their monthly mortgage payments.

The outcome is predictable: foreclosures. Banks that made loans to uncreditworthy buyers are now taking the houses back and putting them on the market for really low prices, putting even more downward pressure on all home prices. Since their homes make up the majority of Americans’ wealth, and since wealth and disposable income are the main determinants of consumption, inflation and falling home prices both lead to huge decreases in consumption.

The cycle continues: declines in household consupmtion signals to firms that it’s a bad time to invest, so investment spending declines. As consumption and investment fall, aggregate demand shifts in, causing output and employment to fall, hence our current recession.

“It now appears likely that real gross domestic product, or G.D.P., will not grow much, if at all, over the first half of 2008 and could even contract slightly,” he said. “We expect economic activity to strengthen in the second half of the year, in part as the result of stimulative monetary and fiscal policies.”

For now, however, judging by today’s headlines, conditions will continue to worsen for the American worker, homeowner, consumer and firm.

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This article was originally posted by SAS senior David Xu at the SAS Economists Blog.

I have posted it here because David does a good job of explaining the tools the US Fed has developed and deployed to combat the economic slowdown in the United States.

Thanks to David Xu for writing this excellent piece.

The Fed has begun to institutionalize a new revolution of monetary policy.

Previously, the Fed has only really been a big factor by lending out to banks, or by being the bankers’ bank. Right? Well not anymore! The Fed has begun to pursue a policy of keeping the economy afloat with new radical measures.

In the short run, Bernanke is waging a war to keep the financial markets from collapsing. The biggest move so far: On Sunday, Mar. 16, the Fed brokered the fire sale of troubled investment bank Bear Stearns (BSC) to JPMorgan Chase (JPM) and announced that it would be willing to lend directly to major Wall Street brokers, which have never before had access to loans from the central bank.

Now, the Fed will be able to DIRECTLY inject new money into the economy and affect firm’s ability to invest in new capital. Before, firms had to borrow from banks to invest and because of the slump-approaching-recession, banks have been less willing to lend out money. Now, the Fed can actively keep the money supply high and investment growing.

At the same time, by stepping in so aggressively, Bernanke is pouring an enormous slug of money into the financial system. To be sure, its full impact won’t be felt right away, because banks are reluctant to lend and consumers are afraid to borrow. Indeed, consumer spending is likely to lag, leading to job cuts in coming months and a deepening of the recession.

Eventually, though, the Fed’s stimulus will show up as some combination of stronger economic growth and higher asset prices. It also could boost inflation, further eroding the value of the dollar and raising the risk of a run on the world’s most important currency. The possibility that a primarily domestic crisis could quickly become global highlights the need for international cooperation.

Inflation would be a deadly impact of injecting so much money into the system. As the price level is already rising due to high energy prices, the Fed, which basically just prints new money and pours it into the system, could exacerbate the situation. With the dollar falling in value, more dollars in circulation further depreciates its value. But the idea is to get investment back on track and to improve productivity in essence, what we discussed in increasing investment to shift the aggregate supply back out and offset its inward shift due to high energy prices.

The engine that eventually pulls the U.S. out of recession will most likely not be consumption but corporate investment. That will be good for big global corporations with clean balance sheets and access to markets around the world. The very fact that they already have plenty of cash will likely make investors all the more eager to fuel their expansion.

The Fed surely is taking a revolutionary stand here but the worry is, once the Fed gets involved, how can it pull itself back out once the economy is back-on-track? If it calls in the loans it is making to the companies, it could effectively cause another slump. It is up to you though whether the ends are worth the means.

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 when 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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