5 Responses to “How imbalances led to credit crunch and inflation”

Comments

1. Charles Dumas (guest contributor):US commentators are sanguine about the medium-term threat of inflation on the grounds that the danger of a wage follow-through, in the style of the 1970s, is minimal. Such a view is especially prevalent among those who believe, as we do at Lombard Street Research, that the US economy will suffer quite a prolonged patch of negligible growth. It is certainly true that such stagnation, accompanied by the almost mandatory cooling-off of China’s currently severe overheating, should take the sting out of resource prices, particularly oil, at least on a cyclical basis.

   But the Asian economy could produce a combination of demand-pull and cost-push inflationary pressure in the medium term, at least in US dollars. The demand-pull element arises from the shift to a shrinking savings glut, as developed country imports slow; the Chinese yuan moves up in real exchange rate; and faster Asian domestic demand growth pulls in imports (the Asian crisis trauma now being largely forgotten). This reverses the deflationary effects of the build-up of the savings excess over the ten years until 2007 - from a purely Japanese phenomenon in 1997 - to $750 billion of surpluses in Asia, and $450 billion in north-central Europe. With huge surpluses and reserves earning highly negative real returns measured in Asian currencies, the natural way to cool off their overheated economies is sharp reductions in net export surpluses.

   Perhaps more important for medium-term US inflation is the cost-push effect of the rising real Chinese yuan. In the year to May, US imports from China were up in price by 4.6%. The yuan had appreciated 9-10%. In the previous 12 months imports were little changed, against a 4-5% rise in the yuan. Previously, they had been falling, in 2005-06 at about 1% a year, but much more in earlier years, before the relaxing of the yuan peg in July, 2005. (China-only data are not available for earlier years, but imports from Asian NICs fell in price by 14-15% in the three years from early 1997 to 2000, ie, through the Asian crisis and its aftermath, and by another 10% in the four years to 2004.) The real effective yuan is now likely to rise continuously, and this means the downward pressure on US manufacturing from ultra-competitive Asian imports is relaxing, as the global goods-price level, set by China, moves up, at least in dollars.

   In any US recovery, probably export-led and with revived manufacturing, it will be essential for the avoidance of excess demand that domestic demand is held back to growth rates well below those of incomes. With aggressive, pre-emptive Fed tightening this might be achieved. But the track record does not induce confidence in such a policy stance.

   An aspect of the analogy with the early 1970s is monetary. Substitute Germany then for China now. Germany had a strong budget, current account surpluses, and burgeoning reserves under the Bretton Woods fixed exchange rates. To avoid inflationary financing of its FX reserves, it had to sell bonds to the non-bank private sector. But the proceeds were additive to the strong budget. Eventually, the flush of cash caused Germany to throw in the towel in 1969 and Bretton Woods was finally buried in 1971. US easy money had stimulated a foreign economy, breaking down a fixed exchange rate system and forcing appreciation of foreign currency that contributed to the US inflation surge. Arthur Burns’ massive stimulation of monetary growth after the 1969-70 recession finished the job off.

   US inflation is already clearly accelerating even on the Fed’s favoured “core” basis. The five-year moving average of the core consumer deflator was rising at 1.5% in the late-1990s and is at 2.1% now. Also, in the early 1970s US inflation was benefiting from the bottoming-out of the oil price cycle in 1972. It is now being ratcheted up by the recent resource boom. The prospects for medium-term US inflation are unfavourable, especially if US commentary leads to complacency on the point.

   Charles Dumas is director and head of world service at Lombard Street Research

   Posted by: Charles Dumas | June 19th, 2008 at 7:01 pm | Report this comment
   

2. Tim Young: I think Martin has cause and effect the wrong way round. If Asian currency intervention had caused the imbalances, then risk spreads would have been relatively wide during the boom, because central banks tend to buy government and agency bonds and some relative increase in the value of such bonds would have been necessary to induce existing investors to buy more risky alternatives. In fact, until the credit crunch struck, spreads were narrow, and, far from being worried about having to resort to buying risky bonds, US investors were expressing confidence about the financial outlook.

