Last week, I caught up with a fascinating piece by Russell Napier, former Asian investment strategist with CLSA. Titled “Bretton Woods on speed” (BWS), the article predicts an inflationary end to BWS, with capital controls globally. BWS is the successor to the original Bretton Woods arrangement that collapsed in the 1970s. It might be appropriate to call BWS Bretton Woods on Steroids.
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The original Bretton Woods was anchored by the US dollar, which was, in turn, convertible at a fixed rate to gold. In BWS, there is no convertibility of US dollar to gold at a fixed rate and capital control restrictions have been largely removed. As one of the parents of the original Bretton Woods, J.M. Keynes was keen on ensuring maximum policy freedom. He saw both the Gold Standard and free and unrestricted capital flows as policy fetters. Somehow, the tide of intellectual support turned in favour of free mobility of factors of production—principally, capital. Free international trade was supposed to facilitate true market economies featuring a large number of buyers and sellers with each one singly having no influence over prices.
Somehow, this morphed into free movement of factors of production. The West wanted to export capital to frontier markets (developing economies) to ensure ownership, control and dominance of economic affairs of capital-importing nations. This was neo-colonialism. At the same time, free movement of another factor of production—labour—never found favour with the West, as that would threaten their jobs and wages. Intellectual support for free capital mobility reached its peak in the 1990s. However, after the Asian crisis, its popularity waned. Post-Asian crisis and the events of 2001-02, Asian nations began to resist the impact of capital inflows on their currencies by accumulating reserves. In turn, these reserves came right back to the developed world as official capital flows. Since March 2009, international reserve assets have gone up by nearly $2.4 trillion.
In effect, this has resulted in loose monetary policy—looser than desirable—all around. Developing country currencies are weaker (or less strong) than they should be. Interest rates in the developed world are lower than they should be. Finally, because official capital flows to the developed world keep the US dollar stronger than it should be, American monetary policy had to be geared towards a stealth depreciation of the US dollar through quantitative easing.
These loose monetary policy settings have come at the time of ultra-loose fiscal policies in the developed world, since the cost of private market failures in the financial sector have been absorbed by taxpayers rather than by private actors. Loose fiscal and monetary policies have come right at the time when climate change and climate volatility are combining with secular declining trends in agricultural productivity to create shortage of food and other raw materials. This has resulted in skyrocketing prices for agricultural commodities. Economists dub these as a rise in relative prices of one particular set of goods and not a generalized rise in the prices of all consumption goods and services.
Ordinary folks do not have time for these semantic distinctions. For them, there is inflation if their monthly consumption basket of goods and services costs more than it did the month before. That has been the case for most households in the developing world lately. Well, it has been the case since 2006. It was interrupted somewhat in 2008-09 only because of the crisis-induced recession. In other words, the inflation pressure was not subdued either by policy decisions or by improved supply that eased availability.
Higher prices are now a reality in the developed world, too. Despite a weak economy and tepid household spending, the inflation rate in the UK was 3.7% in December. It was not caused by higher food and energy prices alone. The German inflation rate is at more than two-year high. In the US, inflation rate measured by official consumer price indices do not indicate any problem with the inflation rate. But the US so massaged its official inflation statistics with hedonic adjustments in the 1990s that it is hard to divine the true inflation rate in the country. However, the five-year forward inflation rate measured by the five-year forward treasury nominal rate and the five-year forward rate on inflation-indexed treasuries is now at 2.5%.
Napier’s thesis is that BWS would end in an inflationary bust. Recent decisions by various governments lend credence to his prediction. China, fearing a higher inflation outcome in 2011 than the target, chose to raise its target from 3% to 4%. Korea not only failed to follow up its last rate hike with another one in February but also added, for good measure, that it would not use the exchange rate as a tool to fight inflation.
There is a vigorous debate in the cyber world on why and how economists missed seeing the financial crisis of 2008. In the process, there is a real risk of them missing the economic crisis of 2011-12. Two wrongs do not make a right.
V. Anantha Nageswaran is chief investment officer for an international wealth manager. These are his personal views. Your comments are welcome at firstname.lastname@example.org