Give Brazil's managers the management prize

The return of global inflation
July 28, 2008

Global inflation is back, and it is shuffling the kaleidoscope of world economic development. Some countries that had appeared to be thriving are coping poorly with inflation while others, including at least one chronic inflation recidivist, are showing a level of monetary maturity worthy of the Fed’s 1980s Chairman Paul Volcker and far ahead of his feckless successors Alan Greenspan and Ben Bernanke.

First, a brief monetary primer. It was established pretty convincingly by Milton Friedman, and proved beyond all doubt in the inflationary episodes of the 1970s and 1980s that if you want to bring inflation under control, you must set interest rates at a margin above the current inflation level. That may not be sufficient to do the job – sometimes, as today, countries may be affected by a global inflation about which they can do little – but it is undoubtedly a necessary condition for success, except in those few cases where global inflation disappears magically without significant action by an individual country. Even in such cases, exceptional monetary sloppiness may have cemented inflation so firmly into the system that monetary heavy artillery is later needed to remove it. In Britain after 1973, for example, the effect of the first oil price shock was moderate, and tempered by Britain’s own growing oil production. However monetary policy was so sloppy in 1971-75, with highly negative real interest rates, that by the time oil prices had stopped rising, in 1975-76, inflation had embedded itself deep in the British economy. At that point sterner methods were needed – which Margaret Thatcher’s government duly provided, with much pain of bankruptcies and unemployment, in 1979-82.

It is often believed that only the United States of the three major developed economies has inflation problems, but this is not entirely the case. The US certainly is in a difficult and worsening position, with inflation of 5%, even on the fudged Bureau of Labor Statistics figures, short term interest rates held down artificially to around 2% and huge amounts of liquidity being pumped into the banking system to rescue Bear Stearns, Fannie Mae and Freddie Mac and any other financial institution currently suffering a hangnail. In the Eurozone, inflation hit a record 4.0% in June in spite of the strength of the currency, and can be expected to get worse in the months ahead thanks to the European Central Bank, which has been expanding euro M3 at 10% or more for the past two years, approximately double the growth rate of Eurozone GDP.

Even in Japan, where policymakers and Western analysts have been bleating about deflation for a decade, inflation has now reared its head, being 2% in the year to June, well above the Bank of Japan’s target interest rate of 0.5%. This is unsurprising; the Bank of Japan under its previous Governor Toshihiko Fukui, appointed in 2003 by the admirable reformist prime minister Junichiro Koizumi, had been attempting to raise Japan’s target interest rate to a more normal 2-3% range for some years. After a rise to 0.5% in February 2007 Fukui was prevented from further rises for several months by the political uncertainty surrounding elections, and then in August the subprime crisis broke, depriving him of further support for tightening. Now he has been replaced by the politically acceptable and therefore inflationist Masaaki Shirakawa, and there is little sign of Japan’s interest rates being increased to deal with a rapidly increasing inflation problem.

It is a great pity the rate-increasing opportunity was missed. Japan’s economy is dominated by its legions of aging savers, who have been receiving nugatory returns on their money for over a decade, and who deserve to cushion their impending retirements with savings returns approaching a normal level of 3% plus inflation. Raising rates to 2-3% last year would thus have been economically stimulative, not restrictive, and would have prevented Japan from falling into the same inflationary bog in which the world is now wallowing.

In emerging markets, inflation has generally risen to rather higher levels. This is not because emerging markets have sloppier monetary management than developed countries (outside Zimbabwe it is difficult to imagine sloppier monetary management than that of the Greenspan/Bernanke duo, though I shall shortly present an example thereof.) However emerging markets are more exposed to commodity and energy price rises, because more of their citizens are impoverished and spend a high proportion of their incomes on commodity-related items. The price of gasoline is a more important factor in the lives of last year’s 8 million Chinese automobile buyers than in those of the 16 million US buyers.

Looking first at the four BRIC countries anointed by Goldman Sachs in 2003 as the pillars of future global growth, we find one monetary failure, two countries struggling with the problem and one surprising success.

The failure is Russia, a country blessed in this decade with every advantage, and managing even so to forge an economic trajectory leading directly back into poverty. Russian inflation is currently 14%, while its benchmark interest rate is only 11%. Needless to say, that inflation rate is heavily understated. Furthermore, Russia pursues policies of property confiscation and arbitrary state action worthy of the worst be-medaled Latin American caudillo. Once oil prices fall back it’s likely Russia will fall into a combination of high inflation and deep recession that will enrage even the battered Russian populace.

