The unexpected re-acceleration of inflation in Russia since late 2007 is bad news, especially as it was already too high to begin with. However, as a global phenomenon, the re-appearance of higher rates of inflation is even worse - it presents a serious political challenge to world leaders at a time when the international economic system is rudderless.

The problem is that the U.S., as the traditional key currency country, is, in effect, abandoning its responsibilities on the altar of domestic politics and short-term interests. As the world's largest debtor country, the repricing of risk is playing havoc with over-valued assets and causing the U.S. authorities to "panic" in an effort to forestall the possibility of a serious economic collapse. But the additional liquidity being created is the source of the inflationary pressure worldwide.  Russia by itself cannot do much to stem this pressure. And each country, acting on its own, may exacerbate tensions in an increasingly fragile, globalized economy.

INFLATION UNEXPECTEDLY RE-APPEARS

One of the hard won achievements in recent years was the taming of inflation. Not just in the OECD area but worldwide. So thorough had been the eradication that many forgot how pernicious inflation can be. The roughly 20 years or so from about 1985-2006 have been called the "great moderation" and seemed to usher in a dawn of a new age with low inflation, low risk, and low interest rates. This significant achievement was based on a wave of central bank independence in most OECD countries and a consequent rise in the public perception of the credibility of anti-inflationary macroeconomic policy.

However, in recent weeks, there has been a stream of bad news concerning inflation. In Russia, inflation had been declining steadily from a high of 20 percent as recently as 2000 and reached its low point of 7.5 percent year-on-year in March 2007.

Then the deceleration stopped and inflation reaccelerated in the late autumn, reaching almost 12 percent for 2007 as a whole. The momentum continues unabated.  In February, inflation rose further to about 13 percent year-on-year, and it could be heading toward 15 percent in the months ahead if net capital inflows resume and budget spending expands. Finance Minister Kudrin, who has been appointed the head of a government task force to urgently rein in inflation, optimistically hopes to achieve 8.5 percent this year, but no one in the private sector believes that he will come anywhere close.

This development is discouraging. It saps the patience of the population that bears the brunt of inflation and pushes the government to take desperate actions in an attempt to demonstrate its resolve to reverse the increase in the price level. It would seem that almost whatever the authorities try to do now, inflation is unlikely to revert to single digits any time soon.

Ominously, it appears that Russia's inflation problem is part of a global problem. In China, inflation accelerated last year to an 11-year high of 4.8 percent. And in the wake of the worst snowfall China has faced in decades - which affected power supplies, closed factories, and disrupted transport - February's inflation was 8.7 percent. India's inflation unexpectedly accelerated in recent months to reach a 4 percent annual rate, fueled by food prices. Sharply higher food prices also pushed Brazilian inflation up to 4.5 percent in 2007, ending a five-year period of disinflation. And Eurozone inflation surged to a 14-year high of 3.3 percent in February, well above the ECB's target zone.

In the United States, concerns over inflation are tempered by an even more overwhelming preoccupation with what could be the most severe recession in at least a generation. The Federal Reserve, while reducing its lending rate to 2.25 percent in mid-March, only noted that inflation was a growing concern, even though the price level rose last year by 4.1 percent - the highest rate in 17 years.  Recently Chairman Bernanke has indicated his willingness to further reduce rates, leading the dollar to fall to an all-time low to the Euro.

This worldwide inflation surge must surely be more than a coincidence. If so, then individual national efforts to fight it may be doomed. And a systemic change may also be happening as observed by Alan Greenspan: after years of exporting deflation, China and India may now start exporting inflation instead.

The irony, of course, is that this sudden re-emergence of inflation occurs as the world economy is slumping. Since economic downturns are normally associated with disinflation, the situation seems contradictory. How can there be too much liquidity if some major economies are entering a recession?

The fact is that in large parts of the financial system market liquidity is in scarce supply. The supply of credit is tightening and the price of risk is going up. But at the macroeconomic level, liquidity remains abundant.

The world is still flush with savings as it has been for several years. One striking example of this: the giant current account surpluses of the oil exporters including Russia, and of other emerging markets including China, which represent surplus national savings. 

