[OPE] Morgan Stanley's Stephen Roach and the prospects for stagflation: blame Asia?

From: Jurriaan Bendien (adsl675281@tiscali.nl)
Date: Fri Jun 13 2008 - 23:42:23 EDT

Stephen Roach, the erudite chairman of Morgan Stanley Asia, says in an FT article "Fears of 1970s-style stagflation are back in the air."

Stagflation would mean rising prices with near-zero or negative growth in gross value added, which normally implies escalating unemployment and a "capital strike" (reduced productive investment).

But he says, "Yet today's stagflation risks are very different from those that wreaked such havoc 35 years ago. Unlike in that earlier period, wages in the developed economies have been delinked from prices. That all but eliminates the automatic indexation features of the once dreaded wage-price spiral - perhaps the most insidious feature of the "great inflation" of the 1970s. Moreover, as the stunning surge of the US unemployment rate in May suggests, slowing economic growth in the industrial economies is likely to open up further slack in labour markets, thereby putting downward cyclical pressure on wages over the next couple of years."

In other words, modal real wages have tended to stagnate (although of course the salaries of top executives have risen explosively), and therefore are not the primary source now of inflationary pressures. Modal real wages would indeed tend to fall in the medium-term.

The "new threat", he says, "is arising from the developing world, especially in Asia, where price pressures are lurching out of control." What he means is that markets in these countries are, effectively, growing too fast, and he provides evidence for this.

His argument is then that "Throughout the region, central banks are keeping short-term interest rates far too low to combat these inflationary pressures. For developing Asia as a whole, a GDP-weighted average of policy rates is currently about 6.75 per cent, fully three-quarters of a percentage point below the 7.5 per cent headline inflation rate."

At some point, interest rates are likely to rise in developing Asia, in response to price inflation, increasing the cost of borrowed capital, and reducing output growth rates. In Japan's deflationary regime, of course, interest rates are still very low, although the experts think this will not continue. Mr Roach argues that:

"Such monetary accommodation in an increasingly inflation-prone developing Asia spells a persistence of elevated price pressures in this vital segment of the global production chain. Not only does that threaten living standards for newly prosperous households in the developing world; it also takes an especially severe toll on those at the lower end of the income distribution. And, of course, it provides a price shock to imported goods in the developed world, which now play a much greater role in meeting the demands of domestic consumption."

Added to the price shock of higher-priced primary commodities (notably foodstuffs and oil) would therefore be an increase in the import prices of manufactured products (finished and semifinished goods). 

He concludes:

"Notwithstanding recent pressures in bond markets, the world remains largely in denial over the outbreak of a new strain of stagflation. The hopes of "core inflationists" depend on a reversion in food and energy prices to take headline inflation lower in the developing world. Yet this will be the sixth year in a row when that has not happened. The "market purists" are counting on currency adjustments - especially sharp appreciation of currencies in developing Asia - to temper the transmission of price pressures from these export-led economies. Yet these are not economies that want to use the currency lever to put their growth imperatives at risk. The risks of a new stagflation are mounting. But it will not be a replay of the 1970s. Like nearly everything else in the world these days, this one is likely to be made in Asia."

The last bit is a vast exaggeration by Mr Roach, but what is interesting in his argument about the contradictions of export-led growth in an environment of speculative capital flows, is that effectively Asia is blamed for inflationary pressures in the West, via the transmission belt of imported goods!

Yet I doubt if Mr Roach's argument is quantitatively very convincing. No doubt the price rises of imported goods from Asia do feed into price inflation in the West, I would not deny that, but it ignores not only domestically generated price inflation in the West (jncluding businesses raising output prices to compensate lower earnings and higher costs), but also that the West's international trade with Asia in capital and services is much larger than the respective trade in goods. The import of goods by value from Asia is, proportionally, a rather small part of total imports by value in Europe and North America. 

In addition, consider the "value chain" he mentions: the price difference between the cost of goods produced in Asia with low-wage labour and the retail price in the West is very substantial. If, for a moderate example, you produce a good in Asia with a unit cost of $40 and it retails in Europe for $100, then if the f.o.b. unit price in Asia goes up let's say 8% a year, then the added retail cost in Europe is only $3.20 per year.

You might in fact argue, that the global superabundance of idle money capital (not invested in production) has exerted a downward pressure on interest rates, and that the biggest single industrial cost problem now is the rise in fuel prices. The reason why food and energy prices have not come down, is I think because these price increases in large part structural and longterm, and not simply conjunctural. 

To reverse this trend would require most of all a fairly massive cumulative increase in output and productive investment, but the overall, ultimate effect of the burgeoning capital markets, with the concomitant rise of the rentier class, actually is to brake this development, in the sense that production levels are far below what they could be given the capital resources available. In truth, the bulk of capital markets involve only a very tiny fraction of the world population who own most of the capital. That may be an astonishing kind of claim to make, but I think it is in a global sense true, and that in the longer term, the low-interest regime is not sustainable anyway. 

The paradox is that on the one side, if the trade in capital assets as such is less risky and more profitable than investment in the cumulative expansion of production, new capital resources available will not be productively invested in the same proportion. On the other side, the gigantic disparities in income and wealth brake output growth. Financially speaking, the more capital you have, the more you can borrow - but the less capital you have, the less capital you can borrow. Whereas stagnant or even falling real wages for the majority may hold down costs and price inflation, they are not conducive to final demand growth. Final demand growth in that case can only occur by integrating more people in more markets, higher debt levels, or access to durables without owning them (renting, leasing etc.), but point is most of the new entrants to markets are positioned at the low end of those markets.

Economists may philosophize about market equilibrium, but the reality of the markplace is imbalanced development. The balancing occurs somewhere else. If markets naturally tended to equilibrium by themselves, you might say economists might as well go home, since market activity naturally produces the optimal allocation of resources anyway. All that is needed then, is the political promotion of free trade such as the Financial Times does. Unfortunately markets do not result in this optimality by themselves, and economic analysis really starts when we probe the nature of the imbalances, considering the causes and quantitative proportions. This requires reference to many influences other than market prices, which is why conventional economics often has so little explanatory value. 


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