Wednesday, June 1, 2011

Global Inflation – It takes 150 to Tango.

The US inflates the money supply leading to a trade deficit. This alone should cause the value of the dollar to depreciate relative to the currency values of its trading partners. Because the dollar flows abroad and because the dollar is the world’s reserve currency, other countries hold these extra dollars – doing so by buying dollar assets. This pressure keeps the value of the dollar stronger than it ought to be and raises the value of US bonds, stocks, and other assets. It also puts downward pressure on the currencies of US trading partners and leads to inflation in those countries. When we import goods from those countries, we also import inflation. It is a long and treacherous global circuit but it shows that what goes around comes around – that is, inflation of US money causes inflation of prices in the USA.

The above scenario was borrowed (I hope correctly) from an article in the Wall Street Journal on May 24, 2011 by Ronald McKinnon called “Return of Stagflation.”

I fully concur with Professor McKinnon’s assessment that inflation is around the corner if not already on our door steps. But I think that not enough responsibility or blame is assigned to US trading partners for the transmission of inflation and the occurrence of stagflation. Yes, the US is culpable but his analysis and policy advice is incomplete because it minimizes the roles played by our trading partners and especially the so-called transforming nations. 

It is true that too much money creation in the US causes inflation in the US and the solution involves a reversal of US monetary policy. But while US monetary policy is not helping to control world inflation it is also true that the policies of other countries do little to deal with world inflation either.  Let’s call these other countries co-conspirators or at least enablers.

What is wrong with the discussion of the first paragraph is that it treats foreign countries like robots – or like Pavlov’s famous dog that predictably salivated when a bell was rung. In fact many of the trading partners of the US are more like mean dogs that bite when the bell rings (and when it doesn’t)!  A distinctive common goal among many developing countries is that they pursue economic growth through exports. Anything that might cause their currency values to appreciate could do harm to this goal and they react with policies that offset the appreciations. That means increasing their money supply – either domestically by buying domestic bonds or internationally by buying foreign currencies. If it is the US that is causing their currencies to appreciate they would buy dollars. If it was Europe causing them headaches they would buy euros. If it was Brazil leading to currency appreciation, the offended countries would buy reals.

Let’s suppose a country – let’s call it Kirstia-Allia – found its currency (ThePretty) rising and thereby threatening its exports of dancing shoes and tutus – reacted to this attack by buying euros. This market action would normally push the value of ThePretty downward and viola save the day. This action also increases the supply of The Pretty. Of course, Kirstia Allia, has other options. Each option below has its own impacts on Kirstia-Allia and the world. Which one is most desirable to a transforming nation depends on its own economic situation and goals. But clearly this list shows that Kirstia-Allia does have control over its money supply and does NOT have to transmit inflation generated by any another country:

·         Recognize that exchange rates are not the only factor affecting their exports and not worry about the currency appreciation. Sales might remain strong despite the appreciating currency
·         Recognize that it might be more effective to sustain exports through policies that made their products more competitive – through lower national inflation or subsidies/tax schemes designed to enhance global competitiveness
·         Recognize that rising exchange rates may be beneficial in ways that might be more important than exports – making imports cheaper and inducing increased inbound foreign investment.
·         Recognize that a policy to beggar-thy-neighbor through export management isn’t viable for the long-run and that it is beneficial to move towards an economy where domestic consumption and investment become more important relative to exports.
·         Recognize that inflation is important and implement a two part monetary action that keeps the money supply from growing: (1) selling ThePretty for euros and (2) selling domestic bonds for ThePretty. By doing these two actions they increase and then decrease the domestic money supply. That is, they insulate or neutralize the international operation with a domestic one. In doing so, they assert control over their own money supply and price level. 