To some extent, the liquidity paradox is an illusion, deriving from the fact that we use the word liquidity to describe several distinct ideas. As investors have discovered in recent weeks, macro liquidity (plenty of savings) does not guarantee cheap and available credit, or micro liquidity (ease of buying and selling in markets).

WHY IS INFLATION HAPPENING NOW?

To understand, start with key role of the U.S. as the hegemonic financial power. U.S. monetary policy is transmitted to other countries via exchange rate regimes where rates are aligned or pegged to the dollar, as well as by the U.S. dollar's role as the ultimate "safe haven" currency and unit of account for major world commodity markets.

With the repricing of risks that began with the subprime mortgage meltdown last summer, there has been a severe impact on asset values as the U.S. enters an election period and as baby-boomers with inadequate savings start to retire. This has led to a rapid easing of monetary policy by the Fed, and loose money is transmitted to the rest of the world.  In turn, this feeds a global commodity boom, with the further assistance of distorted subsidies for grain to produce ethanol and of supply constraints.

The American authorities seem ready to do almost anything to avoid a financial market meltdown. This is perhaps understandable given the importance of the financial sector to the global economy and the fear that, with today's high prevailing debt levels, a financial meltdown could easily result in a severe recession

But it suggests that, in the long run, the authorities are losing some of their anti-inflationary discipline. Short-term American interest rates are, at 3.4 percent, now below the headline inflation rate of 4.3 percent. It is unusual, in the last 20 years at least, for short rates to be negative in real terms. Nevertheless, the Fed is cutting at a time when the U.S. budget is in deficit (a situation that the fiscal stimulus package will exacerbate) and when the dollar has been falling for much of the last 12 months. It all adds up to a pretty loose economic policy.

Why is it so important? We should recall what Keynes wrote in 1919:  "Lenin is said to have declared that the best way to destroy the Capitalist System was to debauch the currencyÉ Lenin was certainly right. There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one man in a million is able to diagnose."

In this context, we could imagine a hopefully unlikely but plausible scenario: economic decline and volatility would lead the U.S. to abandon its guardian role of the key reserve currency in an effort to support its domestic economy. There could be a wave of political populism with the foreigners to be blamed.  In essence, the U.S. would try to monetize its debt problems away - much as the Russian authorities were considering in early August 1998.  In this case, the U.S. rapidly loses its pivotal role as financial hegemon, especially since it is the largest debtor country. In turn, this would accelerate a process already underway in the 21st century for the economic center of gravity to shift to the East and South.  In the interim, this could lead to instability at best with multiple centers of economic power.  But it is unlikely that the US would willingly accept - or even comprehend - its diminishing role. 

There is usually inertia in economic relations outside of times of war. Once a currency is widely used for official and private transactions around the world, and once it is widely held as a reserve currency, its use is likely to continue. However, that situation can change. If a central bank fails to sustain confidence in the future value of its currency, participants in the global market will eventually find substitutes for the currency. One of the consequences of globalization is that substitutes do exist for any currency if policymakers allow its purchasing power to deteriorate.

Even then, historically, changes may occur only with a long lag. For instance, even after the United Kingdom ceded its position as an economic superpower early in the 20th century, the pound remained an important international currency. In the present context, this inertial bias favors the continued central role of the dollar.  However, this may not be the relevant precedent as the UK remained a major creditor nation, while the U.S. is now the world's largest debtor. Doubts about the future soundness of the dollar could bring a swift change in its preponderance in global finance.

In the meantime, in order to maintain their pegs to the dollar, foreign central banks have been forced to print their own currencies to buy all the dollars accumulated by their exporters. This has resulted in upward pressure on consumer prices in their respective nations, with annual increases now reaching alarming rates. Bernanke's message of benign neglect means U.S. exported inflation will likely increase even further in the years ahead, exacerbating the inflation pressures for those nations now supporting the dollar.

WHAT CAN BE DONE?

