Wednesday, October 25, 2006
Globalisation, inflation and confusion
Posted by David Smith at 10:30 AM
Category: Thoughts and responses

Charlie Bean, the Bank of England's chief economist, gave a speech yesterday on Globalisation and Inflation, which is worth reading. There are a couple of things, however, I found a bit unconvincing. He thinks the impact of globalisation on international prices - the China effect - may be wearing off. I think it is impossible to say that, particularly as the experience of the past couple of years has been coloured by high energy prices.

Second, he dismisses the argument that the Bank seems to regard both rising and falling oil prices as bad news as "nonsense". But he went out of his way to dismiss core inflation measures in a speech a couple of months ago, so clearly regarded the rise in oil prices as bad news for inflation. By the same token, the Bank is also worried that falling oil prices will lead to higher wages and margins, so are also bad news.

It is fine for a central bank to raise interest rates to nip inflationary pressures in the bud. But there are perfectly straightforward arguments for doing that, without resorting to much thinner ones.


Maybe my economic knowledge is a bit basic, but I always believed that inflation was a purely monetary problem when the supply of money grows at a greater rate than production. A basic supply/demand curve, if more money is printed then its value wil fall, or to put it better the cost of everything else in terms of money will rise - inflation.

With a limited amount of money being "spent", any price rises will be offset by a reduction in demand offsetting any infationary pressures

Posted by: steves at October 26, 2006 04:13 PM

Assuming China cannot continue to cut prices year on year the only other factor that ought to influence UK prices is if a higher proportion of goods and services, previously available from more expensive sources, are provided by China. China has its own problems in so far as it's starting to experience a labour supply crunch, particularly at managerial level. Yes there may be untold millions of people in the countryside but they can't all be transplanted into the available jobs.

Even India's service sector businesses that have grown as Western companies have outsourced work are experiencing labour supply problems.

In terms of China producing cheaper consumer durables presumably most of the counter inflationary benefits have already come into play.

Given the controversy about the composition of the basket of items on which CPI and RPI inflation are based it will be interesting to see if the Treasury rebalances those baskets when Asian produced consumer durables no longer act to offset inflation in areas like UK services and energy.

And I don't buy into the idea of a new economic paradigm now than I did when it was being trumpeted during the dot com era. Economics is as much psychology as it is number crunching - and people still rush for the door en masse when someone shouts fire.
My instincts still scream that there are serious imbalances in the world economy and things don't always come back into balance in a nice, orderly manner.

Posted by: Jonathan at October 27, 2006 03:44 AM

The China effect will continue as China's share of world trade grows - shifting global production from high-cost locations to China. I don't know of anybody who doesn't expect a significant increase in China's share of world markets in the coming decades. Not only that, but China has scope for enormous productivity gains.

As for the supposed labour shortages, this is a classic 'man bites dog' story. China has plenty of workers, skilled and otherwise. One example: more than half of China's 2006 graduates did not have graduate jobs to go to.

There has been a new paradigm during and since the 1990s, certainly in America - with a shift to a significantly higher productivity growth.

Posted by: David Smith at October 27, 2006 10:58 AM

On the topic of rising money supply, I suspect the MPC may have made a rod for their own backs a couple of years ago when they stopped factoring money supply growth in their inflation assessments and just let it run away to its current level of around 14% - its highest in 16 years. I read that the two most recent MPC members Sentance and Besley (who of course were not on the MPC when the decision was taken) expressed some concern at the effects of M4 growth on inflation.

From the last MPC decision it looks like the message has not sunk in yet, even though the effects may well be gathering speed.

I agree David, that there are strong and weak reasons for pre-empting inflation with rate rises - I just worry that the MPCs' eyes have been off the ball for some time.

Posted by: g campbell at October 27, 2006 01:35 PM

It is simply not true that the MPC stopped taking the money suuply into account - it has been part of their assessment since independence and continues to be.

What's M4 telling us? Probably not much. The data tell us that there is a lot of lending to other financial institutions, including hedge funds, and may just be reflection of financial market activity.

As always, the money supply raises more questions than answers, which is why formal monetary targeting was sensibly abandoned in the 1980s. The relationship between broad money and money GDP changes regularly, the 'chicken and egg' problem persists - does the money supply lead, follow or rise in parallel with economic activity. Applying the tradition monetarist two-year lag, the money supply did not predict the recent rise in inflation, nor could it have done - it has no locus on global energy prices.

Posted by: David Smith at October 27, 2006 06:09 PM

M4 growth doesn't tell us much? Am I on the right forum here?

velocity x money supply = real GDP x real GDP deflator

So if our real GDP growth is not currently 14%, we're almost certainly heading for a sharp inflationary upswing. THAT is what Sentance and Besley are concerned about.