Trading partners are not dogs that always react to bells with spit – they are entities with numerous goals both in the long-term and short-term. They DO NOT HAVE TO hold on to dollars and they do not have to allow an influx of dollars to cause inflation. When dollars flow in that are NOT needed to buy US goods, services, or assets – they can simply sell them – putting even more pressure on currencies.  Depending on the country’s goals, this more extreme currency experience may or may not be debilitating but is the right thing to do. This is especially true with respect to the US – the reserve currency country – who is causing havoc through its own selfish and misguided monetary policies. If the US supplies too many dollars for the world to digest and countries choose to hold their reserves in non-dollar currencies, then the source of the global inflation problem will be more apparent and there will be:

·         More global attention to the misguided US policy
·         More US attention to the misguided US policy
·        A move away from the dollar as a reserve currency

The conclusion is that while the US is now the guilty vortex, it is also true that many other countries are not innocents in the process of global inflation. These countries, through their own selfish and misguided policies abet and unwittingly support the US.  The world is not automatically sentenced to global inflation because of US monetary policy – it very much depends on the goals and policies of our trading parties.

You might retort that if countries don’t use the extra dollars to buy US assets then they will have to buy assets of other countries. And this is true. So why aren’t they more willing to buy the currencies and assets of say China, Brazil, Canada, and many others? The answers are numerous and depend on the specific circumstances of each country. China’s currency is not fully convertible. Other countries may be growing rapidly but a more thorough look at these countries might uncover risk flags.  Despite all the failures of US policy the big picture suggests that to date US assets offer some stability and insulation from extreme financial risk. So many countries continue to hold or buy dollars and dollar assets because they offer attractive risk adjusted real returns. This is not so much because the dollar is the world’s reserve currency. It makes sense because the US offers better/safer investment returns.

So these countries are not without some blame for current global trade problems. If China, India, Brazil, Canada and various other countries had better overall economic policies, then perhaps more nations would be more willing to buy their currencies and assets to replace dollars.

Our current global situation is a phase of a long-term economic development process wherein a couple of world wars and a cold war intervened and held back the economic progress of many countries. Since the 1950s we have witnessed a gradual if not fitful time period in which many countries experimented with and then shed some pretty awful economic policies. But the transformation is not complete and despite great economic progress in many countries, they still contain visible and troublesome weak spots. The world is investing more of its money in these places and will invest even more as time and further actions solidify a more sanguine view of their investment worthiness.  As risks in these countries converge on US risk, we will enter a new time where US mistakes will lead to fewer global ramifications and where the US is no longer able to propagate world inflation.

So let’s keep pointing our boney digits at the US. But let’s also recognize that any real solution requires that US enablers have to clean-up their acts too.  Yes, the US is responsible for printing too much money and leaving it out there for too long. But China needs to hasten its pace of economic development and reply less on exports. Along the way it needs to make its currency fully convertible and more open to market changes. India, Brazil, S. Korea and several other developing countries have responsibilities to find balance between exports and domestic spending. They too could hasten the pace of reforms, especially those that reduce trade barriers. So long as the world gives these countries a free pass we are stuck in second gear—a gear that guarantees that the US has a disproportionate effect on the global economy. We can make the US a smaller disturbance by making the US a more equal global trade partner. We do this not by making the US smaller – but by making her trading partners whole.


  1. In the case of China they need to free their RNB from the US dollar and let it float with the global economy. As it is now they can produce cheap goods which are exported to the US(no or little tariff) and bought by selling US bonds to China. Is this different and if so by how much than the other countries where their dollar floats in the open market?

  2. James,

    Below I paste a list of countries that pegged against the dollar as of 2008. When the dollar depreciates these countries would be at a competitive disadvantage if they did not depreciate too. So they try to keep their exchange rates relatively fixed against the dollar. Note that China has let its currency appreciate against the dollar since 2005. The appreciation has been gradual and less that what the US would like but it illustrates that the RMB is not totally fixed against the dollar and is headed in the right direction.

    Of course, my post this time explains why this mentality may be over blown. Countries have other ways to improve trade and manage than their economies. For example, China would be well served if they had better domestic policy to control growth and inflation.Well managed reforms in currency, finance, and economic development would help a lot more than their current exchange rate policies...