In Russia, as elsewhere, inflation is imported from Washington (although there are certainly other factors at play in each case),  Russians have a particularly vivid and recent experience with inflation. Both Kudrin and the CBR Chairman Ignatyev, who witnessed first-hand the consequences of the 1998 crisis, have no desire to tolerate a resurgence of inflation. 

So why is inflation occurring in Russia when no one wants to repeat the experience of trying to bring inflation under control? What is Russia to do? It seems that the government is unable to control inflation. In the absence of a truly independent monetary policy, the most powerful measure would have been to cut planned budgetary expenditures. But this is hard to do socially when the Government already runs a large surplus.

Other options are limited and all involve costs. Governments around the world are responding, each in its own way, to the re-emergence of inflation that they had so painfully brought under control in the last few decades of the 20th century.

For instance, price controls are being used, to different degrees, to control inflation in Asia, South America and Africa. It remains to be seen if these controls are as efficient as macro policy at curbing inflation, or if they simply distort market prices - but, as in Russia, where "voluntary" controls are being tried, many countries find it hard to remove price controls given the hardships and threats to social stability caused by rising food prices. Some countries have canceled plans to scale back food subsidies.  The problem for Russia, and some other countries, is that there are no easy options.

Ideally, since the problem originates largely in America, it would be logical to seek the solution there.  No doubt the dollar's relative strength results from still favorable factors such as America's political stability and military might, its large $13 trillion economy (27 percent of global GDP), deep and liquid financial markets for bonds and stocks. 

The U.S. economy requires net financing from the rest of the world of over $2 billion every day, absorbing almost two-thirds of net global savings.  If central banks decide simply to withhold new purchases of dollar assets, the results would be catastrophic so the Fed has a vital interest in a strong dollar.

The willingness of individuals and governments to hold a particular reserve currency depends on how they view the stability of that currency's long-run purchasing power. A potential loss of purchasing power can erode the economic benefits associated with using any particular currency for international trade. When viable alternatives exist, individuals and governments will gravitate toward the currency with the most stable purchasing power.

The debtor position of the U.S. underscores a key point, which is that a central feature of the next couple of decades could be about the unwinding of the "dollar balances" - even in the absence of the current U.S.-led inflationary burst. 

The inevitable decline of the dollar as the world's reserve currency could be a painful one. U.S. consumption and economic activity will be so constrained by the need to repay dollar liabilities owed to foreigners, as to lead to a build-up of social pressures or inflation or both. The U.S. is unlikely to pursue such a painful path willingly and we can expect some recourse to economic, financial, political and maybe even military options to avoid or delay the inevitable.

WHAT COULD BE THE CONSEQUENCES OF RENEWED INFLATION?

Central bankers in advanced economies, including the Fed, have largely lost control over money supply growth. The private sector in a globalized environment is able to borrow in countries where interest rates are lower (such as in Japan or Switzerland) and easily bring money to any destination. This increases volatility on currency markets. Meanwhile, central banks now have less power in influencing the macroeconomic situation worldwide than they have had in the past, and more emphasis should currently be placed on fiscal policy as a tool for making macroeconomic adjustment.

In the absence of restored fiscal prudence, the United States risks undermining the faith foreigners have placed in its management of the dollar - it can continue to sustain low inflation without having to resort to growth-crippling increases in interest rates as a means of ensuring continued high capital inflows. It is widely assumed that the natural alternative to the dollar as a global currency is the euro, but faith in the euro's endurance is not assured. 

The implication for the international financial order is that the U.S. risks losing its key currency role sooner rather than later. This would not be without costs to the rest of the world. The use of a universal currency like the dollar has been beneficial, and has served as a source of stability in international relations. A global financial system without a key currency anchor could be a crisis in the making.

Managing the consequences of even a small surge in global inflation could have profound effects when the political classes in leading countries are focused on domestic issues and no one is willing to play a leading role in this adjustment process.  It would certainly not be the U.S. where one is still left with the reality of an unsustainable path of high budget deficits, low national saving, and high current account deficits.

The danger is that the resulting political tensions, including U.S. protectionism, may disrupt the global economy and plunge the world into recession or worse.  Russia has no attractive options.