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01 October 2023

Inflation could be cure for US economy

By Julian Bene


Inflation could be the quickest cure for America’s problem, but no central banker would ever admit it. After all, the problem is that lenders pushed borrowers into mortgages at prices they could not afford on their salaries. If those salaries were to rise the way they did back in the 1970s, hey presto, the mortgage payments would become affordable and house prices could stay up in nominal terms.


It is an awfully tempting solution to a crisis, but things would have to be pretty desperate before our current generation of inflation fighters who stand at the monetary controls could be persuaded to go along with it.


For now, most Western central bankers are professing to be relatively unconcerned about inflation. They see core price increases – excluding food and fuel – as holding quite steady, in the two per cent per year range. This could prove vital. If a US recession were prolonged, there would be a need for low interest rates for a similarly long time, and that would be within the realms of orthodox economic management as long as inflation does not break out.
A US slowdown that also cooled growth in Asia might bring the prices of natural resources down from their record highs: there are hints of this already. To the degree that commodity speculation, rather than underlying demand, is behind the spikes of 2007, prices may have a good way to retreat in 2008. That would be a benign, counter-cyclical factor, allowing loose monetary conditions for longer than otherwise.


A potentially troubling question is whether inflation optimists are ignoring what is happening in China on the prices front, which seems likely to feed through to importing economies sooner or later. China is trying to stop inflation by freezing prices.


Last November, consumer prices in China were nearly seven per cent above where they had stood twelve months earlier. That is undesirably high for the Chinese economy and also could be a bad sign for inflation in the rest of the world, now that China is everyone’s low-cost supplier. In view of the rapid growth the country has experienced for several years and the consequent demand pressure on many resources, this inflation is, however, entirely to be expected. So now the Chinese Government has prohibited increases in the prices of oil products, natural gas, electricity and piped water. Good luck.


Perversely, by interfering with the one market signal that dampens demand for scarce resources, China will actually stoke even more local consumption of energy and postpone investments in energy-saving technology. That will lead to inflation in the traded prices of energy commodities, unless something like a US recession reduces demand somewhere else in the world. Local Chinese oil refiners will again be caught in the crunch between free world market prices of crude oil and controlled domestic prices of oil products. Last time China tried this, it led to shortages as refiners refused to lose money by supplying the market with petrol. It is inevitable that controlling gas prices will lead to shortages unless coupled with subsidies from the taxpayer, or it will end with bankruptcy for the refiner. The Beijing Olympics could be more than usually entertaining if visitors have to bring their own petrol.


The price freeze may sound like a natural holdover from China’s communist-style planned economy heritage. Yet it is an approach that has been tried before in the West to dampen inflationary expectations and wage bargaining, with little success. The stagflationary era of the 1970s saw both the US and Britain trying to use wage and price controls to stem the tide. It was only when governments gave up and allowed monetary authorities to squeeze out inflationary expectations – by sending interest rates through the roof and producing a deep recession – that price rises came back to moderate levels.


For China, the obvious anti-inflation policy change to try first would be to let the yuan float, which almost certainly would result in a big revaluation upward. The other orthodox economic approach, a monetary squeeze to combat inflation, would make maintaining the yuan at artificially low levels even harder, and would hurt Chinese citizens more than a revaluation. A stronger yuan would decrease the prices of imports in yuan terms, control domestic inflation and increase the purchasing power of the Chinese consumer. To that degree it would be quite painless.


What China fears from a free yuan float is what, as we have already noted, needs to happen sooner or later: importers of Chinese manufactured goods are going to have to pay more in dollars, which may reduce their appetite for Chinese exports. A free yuan float could also drive up inflation in countries where low-priced Chinese goods have won a significant share of the shopping basket and have provided an inflation-free lunch to monetary authorities for years.


However, some analysts argue Chinese imports are so much cheaper than the alternatives that they are going to be expanding their share for years, even at higher prices than today, if the yuan rises.


If that is so, these cheap imports would keep overall price levels flat in the West because they keep substituting for more expensive items in the consumer basket. The snag with that logic is it seems to require Americans and others to continue down the path of over-borrowing and over-spending that has just caused the juggernaut to come off the rails. It also threatens to further deepen any job losses that would come with a bad US recession. The US has reportedly lost three million manufacturing jobs to China this decade. If the United States-China trade gap worsens, that would be an invitation to protectionism by the US.


Both the Chinese and the rest of the world’s economies seem destined to move back into closer balance, with everyone tending to consume roughly as much as they produce. It may be less easy in such a new environment to control inflation than it was when the vast cheap labour pool of China first opened to the world economy.


We cannot have everything. A somewhat slower rate of global growth that keeps inflation in check may be the price we pay for more even trade balances, reduced indebtedness, and a system less prone to disruption or crisis. After the stock market ructions of the past few days, global economic leaders may be increasingly keen to see this better balance. Whether they can get there soon is as another matter.