Overview: The Inflation Genie

The imbalance between demand and supply is the root of inflationary dynamics. Prices rise when demand is greater than supply, and they drop when the imbalance reverses. There are multiple caveats and exceptions, but the rule is a tenet of basic human behavior. For most of the 1990s, the global situation was one of excess supply. China’s re-integration into the global economy flooded the marketplace with an enormous supply of cheap goods and labor. Given that most of the labor force entering the marketplace was at sub-Saharan subsistence levels, their initial impact on global demand was nil. Hence, global inflation dropped, despite high rates of GDP growth. However, the growing prosperity in China converted it from being an exporter of deflation to a source of global inflation. The impact of 1.3 billion new consumers, or 22% of the world’s population, triggered a shift in global demand. China’s caloric intake, for example, jumped 30% since the 1990s. This had a huge impact on the agro sector. There were increases in domestic production, but China was forced to increasingly rely on external food markets to meet its domestic needs. Soybean imports tripled during the last three years. Similar trends were repeated across most of the developing world, putting additional stress on global markets. For the last 50 years, most of the world’s output was consumed by less than 15% of the total population, but the growing prosperity across the developing world increased the competition for goods and services—thus unleashing the inflation genie. Unfortunately, myopic government policies are making the situation worse.

There are two effective policy responses when demand and supply are out of kilter. The first is to curtail demand and the second is to increase supply. Unfortunately, most governments are doing the opposite. Instead of stabilizing their economies, they are doing their best to widen the imbalances. For example, governments around the globe are imposing price controls. Mexico was the latest to jump on the bandwagon, introducing price controls on 150 food items. The problem is that the use of price controls is an artificial construct that only aggravates the disequilibrium. Price controls remove the elasticity that tempers demand and supply when imbalances appear. As a result consumers consume more and producers produce less, thus exacerbating the gap between demand and supply. Argentina is a case in point. The use of price controls on residential electricity led to an indiscriminate use of power, to the point where the country halted its energy exports in order to attend its domestic market. The same thing occurred in Indonesia and Mexico. At the same time, the use of price controls removed the profit incentives for producers to invest, thus leading to a decline in output. Policymakers should be doing the opposite. They should liberate prices, incentivize investment and foster competition in an attempt to increase supply. However, not all countries opt for price controls. Some countries, particularly in Asia, rely on subsidies. Nevertheless, the result is the same. The use of price controls obviates the homeostatic mechanisms that are endemic to the marketplace. The decision by many Asian governments to keep fuel prices artificially low through the use of subsidies only led to more demand. At the time, it blew holes in their fiscal accounts, thus erasing the resources available to increase investment and output. The more they tried to put the inflation genie back into the bottle, the more it found ways to escape.

Unfortunately, U.S. policymakers are doing their fair share to help pull the genie out of the bottle. The large fiscal and current account gaps confirmed that the country was living way beyond its means. The objective of U.S. policymakers should be to restore equilibrium. However, the Fed’s obsession with rescuing Wall Street is only fanning the inflationary fires that are spreading throughout the globe. This will only create social and political unrest. Social pressures are already mounting. Truckers across Latin America and Europe are striking—producing food shortages in many urban centers. Some companies are being forced out of business, leading to an increase in unemployment. This is a moment when the IMF could be playing a major role in providing independent policy assessment, advice and coordination. However, the Fund is sitting on the sidelines, without a mandate to address the problems that are on the table. Given that policymakers are doing their best to stymie investment, this means that it will become very hard to coax the inflation genie back into its lair without a major reduction in global demand.