Exporting Inflation to the Rest of the World

weird effects caused by the weak dollar

Like many people, I’d let myself hope that last August’s global financial crisis was just that: a phenomenon arising from and largely contained within the narrow world of finance and capital markets. Much like the 1998 Long-Term Capital Management crisis, or the 1987 stock-market crash.

How wrong I was. The last two weeks have seen growing evidence that disorders in financial markets are having serious spillover effects in real economies around the world.

Everyone is talking about the extreme weakness of the US dollar, which has lost ground against every one of the world’s major trading currencies and continues to slide. The proximate causes of the weaker dollar are poor economic fundamentals in the US, and the Federal Reserve’s interest rate cuts.

Dollar weakness is evidently resulting in a very large and worrisome burst of inflation. In nearly every major economy except the United States.

We’re exporting inflation to the rest of world and not suffering much or any of it ourselves. This is really weird.

More.

Every day brings headlines about the contortions central bankers are putting themselves to, in an attempt to stem the inflationary effects of the weaker dollar. Some key examples:

China is about to raise interest rates and bank-reserve requirements for the seventh time this year (by my count). Food-price inflation, particularly for vegetables and pork, are contributing to an expected rise in inflation this year to almost 6%, from about 1.5% last year.

Chinese stock markets which are off-limits to foreign investors are in the middle of a price bubble that makes the Clinton-era Internet bubble look like a little fart. That’s logical when the inflation rate is higher than the government-controlled rate of interest on individual savings.

The China bubble is going to pop (in fact it may have started to pop already), and it’s anybody’s guess what will happen in this unprecedented situation. Not only has there never been an asset bubble that featured several companies worth nearly $1 trillion each, but it’s also never happened in a tightly-controlled economy with no free markets to pick up the pieces.

India has flirted with controls on currency movements for most of this year. They just pulled the trigger on some new restrictions on derivatives trading that are designed to restrict dollar sales by investors and speculators. The dynamics are somewhat different, but as in China, India is seeing asset-price spikes that are not justified by fundamentals. This can only end badly for India, which attracts only a fraction of the foreign direct investment that China does.

States across the Arab world are feeling the bite from higher oil prices. Oil is traded in dollars around the world, and the weaker dollar puts up the barrel price. There is talk of revaluing dollar-pegged currencies across the Persian Gulf, as the pseudo-economies of these states can’t handle the inflation.

South Korea is seeing serious declines in the results of major exporting companies like Hyundai Heavy Industries, and they’re blaming the strong won. Japan is seeing that effect with companies like Honda and Sony. (Toyota Motor’s problems appear to be more self-inflicted). And the Japanese are also getting an ugly spike in food and consumer-goods prices, just as they appear to be slowing into recession.

And Europe has started talking trade war. The strong euro leaves them no flexibility to raise interest rates, which they have wanted to do to curb high inflation, particularly in Germany. And now their economies have started to slow down as well. Hence the sudden tough talk by French President Sarkozy and European Central Bank governor Jean-Claude Trichet.

But here in the United States, inflation has been muted. There’s been a minor (but politically noticeable) uptick in food prices, that has farmers tickled pink for the first time in a decade, and consumers starting to grumble. And of course energy prices have faintly shadowed the increase in crude prices. I think you can make a case that the domestic food-price increases are partly caused by government-mandated production of ethanol from corn.

And our trade deficit has unexpectedly narrowed in recent weeks as American exporters are suddenly finding their products newly competitive in world markets. That’s the main reason why the Europeans are mad as wet hens. They want the US Treasury to go out and take concrete steps to increase the value of the dollar.

It’s also why Treasury Secretary Paulson’s mouth is saying a strong dollar is in our nation’s interest but his (in)actions are telling the rest of the world to go pound sand.

What does a central bank traditionally do when it considers foreign-exchange rates to be out of balance? It intervenes in the currency markets, buying and selling reserves in order to signal desired price moves to the markets.

But the markets know that trick now. They also know that they are larger than all the central banks put together. In fact, they are vastly larger. A jumbo-sized multi-country intervention might involve the purchase of a few tens of billions of dollars. But nowadays the currency markets can easily trade $3 trillion in a single day.

That’s why, even as they try to jawbone Hank Paulson to support the dollar with more than happy talk, none of the other central banks are willing to throw their own euros, yen, won, reals, sterling, kronor, loonies, Swiss francs, etc. into a gaping black hole. Traditional policy tools aren’t working.

Exporting Inflation

But why on earth is it that the rest of the world is suffering from the inflation that we’re creating? I think this exceptional phenomenon illustrates some perhaps under-appreciated features of the new integrated global economy.

In the first place, the United States still matters as much as ever.

It’s received wisdom that emerging economies around the world are growing faster and attracting more investment than the US, and also that China is rapidly transitioning to a consumer-led economy that will replace the US as a source of demand for goods and services.

Given that, it’s been nothing short of breathtaking to see how quickly the perception of economic weakness in the US has translated into slowdowns everywhere else. This exacerbates the effects of dollar inflation in economies that don’t generate enough organic growth to deal with it. The US is still the critical driver for world growth.

Second, the US is less dependent on imports than many people seem to think (including economically illiterate Democratic Senators and Presidential candidates). Foreign trade amounts to perhaps 10% of our economy. This is probably insulating us from the inflationary effects of importing foreign goods with weaker dollars.

Third, our economy may be more resistant to the effects of higher energy prices than many people think. 90% of the US economy is engaged in providing services rather than manufacturing goods or exporting resources. We have much more opportunity to capture the efficiencies created by improved information technology than other countries do. Just think of the fuel savings if everyone were to work at home one day a week. Things like that are already happening.

That partly explains why countries like Japan, which is still almost as manufacturing-driven as anyone else, are seeing so much inflation. Making and transporting widgets is energy-intensive. Higher oil prices make everything from rice to rice-paper more expensive, but they don’t have as much impact on your computer or your telephone.

At this point in mid-November, I expect continued severe disturbances in financial markets around the world. Just about the only things many people want to buy right now are short-term government debt, and commodities priced in dollars. There’s a lot of bears roaring out there, and they may be roaring for a good long time to come.

I also expect China to finally wake up, smell whatever they drink in the morning, and allow the yuan to appreciate sharply and rapidly against the dollar.

But the United States has a chance to emerge in a considerably stronger position in a somewhat smaller and slower-growing global economy, when we get to the other side of this big mishugas, two or three years from now.

What do we have to do make sure that happens?

Nothing. American businesspeople will figure it out and make all the right moves naturally.

But we have to make d*mned sure that no Democrat gets within spitting distance of the White House. Otherwise she’ll turn a fragile but promising situation into our competitors’ wettest dream.

They are one of the few sources of info on the global economies that are written in plain enough English that even someone like myself can follow.