Stock markets around the world were spooked last week by an apparent resurgence in inflation and central banks’ worldwide attempts to combat it. To a bearish observer, the current market jitters raise a quite different question: why, in the face of low interest rates and rapid money creation over an entire decade since 1995, didn’t inflation tick up earlier and more rapidly?
One can rule out some popular explanations. U.S. productivity did not experience a “miracle” in the decade following 1995. It rose somewhat more quickly than in the preceding decade, but much less quickly than in the postwar economy of 1947-73. Its rise was mostly caused by a surge of capital investment, so that multifactor productivity, correcting for both labor and capital factors, rose rather more slowly than in all recorded previous decades save the lengthy “oil shock” adjustment of 1973-82.
The United States was not alone in experiencing unexpectedly low inflation in 1995-2005. Britain and the EU both found an unexpected respite from price pressures, while Japan experienced significant deflation. The full entry of India and China into the world economy has exercised a substantial downward pressure on world inflation, yet that begs the question of why India and China chose the period after 1990 to enter the world economy, and not some earlier era. There has been no effective political change in either country. The Communists still run a one party state in China, and demonstrated with the Tiananmen Square massacre of 1989 and subsequently that they intend to remain immune to the liberalizing forces which swept the Soviet Union.
India, too, is still dominated by the statist Congress Party in an alliance that includes strongly anti-market elements, while the brief pro-market trend in government policy under Atal Bihari Vajpayee’s BJP in 1998-2004 has vanished as if it had never happened. Manmohan Singh’s inability to force through his policy priorities as India’s Prime Minister make it laughable to suppose that he was more able to produce a policy revolution as a mere finance minister after 1991. Yet China and India’s economic growth continue at a remarkable rate, and neither the obvious banking system problems in China nor the obvious state funding and infrastructure problems in India have shown any sign of slowing those countries’ progress.
If little changed politically after 1990 to produce the economic emergence of China and India, the cause must be sought outside the political arena, and here there is one obvious suspect, the communications revolution of cellphones and the Internet.
Much speculation in 1995-2000 revolved around the possibility of the Internet producing a “singularity” by which economic growth would be accelerated into a dizzyingly prosperous future. As U.S. productivity data demonstrates, when examined in detail that hasn’t happened, and isn’t about to. Internet communication was readily available in Western countries from 1994-95 and in the Third World from 1997-98, while cellphone technology was both available and relatively cheap worldwide from 1998-2000. No singularity in Western economic performance has occurred.
One would nevertheless have expected a communications revolution of this magnitude to have had a major economic effect, and a study of economic developments over the last decade demonstrates that it has indeed had one. Before 1995, if you wanted to outsource manufacturing to China, you were subject to substantial communication difficulties; you could communicate only over an expensive land line that more or less required both parties to be at their office (difficult with a 12 hour time difference) and written communication was subject to the vagaries of fax, and generally only possible on an overnight basis. Distribution logistics, too, were subject to the same barriers as well as to the infrastructure difficulties of operating within China. Only by exceptional effort could production scheduling be carried out remotely. Thus the greater convenience of producing domestically, or even in a low cost country with better timezone and communications, such as Mexico, outweighed the theoretical labor cost advantages that China offered.
After the Internet and cellphones became available, the logistics of Third World manufacturing became much simpler, and the logistics of Third World service production were revolutionized. Provided one side or the other was prepared to work in the middle of the night, the possibility opened of instantaneous communication between manufacturing plant and design, marketing or costing. Services could be provided in real time while the buyer remained unaware that the service provider was the other side of the world. For a wide range of products and services, the possibility opened of instant worldwide labor sourcing.
Naturally, this produced a substantial downward pressure on costs, which has continued for a decade as the communications revolution worked through. It also produced a sustained and increasing U.S. balance of payments deficit, as products and services were outsourced to the Third World and a surge in corporate profitability as outsourcing companies and discount retailers captured much of the benefit of the new lower labor and product costs. The Fed, the ECB and to a lesser extent the Bank of Japan ran monetary policy without adjusting for the new communications’ effects on inflation, thus producing artificially easier money, lower interest rates and higher asset prices without the usual resurgence in inflation.
In essence, nirvana – ever rising stock and house prices, low interest rates and low inflation. However the nirvana must inevitably prove temporary, even though the internet/cellphone communications revolution has by no means played out.
