Disinflation is at risk as the US Congress rushes headlong down the path of protectionism. The cross-border arbitrage of costs and pricing one of the unmistakable hallmarks of globalisation could well turn unfavourable if China bashers get their way. This could be a recipe for the dreaded stagflation scenario an awful outcome for financial markets and the functional equivalent of a tax hike on an already beleaguered American middle class.
Globalisation and the US: 'imported disinflation'
The US economy has benefited greatly from an outbreak of "imported disinflation" over the past decade. Researchers from the IMF have estimated that the so-called import-price effect has lowered the US CPI inflation rate by an average of about one percentage point per year since 1997 (see "How Has Globalisation Affected Inflation?" Chapter III in the IMF's World Economic Outlook, April 2006). Such an externally-driven reduction in domestic US inflation is basically an outgrowth of rising import penetration from the low-cost developing world. US import penetration purchases of foreign-made products as a share of domestic goods consumption has risen from 22% in the early 1990s to about 38% today. At the same time, our calculations suggest that developing economies have accounted for 58% of the surge in total US imports over the past decade. China and Mexico have led the way making up nearly 60% of the cumulative increase of imports to the US from developing economies since 1995.
Nor have currency swings or business cycles altered the disinflationary forces of globalisation. Over the past 12 years, prices of non-petroleum imports into the US have been basically unchanged, punctuated by brief cyclical breakouts that never exceeded 4% and that were, in turn, followed by periodic declines of approximately equal magnitude. This compares with a cumulative increase in the so-called core CPI of 31% over the 1995 to 2007 interval. Even during periods of modest cyclical acceleration in import prices, spillovers from foreign to domestic inflation have been limited. That's due in large part to the still-wide disparity between price levels of foreign and domestically-produced goods a disparity which has continued to open up in recent years. According to the US Bureau of Labour Statistics, prices of nonagricultural US exports, a good proxy for inflation of internationally-competitive products produced within the United States, have recorded a cumulative increase of about 10% since early 1995 hardly a major rise but one that nevertheless stands in contrast with the stability of nonpetroleum import prices noted above. That only adds to the compelling arithmetic of imported disinflation for the US.
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Globalisation and the US: greater efficiency
I suspect there is an equally important productivity angle to this as well. Globalisation and the record expansion of world trade it has engendered have played a new and important role in the execution of global efficiency solutions by US businesses. This arises from increasingly powerful synergies of cross-border supply chains available to US multinational corporations, as well as from the arbitrage between relatively antiquated high-cost facilities at home with newer vintages of low-cost production platforms abroad (see a June 2006 speech by Federal Reserve Vice Chairman Donald L. Kohn, "The Effects of Globalisation on Inflation and Their Implications for Monetary Policy").
Similarly, there is compelling evidence of innovation-driven productivity spillovers from inward foreign direct investment (see "Does Inward Foreign Direct Investment Boost the Productivity of Domestic Firms?" by Jonathan Haskel, Sonia Pereira, and Matthew Slaughter, CEPR Discussion Paper No. 3384, May 2002). To the extent that "imported productivity" growth dampens overall cost pressures in the domestic economy, globalisation has created yet another powerful headwind holding back US inflation.
Globalisation and the US: changing consumption patterns
As a result of these trends, the sourcing of domestic consumption in the United States has shifted increasingly away from high-cost goods made at home to cheaper and increasingly high-quality products produced by low-cost developing economies. In one sense, these impacts are temporary they reflect globalisation-driven impacts on the US economy that have taken it from one state of "openness" to another. Consequently, as import penetration eventually levels out, the impacts of imported disinflation could ebb. At the same time, should forces come into play that arrest globalisation namely an outbreak of trade protectionism there could well be a reversal of the external pressures of disinflation, thereby boosting overall inflation.
Unfortunately, that is precisely the risk today. As Washington moves to contemplate policies that could lead to trade frictions and protectionism, America's global sources of disinflation would be very much at risk. Tariffs and non-tariff duties are the functional equivalent of a tax on low-cost imports. Depending on pricing leverage, such taxes could be directly passed through to American consumers. At a minimum, they would boost cost pressures on US multinationals, with the potential to interrupt the shifting of high-cost domestic production to cheaper offshore locations.
