The Up Side of Inflation

9 April 2011

Saturday


A longish article in today’s Financial Times, Global economy: An inflated outlook, was of some interest to me. As is usually the case, I was more intrigued by what it didn’t say but rather assumed, than with what the article explicitly stated.

The focus of the article was inflation in China, which has been rapidly gaining, and is now having global consequences. This demonstrates the rapid maturation of the Chinese economy as a fully industrialized entity. That is to say, the wealthy coastal cities that are fully integrated into the global economy, and which are more closely tied to the world’s other major ports, vendors, and purchasers, than they are to the largely still poor and rural economy of the Chinese interior, are fully industrialized. That means that, over time, the Chinese workers in these coastal cities (that are magnets for workers from the poor interior) will become consumers, will seek better wages and better opportunities, and will attempt to move up the economic food chain in the same way that China on the whole is moving up the economic food chain. The FT article mentioned that factories — heretofore the mainstay of Chinese economic growth — are already seeking less expensive labor by moving to the next tier down, setting up shop in Indonesia, India, Bangladesh, and Vietnam.

Chinese workers becoming wealthier will demand more and better quality consumer products, better career opportunities for themselves and their children, and a cleaner environment in which to live. These developments will inevitably drive inflation as the dollars these wealthier workers earn chase too few goods, and as prices are driven up in China, the rest of the world which has gotten used to buying cheap goods from China will have to pay more for these Chinese goods, eventually driving up inflation in all those countries purchasing Chinese goods.

People around the world will complain about the consequences of Chinese inflation, just as people over the past twenty years have complained about the consequences of China’s rising economic power. Either they don’t care or they don’t see that this is all part of the same process, and that the cheap Chinese goods that they were complaining about are now more expensive Chinese goods with which domestic producers can compete one something closer to being a level playing field. I have repeated argued in this blog China is experiencing its Industrial Revolution, and that an industrial revolution is a one-time historical process. It will not happen in China a second time any more than it will happen in England a second time. During an industrial revolution the entire economy is re-configured, and an economy going through such dramatic changes will look like it is an exception to every economic rule in the book. And it is — but only temporarily.

As China’s working consumers become wealthier and more sophisticated in their tastes, and China becomes wealthier and more subtle in its ambitions, China becomes more and more like the other economies of the developed industrialized world. In effect, China’s coastal cities have economies very much like coastal cities in western Europe and North America. It will take an additional several decades to bring the Chinese interior up to speed, and it will always lag behind in the same way as the center of the continental US does not possess the economic dynamism of New York or LA. This homogenization of industrialization between China and the industrialized West means that China will be buying German engineering products, patronizing US financial services, and going on vacations in the south of France. Money will increasingly move in both directions.

The FT article mentions three factors off-setting the global consequences of Chinese inflation: 1) labor represents only a small fraction of the cost of finished goods produced in China, 2) rising Chinese productivity, and 3) the above-mentioned shift in production. Of this last it must be pointed out that, in the fullness of time, the Industrial Revolution will also come to these other countries, and eventually there will be no cheaper place to move factories. The world will have to get used wealthier people everywhere. If the increase of wealth among China’s more than a billion people affects world markets and commodity prices, so too an increase of wealth among India’s billion people will eventually have the same effect globally.

This brings us to productivity, which is now seen to be central. Even in advanced industrialized economies like the US and western Europe productivity can continue to rise through technological innovations and smarter ways of working. Computers drove a revolution in productivity in the advanced industrialized economy (which is why you now deal with a machine and not a person when you call a company for help or go to the airport to get your boarding pass); this development has not yet run its course, and it has not yet been fully realized in the developing economies of the world. There is very little we can do about the spreading industrialization that will drive inflation, but there are most definitely things we can do in relation to productivity that will make a difference in the long term.

The way the Financial Times reports the story of Chinese inflation it seems strangely isolated from demography, but demography will play a major role in commodity price inflation in the future. This is for the simple and obvious reason that world population continues to grow. Even if standards of living stay static, or even if they decline, there are still ever more people consuming commodities, resources and energy, and this increased demand will drive up prices unless supply or substitution can make up the difference. Thus even if the world’s economies essentially stand still, and little or no economic growth occurs, commodity prices will continue to be driven upward by increased consumption by an increase in absolute population numbers.

And we know that population growth is not spread evenly over the globe, but is in fact concentrated in those regions of the world that are poorest and least developed. Thus demand for commodities will continue to increase in those parts of the world with the fewest technological resources to offset the growth through additional production or substitution of an alternative commodity. Productivity could make the greatest difference in these regions of the world, but these regions of the world are the least likely to benefit from innovative methods of increasing productivity, since the latter tend to be centered in advanced industrialized economies.

If global inflation in commodity prices were to be addressed on a global scale, the way to do it would be a massive effort to speed the industrialization of the developing world, so that the fruits of productivity could be brought more rapidly to those who need it most. But what we need is not the sort of indiscriminate growth that the Chinese Communist party has prioritized over all else in China. What we need is smart growth.

What is smart growth? Well, this is a subject that obviously needs its own exposition, as it is potentially a very large topic, but off the top of my head I would say that smart growth would be economic growth focused on sustainability, sparing and efficient use of energy, high productivity, extensive education, and the sort of developments that have only come late in the history of the advanced industrialized economies, but could, if the will to do so were present, be applied from the beginning, at the opening stages, of the industrialization of the developing world.

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