First, there is a fairly limited range of products and service for which remote manufacturing and service provision makes sense, and which were heavily affected by the new communications. Some products, such as automobile parts, had already been manufactured in lower cost labor centers and the cost gain through moving from say Mexico to China was not that great.
Other products and services are highly capital intensive or design intensive, so the savings from remote manufacture are modest (though outsourcing design itself offers important benefits.)
Other services, in particular tourism, hotel services, retailing and construction, cannot at present be provided remotely. The United States has produced downward pressure on prices on these, too, by allowing high and unregulated immigration, but at great social cost, producing little gain in overall efficiency and a wealth transfer from low income earners and government social security budgets to the rich and corporations.
While high speed telephone lines are continuing to spread, they remain subject to the infrastructure glitches that plague the Third World, and are thus likely to remain restricted to big cities outside the West. Further Internet and cellphone developments, such as the ability to watch movies in real time, may revolutionize the entertainment industry, but offer no equivalent bonanza to business communication. Thus the Internet/cellphone communications revolution was indeed a major event, particularly in countries outside the major Western consumer markets, but it is largely complete, and its initial “singularity” effect is already several years in the past.
Once rapid communication with India and China has been fully established, there is little further to be gained from the communications revolution, and natural market forces will begin to erode the benefits it provided. Physical movement of goods has not been greatly affected, and remains limited by poor infrastructure and grasping customs officials. As outsourced manufacturing and services spread, local costs will rise rapidly, as shortages of skilled and language-capable labor appear and taxes, energy costs and infrastructure costs in India and China soar. Commodity prices will also soar, raising costs and causing spot shortages that disrupt production. Rapid economic growth will continue in India and China, but will spread only unevenly to the Middle East, Latin America or Africa, where countries left behind by India and China will see their productivity decline (as has happened in the last two decades in Latin America) and will become increasingly alienated and unable to join the new world economy.
As inflation ceases to be artificially suppressed, it will rise, and central banks will find themselves needing to raise interest rates more than they expected to combat inflation that proves unexpectedly stubborn. Interest rates that were appropriate when international inflation was suppressed by say 2 percent per annum will become too low when it is suppressed by only 1 percent per annum and much too low when it is no longer suppressed at all because a new equilibrium has been reached.
If interest rates, both short and long term, rise more than expected, and the artificial stimulus to profits from rapidly falling world unit labor costs is removed, asset prices will appear far too high. Profits will fall back to their natural level, share prices will be doubly affected by the decline in profits and the rise in interest rates and asset prices will enter a period of huge overhang and illiquidity. The result cannot fail to be a major Western recession, which itself will produce still lower profits, asset prices and stock prices – the artificial stimulus of the late 1990s will be removed as the world returns to equilibrium. Rapid economic growth will continue in India, China and the better run parts of the Third World, but that will be of little consolation to Americans and Europeans who have lost their job, had their homes repossessed and seen their retirement savings devastated.
Of course, the missing link in this tale of disaster is the time period over which the effects of the communications revolution pass their apogee, and its price suppression effects begin to decline or go into reverse. While one could construct an economic model to estimate how large the one-off effect of the communications revolution across the world should be, over what period it should take place, and at what point within that period the price effect should begin to go away, the reality is that we don’t have data accurate enough to do this, and may indeed not have the full theoretical background to do it properly, even if data was available – after all, this is quite dissimilar to any previous event in the world’s history.
However, if analysis can’t tell us in detail when the favorable price effect of the communications revolution will begin to diminish, there are some pretty clear signals that will be emitted when it does so. Inflation in general will begin to rise, while central bank increases in interest rates will lag behind it. Commodity prices will increase rapidly, as the increased purchasing power in China and India produces bottlenecks. The U.S. dollar will begin to decline as the trade deficits produced by product and service outsourcing become unsustainable, and it adjusts downwards to the new economic realities. Finally, prices of U.S. imports will rise rapidly, as cost increases and bottlenecks in the Third World begin to eliminate the extraordinary efficiency gains from manufacturing and service outsourcing, and bring the system back into equilibrium.
Friday, the Bureau of Labor Statistics announced that U.S. import prices rose unexpectedly by 1.6 percent in May, or 0.6 percent excluding the effect of petroleum imports. This followed a 2.1 percent jump in April, and marked the largest 2 month increase in import prices since October 1990.
Be afraid! Be very afraid!
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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
This article originally appeared on United Press International.