June 25, 2008
How to see world economy through two crises
By Martin Wolf
Two storms are buffeting the world economy: an inflationary commodity-price storm and a deflationary financial one. Last week I argued that exchange-rate regimes were a link between these distinct events. This week, let us look at how to sail on these storm-tossed seas.
The place to start is with the world economy as a unit. The more globalised economies become, the more appropriate it is to think of the world economy in this way. So what have we learnt about the world economy as a whole? The answer is that it is running into limits on resources, at least in the short term.
Our civilisation is based on fossil fuel. But since the end of 2001, the real price of oil has risen some six-fold. Today, the real price 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, or permanent. We do not yet know.
The remainder of this column can be read here. Debate from our expert panel appears below.
Sharada Selvanathan (guest contributor): In a recent publication, I argued that the surge in inflation was bring driven by commodities and consequently the emerging market world. Data from the 2008 BP Annual Statistical Review of World Energy show that emerging market countries (including Africa and the Middle East) used 40.3 mb of oil per day in 2007 compared with emerging market consumption of 30.9 mb per day in 1998. Other commodity markets signal a similar trend with developing countries accounting for more than 59% of global copper consumption in 2007 versus 36% in 1998.
Note that emerging market policies (both on the fiscal and monetary side) have been primarily aimed at promoting growth. Policies that reflect price stability have traditionally been on the backburner.
My view that emerging markets are the cause of the global inflation problem leads me to agree with Martin Wolf’s view that tighter emerging market monetary policy is crucial. The Reserve Bank of India hiking rates by 75 bp in a month is a step in the right direction. However, Indian inflation running at 11% y/y shows that (a) real rates are still in the negative and (b) the central bank is clearly behind the curve. The RBI is not the only Asian central bank that is behind the curve; negative real rates, in a host of Asian countries, have been evident for some time. Furthermore, our exchange rate models show that seven out of the eleven Asian regional currencies we focus on are undervalued – providing additional monetary stimulus.
Hence a key question is whether emerging market officials are willing to sacrifice (near-term) growth to solve the longer-term inflation problem? Furthermore, how quickly are these central banks and governments willing to act?
If emerging market countries are not willing to act swiftly, given political sensitivities and near-term economic pain, the only other credible solution to the global inflation issue, in my opinion, would be via the USD. In this respect, rhetoric and action by the Fed are essential.
A stronger USD would come through once the Fed starts to take away some of the emergency stimulus it provided at the height of the financial crisis. One could argue that with the US housing market in a recession, the economy is too sensitive to higher interest rates. Furthermore, rate increases would flatten the US yield curve at a time when institutions are trying to secure long-term funding at minimal cost.
However, key financial market indicators signal that conditions have improved owing to successful unorthodox policy measures by the Fed. The Fed has given itself room to focus on inflation while allowing the financial market to unwind risk in a systematic manner. Furthermore, a higher USD would not only be in the interest of global central banks but also of the Fed. First, a higher USD will help remove some of the froth present in the commodity market. Second, it will help ease US imported inflation which is rising at an annual rate of 18%. Third, Fed inflation fighting credibility is crucial for GCC and Asian central banks to hold on to and buy additional US debt. Note that these central banks command around USD 4.3tr in fx reserves. Basic economic theory suggests that holders of bonds need to be sure that inflation will not eat into their nominal capital gain.
Hence, stabilising the USD will keep foreign financing of the US current account deficit from drying up but will also make inflation fighting easier for the Fed and others. This way, we would not need to hold our breath for emerging market central banks to make the moves.
Sharada Selvanathan is currency strategist at BNP Paribas
Posted by: Sharada Selvanathan | June 25th, 2008 at 10:57 am | Report this commentMartin Wolf: I think Sharada Selvanathan has made an important point.
There are two ways that needed monetary tightening could now be introduced into the world. The first would be a tightening by emerging economies, together with upward movement of their currencies. The advantage of this is that the tightening would occur where it is most needed. It would also represent a move towards a more flexible global currency regime. The second way would be for the Federal Reserve to tighten monetary policy, thereby also tightening policy in countries whose currencies are linked to the dollar. The advantage of this is that tightening would affect much of the world economy. The disadvantage is that the tightening is likely to be too much for the US and too little for the emerging countries whose currencies are linked to the dollar.
At the present juncture, I would prefer a bit of both: a modest tightening in the US and a much bigger tightening in emerging countries, together with further upward currency adjustment by the latter.
Posted by: Martin Wolf | July 18th, 2008 at 7:21 pm | Report this comment