Neither India nor China are tackling inflation effectively. In India, inflation is running at 12% compared with a benchmark interest rate of only 8.5%. Furthermore, India is attacking the problem with price controls and government subsidies, which are having their usual effect of distorting the economy (making Indian oil refining, for example, an economically suicidal business). The government is also running a huge budget deficit, even at a time of massive economic boom. Fortunately in 2009 the Indian electorate will be given the chance to undo their terrible mistake of 2004, when they threw out the BJP government of Atal Bihari Vajpayee, the only truly free-market government India has ever had. Vajpayee has retired; whether the new BJP leaders are as committed to the free market and as economically competent only time will tell, but re-election of the Congress Party coalition would almost certainly prove disastrous, particularly as the mildly reformist prime minister Manmohan Singh is already 76.

In China, if you don’t like the government, tough. Inflation is nominally 7.1%, but that figure is distorted by subsidies and almost certainly artificially suppressed pending next month’s Olympics. In any case interest rates at 7.47% are far too low to have any beneficial effect, particularly as returns for savers are only around half this level. In both India and China therefore, while property rights are safer than they are in Russia, savers are losing ground all the time even before tax, not the recipe for a healthy economy .

Before turning to the last and well-governed BRIC, a couple of other examples which may be illuminating. Vietnam has inflation of 27%, but that is almost entirely imported. Its benchmark interest rate is only 14%, but its economy is highly unstable; it runs a trade deficit of 30% of GDP, balanced by a foreign direct investment inflow of 65% of GDP. While theoretically Vietnam is not doing enough to stem inflation, in practice its economic position is so singular it may find inflation an inevitable price of improving rapidly the living standards of its people. The country has a real estate boom, as one would expect given its negative real interest rates, but overall its problems are mostly those of success, and it seems likely that an end to the world commodities bubble will also cool inflation in Vietnam.

Finally, the Idle Apprentice, to contrast with Brazil’s Industrious Apprentice. Dubai has enjoyed a construction and tourism boom on the back of record revenues to the Gulf region and the oil-rich United Arab Emirates of which it is a part. It has used the money to build ever more extravagant prestige construction projects, including the world’s only 7-star hotel, its tallest building, an $82 billion aerospace project to include the world’s largest airport and a recreation of a world map in the harbor. With only 0.02% of the world’s population, and expatriates representing 80% of its workforce, it employs 10% of the world’s tower construction cranes. Its inflation rate is 22%, while long term mortgages are available there for 7%. Needless to say, the construction boom is proceeding without hope of restraint – after all the country has combined the monetary policy of Ben Bernanke on steroids with the building frenzy of the 2006 Florida condo market. Once oil prices drop back to any kind of long term equilibrium, probably much higher than their historical level but below $100, Dubai should be in for the mother of all construction crashes. By 2010 one can expect it to be a forest of half-completed concrete, with 10% residential and commercial occupancy rates. GE has just announced an investment of $40 billion in Dubai infrastructure; it is most unlikely to see its money back.

Finally Brazil, which in the past has indulged in the typical Latin American follies of excessive government spending, wild borrowing sprees, hopelessly sloppy monetary policy leading to hyperinflation and inadequate protection of property rights, particularly foreign property rights. Now things are different. Foreign debt has halved as a percentage of GDP since 2002, while the government’s finances are in only modest deficit. Foreign investment is encouraged and its rights protected. Most impressive, while inflation is around 6%, because of high commodity prices, the benchmark Selic interest rate has just been raised to 13%. At that level, inflation will be squeezed out of the system and excessive borrowing will be discouraged. Thus when the commodities boom from which Brazil has benefited deflates, Brazil will be able to lower interest rates and continue domestic expansion without fear of running out of money. The Nobel Committee really needs to give a prize for monetary policy; from the above survey of mild or extreme inflation-producing sloppiness there can be no question that Brazil would win it and deservedly so.

It is unclear why Brazil has since 2002 deviated from the usual Latin American track, exemplified by the basket-cases of Argentina, Venezuela and Bolivia. One can speculate that the honor of being termed a “BRIC” super growth market – quite undeservedly so, in 2003 – caused Brazil to attempt to live up to its new billing – like the wayward teenager who is straightened out by a teacher who values his achievements.

The overall lesson from the above review is as usual bearish. Almost all the world has abandoned proper anti-inflationary discipline and is destined to suffer a period of high inflation and recession in the coming years. Some countries, like Dubai, will become true basket-cases, others like China and Vietnam may muddle through fairly satisfactorily. Only a few countries like Brazil have taken the inflationary threat sufficiently seriously and will thus be in a position to continue expanding even while the rest of the world endures recession.

The monetary Idle Apprentices are about to get their comeuppance.