Inflation, Not Deflation, Mr. Bernanke

The global economy seems to be bifurcating into the ice-cold developed economies and red-hot developing economies. Will the bifurcation persist?  If the two sides converge, which side will dominate?

Let me write the conclusions first: Inflation, not deflation, will dominate the global economy. The deflation scare causes the central banks in the developed economies to sustain a loose monetary policy. It will fuel inflation in emerging economies. Through trade, currency markets, and ultimately inflation expectations, inflation will hit developed economies.

We are seeing the interplay between the forces of globalization and policy mistakes.  Globalization has severely restricted the effectiveness of economic stimulus. Trade plus FDI are half of the global GDP. Trade is visible in terms of stimulus leakage. But, where investment occurs in response to demand growth is far more important.  Multinationals can invest anywhere in response to demand. It cuts the linkage between demand stimulus and investment response. The latter is crucial to employment growth, which is necessary for sustaining demand growth beyond stimulus. Essentially, demand is local, but supply is global. This is why the old assumptions on stimulus are no longer reliable.

The above analysis always applies to a small, open economy. A typical macroeconomics textbook will study the extreme cases of a small, open economy and a large, closed economy.  In the former, the leakage is so powerful that stimulus is futile. The latter has no leakage and has maximum stimulus effectiveness. The economies in the real world are in between. A large economy like the U.S.'s is always assumed to resemble a closed economy, while a small trade-oriented economy like Singapore's is close to a completely open economy.

Multinational-led globalization has made large economies behave like small, open economies. Demand is still local, but supply is global. When the Fed or the ECB tries to stimulate, they are actually stimulating the global economy as a whole. Water, no matter where it comes from, flows downwards. Stimulus, similarly, flows to where costs are low and banking systems are healthy. If you believe this logic, the actions of the Fed and the ECB fuel inflation and asset bubbles in emerging economies rather than stimulate growth at home.

A similar move occurred after the U.S.'s Savings and Loans crisis in the early 1990s. The Fed cut interest rates to 3 percent to help its banking system recover. The lower interest rates pushed Western banks to lend a lot to Southeast Asia, fueling a property bubble there. When the U.S.'s monetary policy was tightened, capital was pulled back. It caused the Asian Financial Crisis of 1997-98.

Today's story is much bigger and with more dimensions. The emerging economies are twice as big relative to the developed economies with double the trade volume relative to the global economy then. Investment and financial capital can now flow with little friction across the world. I suspect that the Fed policy today would cause distortions in the global economy three times as big as it did in the early 1990s. Its consequences would cause a global calamity far bigger than the Asian Financial Crisis.

The big difference from the 1990s is the employment response to the stimulus in the developed economies. Despite trillions of dollars in stimulus and a sharp one-year rebound in the global economy from the middle of 2009, the developed economies have virtually seen no employment growth. The consequences of the financial crisis have eaten away quite a big chunk of the stimulus. It is, however, not the full explanation. We are seeing overheating in emerging economies. The stimulus is just working somewhere else.

For the stimulus to work in developed economies, it needs to inflate costs in emerging economies so much that the multinationals want to add additional capacity in the developed economies. That is unlikely. The average wage in developed economies is about ten times the average level in emerging economies. And there are five people in emerging economies for each one in developed economies. The math just wouldn't work out for this approach.