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.
