Asia and Global Stagflation

The world economy is poised on a knife edge. The United States may or may not be technically in a recession, but it is undoubtedly experiencing a sharp growth slowdown. Having been in Ireland last week, where informed opinion doubts that growth will be positive this year, I suspect that not just Ireland but also the UK, Spain, Portugal, Italy, and the Baltics (that is, nearly everyone in Europe excluding France and Germany) – are in a similar position. So much for decoupling.

I am similarly skeptical about the prospects for decoupling in Asia. Asian countries can trade parts and components amongst themselves all they like – everyone talks about the growth of intra-Asian trade – but they still need someone to buy their final products. And with growth slowing to a standstill in the U.S. and Europe, it is not clear who that someone is.

Credit market turbulence has also affected Asia in negative ways. In the Philippines, sovereign spreads jumped by 200 basis points between August 2007 and February 2008. In the same period, spreads went up by 131 basis point in Indonesia, 93 basis points in Korea, and 70 basis points in China. Since the Bear Stearns rescue, these countries have seen their spreads decline, reflecting the belief or at least hope that the worst of the credit crisis is over. But more recently there have been capital outflows from Thailand, Vietnam and the Philippines. None of this means that growth in Asia will stop, but it does mean that a slowdown is likely. For those who say “there is not much evidence of this yet,” I say “just be patient.”

The new development, along with this growth slowdown, is the acceleration of inflation. In April headline inflation in Asia ex Japan was 7.5 per cent, a 10 year high. (You will remember, of course, what was happening in Asia ten years ago.) Core inflation was 4 per cent.

As for where this inflation came from, it came mainly from the United States. Starting last summer, in response to the subprime crisis, the Fed cut interest rates sharply. One can debate whether Bernanke and Co. overdid it, or whether they should have relied more on credit injections at penalty rates; such criticisms have an element of Monday-morning quarterbacking. But whether one agrees with this or not, it is indisputable that those cuts were not appropriate for Asia. The Asian economy was growing full out in 2007. The last thing it needed was lower interest rates. But that’s what it got, given the habit of limiting the fluctuation of Asian currencies against the dollar. Allowing Asian interest rates to rise more sharply against U.S. rates would have caused Asian currencies to appreciate against the dollar more strongly. And for all their talk of greater exchange rate flexibility, this was not something that Asian governments and central banks were prepared to countenance.

As a result, Asian economies that needed demand restraint got demand stimulus instead, what with the impact of central bank policies showing up first but slower growth in the U.S. and Europe taking time to develop and then feed through to other regions. There would have been more inflationary pressure in Asia in the first half of 2008, in other words, even without the geopolitical uncertainty, oil-market speculation, bad weather and ethanol programs that have garnered the headlines.

Note that this is quite the opposite of the now fashionable argument that Asia is exporting inflation to the West. To the contrary, the Fed, by cutting interest rates so dramatically, exported inflation to the East. To be sure, the failure of Asian central banks to tighten more aggressively does tend to re-export inflation back to the West. But to start there is to tell only the second half of the story.

What should Asian central banks do now? They should raise rates. There have been half-hearted efforts in this direction, but they have not done the job. Indonesia’s central bank rate is 8.5 per cent, but its inflation rate is above 10 per cent. The Philippines’ central bank rate is 5.25 per cent, but its inflation rate is 10 per cent. Vietnam’s central bank rate is 14 per cent, but its inflation rate is 25 per cent. It makes no sense when most Asian countries are growing at or near capacity that they should have negative real interest rates. Negative real rates are an unhealthy subsidy for borrowing by households and firms. They encouraged inefficient investment and excessive leverage in Asia in the first half of the 1990s, and we all know what followed.

These negative interest rates and their artificial stimulus to consumption and investment are also why we haven’t seen more of a slowdown in Asia – why we haven’t seen more recoupling. But now that Asian central banks are being forced to tighten, we will see more evidence of their economies slowing down. Asian currencies will appreciate against both the dollar and the euro. Although the Fed and the ECB may raise rates as well, both inflation and growth are weaker than in Asia, so they will have reason to respond more moderately.

Critics of inflation targeting will say that central banks have a dual mandate not just to fight inflation but also to foster growth and that Asian central banks have no business raising rates in a deteriorating growth environment. But the fact of the matter is that they now face a very serious test of their credibility, leaving no alternative to tightening. The alternative to painful interest rate increases now will be even more painful increases later.

Fortunately, there is another instrument for sustaining demand in these circumstances, namely fiscal policy. Higher interest rates will push up the exchange rate and damp down inflation. Tax cuts and increases in public spending on locally-produced goods will limit the contraction of aggregate demand. Insofar as these fiscal actions stimulate the demand for locally-produced goods, they will push up the exchange rate still further, which will moderate the rise in import prices and further contain inflationary pressure.

Which Asian countries have scope for responding this way? In China, there is likely to be a high return on additional infrastructure investment, especially in the relatively underdeveloped west where producers still find it difficult to get goods to the market. There is the need for public spending on reconstruction in the wake of the earthquake. There is the need for increased public expenditure on health care, education and pensions. That the public sector is running a current surplus of 4 to 6 percent of GDP, depending on who is doing the measuring, points to the existence of maneuvering room.

Elsewhere in Asia, tax cuts and public spending increases should be calibrated to the U.S. and global slowdown – in contrast to the case of China they should be explicitly temporary. Korea, Malaysia, Singapore, and Taiwan are at the top of my list of countries with room to expand public spending temporarily to offset the dampening effects of higher interest rates.