    Here is the paste: As the actions of China and Syria indicate, no list of pegged currencies can always be accurate. Nevertheless, as of 2008, there were at least 17 national currencies pegged to the U.S. currency, not counting other organizations that maintain a similar link. These include the Netherlands Antillean guilder, Aruban florin, Jordanian dinar, Bahrain's dinar, Lebanon's pound, Oman's rial, Qatar's rial, the Saudi riyal, Emirati dirham, Maldivian rufiyaa, Venezuelan bolivar, the Belize dollar, the Bahamian dollar, the Hong Kong dollar, the Barbados dollar, the Trinidad and Tobago dollar, and the Eastern Caribbean dollar, which is used by Antigua, Dominica, St. Kitts, St. Lucia, St. Vincent, the Grenadines and Grenada

    Read more: What Currencies Are Pegged to the Dollar? |

  3. So what's the big deal? China ships us their manufactured goods, and we buy them with the dollars they loaned us.

  4. Crash,

    I think James is concerned that by China manipulating their currency we lose exports and jobs in US manufacturing. But James can speak for himself...

    My additional belief is that this is not good long-run policy for China since it is unsustainable to keep lending money to America. They have better things to do with their money. It also contributes to rising US and global inflation.

  5. Yes! They can use their money to build more sophisticated weaponry with the technology we have given them/they have stolen from us. Eventually, along with Pinky and The Brain, they can take over the world an we won't care about inflation...or much else for that matter.

    I had two bowls of Depressios this morning.

  6. Crash,

    I hope you had a little milk and bourbon on those depressios.

  7. Are these circumstances comparable to anything before the dissolution of Bretton Woods?

  8. John,

    Bretton Woods lasted from about 1946 to 1971. Under this system currency rates were fixed against the dollar. The dollar's value was fixed to gold. When a currency had market pressure on it the country had to buy or sell its currency until the market value converged on the agreed fixed value. This system had its ups and downs. Sometimes countries were given permission to fix at a new value if the old one no longer seemed relevant. The system ended when the US failed to keep its pledge to maintain a constant value to gold. The US monetary policy was causing global inflation. Since the US would not promise to reverse its monetary policy and therefore could not keep the gold peg, this ended the system. Today we have similarities since some countries willingly peg to the dollar. Thus US monetary policy has been causing global inflation. Nowadays the difference is that these countries do not have to keep their currencies pegged tot he dollar. And that was the point of my blog -- they are willingly participating in a process of global inflation. They have other choices.

  9. Just my two cents. You go into a bar around 9:00 PM and order a Becks and check out the babes. When closing time rolls around a few hours later you have a stack of Becks bottles on your table and are still checking out the babes; but they have all started to look better than they did at 9:00.

    The US dollar is one of the babes that has been there since 9:00, but is looking a lot better after drinking Becks, especially compared to the other babes.

    It is not so much that the US dollar is the best choice for currency buyers, rather that the other choices are worse choices.

  10. Dear Rage,

    I'll drink to that.

  11. "It is a sobering fact that the prominence of central banks in this century has coincided with a general tendency towards more inflation, not less. [I]f the overriding objective is price stability, we did better with the nineteenth-century gold standard and passive central banks, with currency boards, or even with 'free banking.' The truly unique power of a central bank, after all, is the power to create money, and ultimately the power to create is the power to destroy."
    -- Paul Volcker, former Federal Reserve chairman

  12. While Volcker is correct and always worth listening too the probable truth is that we will never return to the 19 century or a situation without a central bank. Seems to me we could control inflation under the current system if central bankers would just keep their eyes on one ball -- inflation. Unfortunately that isn't going to happen under Bernanke.

  13. Yes, and it is the focused intent of this administration to continue to print more money then spend it as fast as it can.

  14. By law the Fed is independent of the administration and has both the right and the responsibility to not fund or monetize government deficits. Unfortunately Bernanke has not exercised his right of independence and acts as if he is a member of the administration. That's a shame but this will provide a nice chapter in a future textbook as to how not to do central banking.