But with M4 growth at its higest level for over 16 years now, it's unclear how the MPC is concretely taking it into account in their inflation assessment - if at all!

As I've said I suspect they're studiously ignoring it, and hoping that after they let go of the reins a couple of years back, the applecart will somehow steer itself.

Posted by: g campbell at October 27, 2006 06:42 PM

Yes, right site but simplistic monetarism, which you seem to believe in, has never worked. As I say, the MPC does monitor M4. The relationship between M4 and money GDP is not a precise one, indeed it appears to be extremely imprecise. You need to look into a bit of the history of this, to see how broad money measures have been spectacularly unreliable in the past.

There's a very easy sum to do on this: In the past 10 years money GDP has risen by less than 70%, M4 has risen by 120%. Great relationship.

Indeed, I can recommend a very good book --- The Rise and Fall of Monetarism, which I wrote quite a long time ago.

Posted by: David Smith at October 27, 2006 07:03 PM

You're throwing the baby out with the bathwater. Monetarism is a different thing altogether. What I've said is ignore runaway M4 supply at your peril (or rather allow the MPC to ignore it at our collective peril).

Sentance, Besley and I are agreed on that. You can heed what you wish.

Posted by: g gampbell at October 28, 2006 12:37 AM

In that case, I might ask why you were quoting the quantity theory of money, and predicting a sharp rise in inflation. But I won't. As I say, interpretation of M4 is not easy at the moment, but it is of concern to the MPC, and it is one of the reasons why they will almost certainly vote to raise rates next month. It's always worth looking at the MPC's minutes, rather than relying on summaries.

This was from August, when Bank rate was raised:

'Against the background of firm growth, limited spare capacity, rapid growth of broad money and credit, and with inflation likely to remain above the target for some while, the Committee judged that an increase in the official Bank rate was necessary to bring CPI inflation back to the target in the medium term. Most members favoured an immediate increase of 0.25 percentage points to 4.75%.'

Posted by: David Smith at October 28, 2006 10:09 AM

Then I would ask you why you why you thought fit to ignore M4 money supply (where the newer MPC members have warned about it) in your statement:

"What's M4 telling us? Probably not much."

But I won't either.

The well respected NIESR has recommended a 50 base point increase already, even without wage settlements taken into account, but I've no doubt the warning will fall on deaf ears.

Posted by: g campbell at October 28, 2006 10:59 AM

Well hats off to you David - no one can accuse you of fighting shy of a debate. However I think we need to be mindful of what happens to the rest of the world as production shifts to China - particularly to countries like the UK that have struggled to improve productivity.

And I think your view of labour problems in Asia is rather rosy tinted. One of the big problems that many Asian countries face is not producing graduates, but producing ones that are employable. Malaysia, which I know well, has at least 80,000 unemployed graduates, most of them male. But what do you do when they have degrees in things like Islamic studies, or more generally are products of an education system that gives them bits of paper but no marketable skills.

The answer is that case is to create jobs for them in a bureaucracy that's increasingly becoming an obstacle to doing business rather than a facilitator.

Even in the UK there's the question of what you do when you raise the expectations of graduates by encouraging them to take degrees but where the degrees, like media studies are again difficult to market.

I don't want to overstate it as a factor but there is a real issue of a mismatch of skills to work in this part of the world. And I stand by my assertion that Chinese companies are struggling to fill key managerial posts.

Posted by: Jonathan at October 28, 2006 11:36 AM

I like a debate, but I get irritated by people who don't take anything in when I take the time to try to explain - and I don't mean you Jonathan.

So let me say this again. The MPC has collectively expressed its concern about M4 - Besley and Sentance did not vote to raise rates this month because of their overwhelming worry about broad money. It came, for them, at the end of a very long list of other reasons. So, G. Campbell, read the minutes. It is there in black and white, and they are easily accessible. The right place for M4 is indeed in a long list of factors. The moment the MPC started obsessing about broad money to the exclusion of these other factors would be the moment we would really be in trouble.

While I'm at it, the National Institute did not call for a 50-basis point hike in interest rates. Its director Martin Weale said to raise rates by that amount in November would be a bad idea. It predicted that rates would rise to 5.25% by next year, before levelling off and possibly coming down, which is a different thing. The National Institute, if you know anything about its history, is the last organisation to call for a rate hike on the basis of broad money growth.

On your point about Chinese management Jonathan, I admit there is a problem. But there always has been and that hasn't stopped China from being price competitive. Turning the people who have traditionally run state enterprises into commercial managers is not easy. Incidentally, many of the unemployed graduates in China hold business and engineering degrees.

Posted by: David Smith at October 28, 2006 12:58 PM
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