Andy Xie

Inflation is coming, and the world economy’s fate depends on the Fed

China’s entry into the global economy took away the pricing power of labour everywhere else. That drove a disinflationary trend for decades

But inflation is returning, as monetary largesse becomes a mantra among major economies. There are two possible endings to this story

Three decades of disinflation are coming to an end. The rise of big government in the United States on the demand side and the depressed appreciation in labour income in China on the supply side are the twin forces that are inevitably pushing the world towards inflation.

The big central banks must decide whether to normalise monetary policy, which would deflate the greatest stock bubble in history. If they try to defend asset prices and let inflation rip, social and political chaos may engulf the world.

In the 1990s, Alan Greenspan, chairman of the Federal Reserve, puzzled over missing inflation in a robust growth environment. The disinflation trend has convinced big central banks not to worry about inflation in setting monetary policy. That is why they have become superheroes: bailing out financial markets, lending to small and medium-sized enterprises, buying government bonds, and so on.

Some economic quacks have seen the possibility to spend and spend, with no consequences, at least in the short span of a political career, and have proposed so-called modern monetary theory (MMT). They argue that there are no red lines for government indebtedness. Governments can spend and spend until the market says otherwise, that is, when interest rates surge.

Most economic theories are usually a little dodgy. People who teach economics like physics have fooled two generations. Economics is about human behaviour, which is rooted in culture, history, institutions and political systems; it is not just price mechanisms. MMT, though, is even more dodgy.

It basically says you can keep drinking beer as long as you are still standing. If you fall down like a sack of potatoes, then you have had too much. This is how low the economics profession has sunk: they are basically a bunch of quacks who’ll say anything for a buck.

Unfortunately for the world, MMT has taken hold in major governments in substance, even if not in name. “Going big” has become a mantra among major economies. Under this governing philosophy, inflation is inevitable because governments will keep spending until it occurs.

Inflation is popping up everywhere now. Food prices in China have been surging for three years, though official statistics appear tame. Warren Buffett is seeing it in his portfolio companies. The Fed is trying to inoculate the market against inflation fear by arguing that it is temporary. Is the current inflation signal transitory or does it signal the beginning of an inflationary era?

To judge when the disinflationary trend will end, we must figure out why it even happened. Some have offered automation as an explanation; others, ageing. I have argued for many years that China joining the global economy is the main reason. That unleashed hundreds of millions of workers into the global labour market. There was around a 20-fold difference between Western and Chinese wages at the beginning. That wouldn’t have mattered if there was a similar difference in productivity.

But Chinese workers could do similar jobs from the beginning. Wage arbitration led to surging manufacturing activity in China. Its exports are likely to top US$3 trillion in 2021, twice the US’ level. Why are Chinese exports still surging despite the trade war?

It is because China’s manufacturing can scale up really fast. As the pandemic slows down production everywhere else, while government stimulus measures prop up demand, China is benefiting.

Twenty years ago, many prominent economists argued that China wasn’t important to inflation, because its exports were relatively small. That ignored the fact that inflation was about pricing power. China’s entry into the global economy took away the pricing power of labour everywhere else. That was the key driver of the disinflationary trend.

A shock to the global labour market like China should dissipate when its labour force peaks. This happened a few years ago. Also, China has been experiencing a massive property bubble, similar to those in other East Asian economies. It has devalued labour income and severely cut work incentives. China should have become a source of inflation.

But the Chinese government has cleverly used the property bubble to increase capital supply. New residential property sales account for 15 per cent of gross domestic product, and two-thirds go into government coffers. It has fuelled subsidies for automation. While the world still thinks China’s manufacturing is driven by labour, it has already become one of the most automated sectors in the world.

Automation has contained China’s manufacturing costs. But as the property bubble peaks, capital costs could rise. China’s manufacturing may have to raise prices. While the world expects China’s rising costs to drive manufacturing elsewhere, it won’t happen, at least for the foreseeable future. Prices would have to rise a lot for it to happen – probably 100 per cent. From here to there is inflationary for the world.

Financial markets are terrified of inflation signs. In the coming months, the Fed will try to manipulate the market by persuading it not to worry. One tame inflation figure and the market will be back to its partying ways. But the odds are that inflation is a secular trend.

There are two endings to this story. If the Fed is sincere about maintaining price stability in the long run, it will try to normalise monetary policy soon, and not worry about the impact on the financial bubble. Then the world may experience a period of financial normalisation. Bubbles big and small will burst here and there. After normalisation, we will be back where we were 20 years ago.

If the Fed wants to target asset prices, it will try to explain away inflation again and again. One day, the market will lose its nerve: bond yields will surge and the dollar will plunge. The global economy would enter a dark age.