My friend John Tamny, who runs the Op-Ed operation at Forbes, emailed last week asking me to fire up my Forbes column again, I couldn’t be more pleased. My first column is below. Hope you enjoy. You can view it on the Forbes.com website by clicking here, or at RealClearMarkets by clicking here.
China Inflation: The Canary In the Coalmine
The real inflation story is here in the United States.
Rising inflation in China has investors running scared, fearing that Chinese central bank tightening will end global growth. They are worrying about the wrong problem. China’s inflation problem is transitory and will not interrupt China’s growth. But it is a canary in the coal mine that should warn us of a serious, long-term, inflation problem building up in the U.S.
China’s most recent inflation figure, 5.3%, is a very big deal in China. In Chinese history, periods of high inflation are associated with social, economic, and political unrest, something China’s leaders do not want. In spite of their extraordinary growth record since Deng Xiao Ping opened China in 1978, China’s per-capita GDP is just $4,399 ($7,481 purchasing power adjusted), less than one-tenth of the $48,157 U.S. level. They need 30 to 50 years of uninterrupted high growth to bring Chinese living standards up to current developed country levels. That’s why their central bank, the People’s Bank of China, has raised reserve requirements for Chinese banks five times so far this year to more than 20% today and adopted a number of other policies to curb price increases, such as selling food from government stockpiles.
China’s inflation is not high across the board–it has been driven by two factors: rising food prices and rising energy and industrial commodity prices. So-called “core” inflation, excluding food and energy, is still quite low, productivity is growing 10-12% per year, and there is widespread excess capacity in Chinese industry that is keeping finished goods prices in check.
Since China’s currency is, effectively, pegged to the dollar, soaring global food, oil and commodity prices, expressed in dollars, are the culprit. Both can be traced to U.S. policy mistakes. The Fed tsunami that increased bank reserves by 17x since 2008 is driving global energy and industrial commodity inflation. And Fed policy, along with our misguided ethanol policy that has diverted 40% of U.S. corn production into ethanol, have more than doubled corn prices in the past year.
The impact on China will be short term. Rising productivity and excess capacity will return inflation to lower numbers. And their monetary tightening won’t derail growth for the simple reason that monetary tightening in China isn’t as effective as it is in the U.S. Growth in China is largely driven by small, private companies that do not get their working capital from banks. China’s banks are not nearly loaned-up. And Chinese companies are enjoying strong cash flow, driven by roughly 15% average sales growth (10% real GDP growth plus 5% price growth).
The real inflation story is here in the U.S. For us, China’s inflation is the canary in the coalmine. The Fed has increased the stock of bank reserves by more than 17x since they turned on the printing presses in 2008. That’s enough money to more than double the U.S. price level in the next decade.
The weak dollar and soaring gold, oil, commodity, and food prices are warning signs of what is to come. I do not believe the Fed will have the political will to shrink bank reserves back to levels that will keep inflation in check. Financial reform legislation has undermined the political independence of the Fed. Inflation hawks at regional Fed banks are resigning. Inflation doves are firmly in control. And monetizing our ever-expanding government debt in the coming years will be politically easier than shrinking bloated entitlement programs.
Ironically, this story will ultimately force China to abandon their fixed exchange rate with the dollar, not in response to pressure from our government, but when China’s leaders decide that U.S. policy has become too unstable and too inflationary to serve as a useful anchor for their price level. When that day comes, it will not be a good day for the U.S.