I am aware that what I am arguing Asia needs now – monetary tightening, currency appreciation and fiscal stimulus – is the same thing that the Bush Administration has been arguing for three years. But the fact that the advice is old hat and that it comes with unwelcome associations should not lead to its rejection. Now, when inflation expectations threaten to become unanchored and the outlook for global growth is increasingly clouded, the need for a change in the Asian policy mix is more urgent than ever.

9 Responses to "Asia and Global Stagflation"

  1. DC   June 19, 2008 at 10:35 am

    The real US Economy is collapsing. Auto sales are dropping to Depression-like levels. Bailouts for Wall Street, but not for the real US Economy: “From the Detroit Free Press: * After months of confident talk that Chrysler LLC anticipated the economic downturn better than other automakers, Chairman and Chief Executive Officer Bob Nardelli told employees Tuesday, in a memo obtained by the Free Press, that the last few months — and this month in particular — have been even worse than Chrysler anticipated. * So far in June, he said, J.D. Power and Associates and Citigroup are seeing a sales pace that is almost 20% lower — only 12.5 million vehicles per year. * “We thought we were being extremely aggressive in our conservative view” of 2008, Nardelli said late last month. “As it turns out we may have been spot-on.” * If J.D. Power’s forecast for June — an annualized rate of 12.5 million sales — continues for long, Erich Merkle of IRN Inc. said, it would be “Armageddon. Doomsday.” * “I don’t think there is anyone out there prepared for 12.5″ million annual U.S. sales, he said. “I know it is only one month, but still that would show some signs that there is some real deterioration in the market, that would mean the economy is really slowing down significantly.”” If this trend continues, the collapse of the Big 3 is inevitable, as they cannot re-tool fast enough to produce enough (low profit)sub-compact gas-sippers to make up for lost big pickup/SUV profits. Chrysler, GMC and Ford will fail in that order, although it is a real tight race to the bottom. Toyota and Honda are laughing, while the rest weep.

  2. bsetser   June 19, 2008 at 2:25 pm

    Dr. Eichengreen — I very much agree with your analysis and recommendations. I woudl though argue that Asia’s inflation didn’t come from the US so much as it came from Asia’s own policy of following the US in order to limit currency appreciation. The ECB hasn’t followed US monetary policy even though there were strong financial interlinkages between European banks and the US market.

  3. akmi   June 19, 2008 at 5:19 pm

    Why should the Fed care about conditions in other countries unless they affect the U.S. economy? It’s not like we force asia to peg to the dollar (or do we?). Asia needs to take charge of its problems at home and realize its high commodity demand is causing its own inflation headache. U.S. oil demand has already slowed yet oil prices are still rising to new highs. Maybe asia already knows its role in high commodity prices but doesn’t care enough yet to stop the rise using monetary policy. Or maybe it’s just waiting for the U.S. and/or developed markets to make a move and intervene on behalf of the dollar by raising policy rates. Fortunately, China, India and some smaller asian countries are cutting fuel subsidies… as the cliche goes, "the cure for high prices is high prices". Besides, any single asian central bank’s rate hike (except maybe a very large revaluation by China) would do little to curb commodity price rises and may just exacerbate the downturn in already fragile demand growth (like in smaller countries like the Philippines that rely on dollar remittances to prop up investment and consumption). Maybe Asia should coordinate a joint policy rate hike or currency revaluation, to remove any intra-regional competitive pressures that keep individual central banks from making independent moves that have a first-mover DISadvantage.

  4. Anonymous   June 19, 2008 at 10:04 pm

    Monetary action has probably delayed because central banks thought inflation arising from supply side factors cannot be dealt with monetary tightening. Unfortunately, inflation started leading to higher inflation expectations, feed to the rest of the economy and raising the risk of wage–price spiral. Moreover, they wanted to abstain from rate hike given that domestic demand was their last hope as US slowed. But soon they realized they had to decouple from the Fed (which itself is fighting a growth vs. inflation battle)

  5. Guest   June 19, 2008 at 10:12 pm

    Unfortunately, current fiscal positions of many Asian countries may deter them from raising fiscal spending (Raising oil prices may have provided some relief to subsidy burden, but if oil prices rise further, they won’t be in a position to raise prices further without facing the social and political consequences). Also, some of these smaller countries with fiscal vulnerability are also the ones which would be deeply affected by global slowdown.

  6. Guest   June 19, 2008 at 10:23 pm

    Seems like even though some Asian countries want currency appreciation (to control import inflation), there currencies are actually trending down as capital is flowing out. Looks like the global players are posing a perfect storm for the Asian central bankers. It raises the serious question of why did these economies after all make themselves so dependent on exports rather than giving the purchasing power and entrepreneurial ability to its own people, and why did these economies allow large capital inflows to create exuberance in their asset markets. So one should not be surprised if Asians follow the American way of becoming pessimistic about globalization.

  7. Anonymous   June 19, 2008 at 10:26 pm

    Guess timing is the issue: they need to tighten and appreciate currency to control inflation for now, but as global economy slows and commodity prices decline, the impact of fiscal expansion will kick in, which then can be complemented by rate cuts and currency depreciation.

  8. Guest   June 19, 2008 at 10:37 pm

    Given the nearly double digit inflation in some of these countries, there is a limit to which interest rates can be raised. They will have to wait for commodity prices to ease (i.e. easing of oil speculation and export restrictions on food). At least the Fed staying on hold or tightening in the next few months may provide some relief.

  9. Guest   June 20, 2008 at 8:28 am

    It is the revenge of the Inconsistent Trinity!