Martin Wolf’s FT economist’s forum, 9th September 2006
Andrew Smithers
Response to Martin Wolf’s FT article 6th Sept 2006 ‘We must act to share the gains with globalisation’s losers’.
Martin is eloquent as well as correct in emphasising the gains from globalisation and the need to preserve them. I particularly liked his comment that “…the offshoring of tasks is the equivalent of technological progress”.
It is, however, impossible in a short article to cover everything that matters and I think it is important that we should be alert to some of the temporary impacts that have resulted from the rise in globalisation and which have encouraged unsuitable policy responses.
One example is the impact of developing economies on world inflation.
Rapidly growing economies have naturally rising real exchange rates (Balassa-Samuelson). This can be effected either by inflation rates which are above average, or by rising nominal exchange rates. The choice is, however, important.
If, as China has chosen so far, the nominal exchange rate is pegged, then the route will be via higher inflation. The transmission mechanism is a rapid build up in foreign exchange reserves, which cannot be fully immunised and leads to rising inflation. The process is not without frictions and delays, so that the temporary impact is to lower inflation everywhere, improve the terms of trade of mature economies and increase liquidity.
The alternative, which is to allow the nominal exchange rate to appreciate, will generally produce a less risky and more even adjustment.
One unnecessary, but important, impact of the way globalisation has actually developed has thus been to depress inflation on a temporary basis. Another has been to increase world liquidity both directly, through the need to finance rising exchange reserves and indirectly, by encouraging easy monetary policies in response to the temporary impact on inflation.
The risks involved have been multiplied by two biases for which the Federal Reserve has been criticised, even by other central bankers. One is the belief that asset price inflation can safely be ignored; the other comes from the asymmetry of developing economies’ influence on the inflation rates of mature ones. If their development pushes up raw material prices, including oil, relative to goods’ prices, inflation indices which ignore one but allow for the other will underrate the risks of inflation.
Whatever the reasons, it seems clear that asset prices have moved out of line with incomes. Either nominal asset prices must fall or incomes must inflate. If the second is unacceptable to the Fed, its ability to manage the US economy as nominal asset prices fall will be a severe test. If they are successful, it will provide good evidence that ignoring asset prices and concentrating on “core inflation” are the correct policy guides for central bankers. If not, then contrariwise.