   An alternative explanation which I believe fits the facts better, is that the irresistible force of a US credit boom driven by financial innovation and unchecked by the Fed, met the immovable object of a dollar peg, forcing currency intervention to hold the peg. Since, in China’s case, the peg had been fixed since 1994 and maintained against pressure to depreciate in 1997, it is unfair to argue that this currency policy was designed to accumulate reserves or increase exports. The expansion in spread product came first, and the currency intervention was a response to the resulting increase in US demand for imports.

   Now that US investor confidence has turned out to be misplaced and boom has turned to bust, US consumption ought to have fallen sharply. But this adjustment has been resisted by monetary and fiscal stimulus, so the US current account deficit persists, and US inflation is rising. Worse, as Asia has become richer and its consumption of commodities has not unreasonably increased, America’s refusal to cut its consumption in line with its relative decline has made inflation a global problem.

   Posted by: Tim Young | June 20th, 2008 at 11:58 am | Report this comment
   

3. Sheetal K. Chand (guest): Martin Wolf portrays the US Federal Reserve Board as hapless victim, rather than a bumbling serial killer, to paraphrase the late Rudi Dornbusch. Long ago David Hume wrote about how the discovery of treasure is stimulative, first of activity and then of prices. For many around the world the dollar used to be the equivalent of Inca gold. The Fed’s extraordinary pursuit of an easy monetary policy greatly expanded the international supply of “treasure” through the financing of excess US consumption and corporate asset acquisitions abroad. The pace of activity overseas quickened, new sources of production were mobilized for the first time, and global costs declined. No doubt most benefited, but it was too much of a good thing. The explosion of dollar based increases in global liquidity triggered inflation, first in commodities, and now wages, though as yet confined mostly to emerging economies. Yes Milton Friedman! Inflation is always and everywhere a monetary phenomenon, but globally the money that counts most is the key reserve currency.

   Martin raises the interesting point that emerging economies, with China in the lead, should have allowed their currencies to appreciate earlier so as to reduce the persistent and growing imbalance of trade with the US. But then the dollar-gold proxy would have lost its luster even more rapidly. The decline in the value of the dollar would have been more pronounced, now not only with respect to commodities, but also to currencies and assets denominated in them. Instead of emerging economies absorbing the excessive dollar induced increases in global liquidity through a combination of hoarding reserves and domestic price increases-the flip side of dollar seigniorage- it would have been stemmed through an increase in the dollar denominated price level, which reduces seigniorage. More of the global inflation would have been bottled in the US, and the serial killer instinct of the Fed would have been activated earlier.

   Some would argue that would have been beneficial, instead of the belated activation in store as and when emerging economies start responding to their domestic and partly imported inflation with tighter monetary policies and appreciating exchange rates. But if global floating results, the US would not then enjoy the seigniorage advantages from issuing the key reserve currency. The quid pro quo for seigniorage is a stable dollar internationally. It might have been easier all around to have aimed for that at the outset rather than focus on domestic US contingencies. Yes Milton Friedman! There is no such thing as a free lunch.

   Sheetal Chand is a researcher in the department of economics at Oslo University

   Posted by: Sheetal K. Chand | June 23rd, 2008 at 10:01 am | Report this comment
   

4. Joaquin Vial (guest contributor): As Martin explains, worldwide inflationary pressures are the result of global tensions coming from fast growth in China and most of the Developing World, fueled by overly expansionary monetary policies there and especially in the USA.

   The Asian Tigers were able to get away with fast convergence in the past because they were small, but when China comes into the picture, we are in a different ball game. Initially the World got a free ride thanks to the vast pool of human resources and the low cost of Chinese manufactures, but at the end, in a finite world, nature is showing its limits: first energy, then metals, and now food began to show capacity constraints. These are the kind of commodities that cannot be produced at constant costs, so until technology comes to the rescue, their prices will be the vehicle to absorb monetary excesses at the global level.

   And if food prices rise, salaries will follow, sooner than later, especially in the Developing World: manufactures will become dearer in the future, unless monetary and fiscal restrain slow down the World Economy. At a time of a looming credit crunch, this makes the task of the Federal Reserve and the ECB very difficult. They will have to act thinking globally, while suffering local pressures.

   But if they want to contain inflation, Central Bankers in the Developed World will have to realize that they have to leave room for convergence to happen, perhaps at a slower pace, something that Chinese authorities seem willing to accept. This might not be such a big sacrifice after all, if we think long-term, and realize that sustainable growth will require new – cleaner and more efficient – technologies that are not here yet, but look close enough to make the slowdown in the biggest economies worthwhile.

