Does globalization cause inflation?

Does globalization cause inflation?

Does globalization cause inflation?

Moneybox
Commentary about business and finance.
April 26 2006 5:06 PM

Inflation Everywhere

Globalization used to drive down prices. Not anymore.

The conventional wisdom on inflation can turn on a nickel—and on copper, zinc, and gold. Trading data from the New York Mercantile Exchange and the Markets section of the Financial Times chronicle the relentless rise in commodity prices. Copper (more than $7,000 a ton), nickel ($20,000 a ton), and zinc ($3,385 a ton) have all recently hit record prices. Gold is above $600, while oil trades hands for $72 a barrel. Rates on the 10-year U.S. government bond have spiked above 5.10 percent, hitting levels not seen since 2002, largely because of fears that inflation is picking up. And it is. The consumer price index rose at a 4.3 percent annual rate in the first quarter of 2006, compared with 3.4 percent for all of 2005.

Ironically, one of the chief culprits of today's inflation—and today's fear of inflation—is the same source that has kept inflation low for much of the last two decades: globalization.

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It's long been an article of faith among economists that the increasing integration of national economies contributed heavily to the global decline in inflation. As then-Federal Reserve Chairman Alan Greenspan noted in this May 2004 speech, globalization affords Americans access to goods and services that are produced more cheaply abroad in places where large labor forces work for less money (e.g., China and India). Charles Fishman reported in Fast Company that Wal-Mart—one of the biggest single contributors to American productivity growth in the 1990s—in 2002 accounted for "nearly 10% of all Chinese exports to the United States." Globalization also allows domestic companies to hold down labor costs—via outsourcing, or via the threat of outsourcing.

In addition, globalization forced the world's central bankers to raise their game to ensure that their countries can attract capital and investment. In a recent study ($ required), economists Richard Fisher and W. Michael Cox of the Dallas Federal Reserve found that "the more globalized nations tend to pursue policies that achieve faster economic growth, lower inflation, higher incomes and greater economic freedom."

But now globalization's deflationary run may be flagging. In its "World Economic Outlook," released earlier this month, the International Monetary Fund displays charts (on Page 98) that unambiguously show how inflation has generally declined around the globe in the last two decades—although the charts conveniently end in 2004, when inflation began to rise again. But as in investing, the past is not necessarily a guide to future performance when it comes to macroeconomics. The migration of U.S. manufacturing to China in the 1990s surely played a gigantic role in moderating inflation. But that can't be repeated. Once a factory is in China, its managers will have difficultly finding a place where labor costs one-fifth as much. And, indeed, there are signs that wages for skilled factory workers in China are on the rise. Meanwhile, the service sector, which dominates the U.S. economy, will likely have difficulty realizing the same type of productivity gains as manufacturing has thanks to globalization.

Then there's the matter of timing. In the early part of this decade, the global economy was in a deflationary post-bubble environment, characterized by excess capacity. Since then, however, we've had four straight years of global synchronous growth. (Quick: Name a significant economy that's in recession.) So, there are no weak markets to keep import prices down.

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There's another risk to inflation: the recent commodity boom, propelled by the rise of emerging economies. Globalization doesn't just mean that American companies gain access to cheap labor in the developing world, or that the cheap labor in those markets gains access to our rich markets. It means that people living in those places gain access to the infrastructure and products and services that we take for granted—like McDonald's or Chevrolets. China is one of the few bright spots for General Motors—last week the beleaguered company reported that vehicle sales in China were up 76 percent in the most recent quarter. In the coming years, car sales in China and India are likely to continue to grow rapidly.

Such growth is boosting demand (and prices) for steel, as well for rubber and other car components. But it's also boosting demand for gas—and raising concerns about the world's oil supplies. As Shai Oster noted in the Wall Street Journal, China is already the "second-biggest oil consumer after the U.S.," gulping about 7 million barrels per day. (The United States uses about 21 million barrels per day.) This forecast from the Energy Information Administration suggests that Chinese oil consumption will double in a dozen years.

In other words, the rise of a massive consuming class in China and, to a lesser degree, India, is making gas more expensive for everyone. A look at the most recent CPI report reveals that inflation is concentrated in energy. But when energy costs remain elevated for long periods of time, the higher costs start to spill over into other sectors. The cost of transportation has risen 5.1 percent in the last 12 months. And if the fuel surcharges tacked on in recent weeks by my garbage collection and lawn-care companies are any guide, the high cost of oil is being passed on.

Globalization means people all over the globe have a greater ability to share common experiences, whether it's watching the World Cup, buying lattes at Starbucks, or wearing clothes made in China. It may soon mean that we all have the ability to share the common experience of inflation.