   Joaquín Vial is chief economist, Global Trends Unit, BBVA Research Department.

   Posted by: Joaquin Vial | June 23rd, 2008 at 6:59 pm | Report this comment
   

5. Martin Wolf: I do not wish to comment on what Charles Dumas has to say, with which I largely agree, but I would like to respond to Tim Young, who has produced another in a long line of “money glut” explanations for the current financial situation, against my “savings glut” view. Incidentally, we have already had many debates in this forum on this theme.

   My answer is that if Tim were right, one would expect to have seen far greater inflation in the US and far higher long-term real interest rates in the world. The US is a large, relatively closed economy. If the US current account deficit had indeed reflected excess demand in that country one would have expected to see significant excess demand for non-tradeables which showed up in higher domestic prices. This would then have diverted spending onto tradeables.

   Yet there has been little sign of this process: domestic inflation in the US has been subdued over the past decade. Again, if the driving force had been loose monetary policy in the US, one would not have expected to see exceptionally low long-term real interest rates around the world. The long-term real interest rate is not a monetary phenomenon, but a real one.

   The best explanation for what has happened, in my view, is in terms of the Hicksian IS-LM model. After the Asian financial crisis, there was a significant shift in the global IS curve to the left. Then there came the collapse of the stock market bubble in 2000, which ended the investment boom of the late 1990s. Then surplus savings emerged on a massive scale in China and the oil-exporting countries in the 2000s.

   To ensure global “full employment”, monetary authorities needed to respond with an aggressive loosening. But there is no global monetary authority. The closest the world has to one is the Federal Reserve. So excess savings appeared in the rising current account surpluses of the emerging economies and the offsetting expansion occurred largely in the US, though also in a number of other credit-elastic economies (such as the UK). Unfortunately, the monetary policies required to sustain spending at a high enough level to offset the current account deficits worked via yet another big asset-price bubble, this time in housing, with the consequences we now see.

   Finally, these surplus savings did not just happen. In many countries, they were a reflection of deliberate policy decisions, particularly exchange-rate intervention. Thus a very large part of the capital outflow was effectively nationalised, taking the form of gigantic reserve accumulations (with global reserves up by about $5 trillion in the 2000s). The counterpart domestic savings were engineered via domestic monetary and fiscal policies.

   Tim argues that it is unfair to blame the Chinese authorities, since they merely kept a peg that they had initiated in 1994 and kept in 1997, during the Asian crisis. My answer is that it had ceased to be appropriate. China needed a huge real appreciation of the exchange rate by the early 2000s. Since the Chinese authorities were determined to prevent higher inflation, they needed to accept a currency appreciation, particularly when the dollar itself started to decline after 2002. In practice, they did neither, progressively increasing the disequilibrium.

   So, in my view, the US was largely responding to the policies of others, by running domestic demand at a level high enough to offset the excess savings elsewhere. The latter were also, in substantial part, the result of deliberately mercantilist policies. We have now reached the end of this period. But if the world economy is to remain reasonably dynamic, those excess savings must now be absorbed elsewhere. How that happens is one of the most important questions confronting the global economy.

   I have a book coming out in the autumn on these topics. It is called Fixing Global Finance and will be published by John Hopkins in the US and Yale in the UK. It is about the macroeconomics of the financial crises of the past 30 years.

   The points I make immediately above are also my response to Sheetal Chand. The emerging countries decided to accumulate this treasure by pursuing mercantilist exchange-rate and monetary policies. The US supplied them with what they wanted. Of course, he is right that a decision by emerging economies to stop accumulating “treasure” on this scale would also have reduced US seignorage. But the latter has been excessive and so unsustainable, in any case. Now a big adjustment is under way, on both sides.

   So my view remains that the driving force in monetary policy has been the exchange-rate policies of big emerging economies, not US monetary policies. The latter has responded, instead, to those policies, by driving domestic demand to a level sufficient to absorb the external supply of capital. It would have been far better if these policies had never been adopted by emerging economies. That would have greatly reduced today’s inflationary pressures.

   I find myself in broad agreement with Joaquin Vial and thank him for his thoughtful comments on resources scarcities.

   Posted by: Martin Wolf | July 18th, 2008 at 3:34 pm | Report this comment
   

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