Moreover, such frictions might also diminish the productivity dividend offered by global supply chains. This latter possibility could well be reinforced by ongoing efforts of the US Congress to tighten up the so-called CFIUS (Committee on Foreign Investment in the United States) approval process for foreign direct investment into the United States a development that has gathered considerable momentum in the aftermath of the aborted 2006 acquisition of US port facilities by Dubai Ports World.
Furthermore, the cyclical timing of all these developments is far from ideal. The imposition of trade and investment barriers could lead to the return of the closed-economy inflation dynamic at just the time when slack has diminished in America's labour and product markets. And, of course, the dreaded dollar-crisis scenario hardly a trivial consideration in a protectionist climate could lead to a much sharper spike in import prices than has been evident in a long time. All in all, such an unfortunate confluence of circumstances could exacerbate domestically driven inflationary pressures at the wrong point in the business cycle in sharp contrast to a globalisation that has acted increasingly to offset such cyclical pressures over the past 15 years.
Globalisation and the US: the scapegoating of China
There is great irony to congressional attempts to "fix" globalisation: The odds are that the most extensive damage will be inflicted on the very constituency in the US economy that the politicians are trying to assist America's middle-class. One of the most important lessons of the 1970s is that inflation is the cruellest tax of all. And yet that lesson now seems all but lost on Capitol Hill today. There is no refuting the reality of pressures already bearing down on American labour. In the current economic upturn, our calculations suggest that the cumulative gains in private sector worker compensation remain about $430 billion (in real terms) below the trajectory of the typical expansion.
Moreover, according to the US Bureau of Labour Statistics, the median wage inflation-adjusted weekly pay for the worker in the middle of the wage distribution has risen a cumulative total of just 0.9% over the seven years ending in the first quarter of 2007; that's an especially disturbing development in a period of accelerating productivity growth very much at odds with the long-standing conclusions of economic theory and experience. As an outgrowth of these developments, the labour share of America's national income has fallen sharply in recent years and remains near its post-1970 low of 56%. Sadly, Congress now appears to be contemplating a response to these pressures that would impose the functional equivalent of an inflation tax on US workers at precisely the time when they can least afford it.
America's beleaguered middle class deserves better. Due to under-investment in education and human capital over the past 25 years, American labour is lacking in many of the skills required to face the new competitive challenges of an IT-enabled globalisation that are bearing down on white- and blue-collar workers, alike (see my 3 February essay, "Unprepared for Globalisation"). Moreover, by failing to save or to embrace pro-saving policies, the US has set itself up for chronic current-account and trade deficits. This is a lethal political and economic combination that has injected a new sense of urgency into the globalisation debate. And Washington politicians, rather than taking a hard look in the mirror, have embarked on a dangerous course of "scapegoatism" blaming China for all that ails the American worker. That has taken the Congress to the brink of moving beyond the rhetorical bluster of the past few years and enacting legislation that would impose severe trade sanctions on China.
Globalisation and the US: legitimate trade policy concerns
None of this is to say that there shouldn't be active and direct negotiations with the Chinese on more legitimate conflicts over trade policy especially those issues that bear directly on broad constituencies of the US workforce. The area of intellectual property rights (IPR) is especially important in that regard, particularly since it directly affects the core competencies of America's knowledge workers the professionals, managers, executives, sales workers, and office support staffs who, by our calculations, collectively account for 61% of total US employment. The US Trade Representative's recent decision to initiate IPR complaints against China with the WTO is a far more appropriate course of action than misdirected congressional scapegoating over the currency and bilateral trade deficit issues. Unfortunately, Washington politicians are having a hard time making this critical distinction.
In looking back over the past quarter century, few accomplishments in the economics sphere match the successes of the battle against inflation. Globalisation and trade liberalization have become important in insuring the post-inflation peace. Yes, for many, this has been a mixed blessing. There is no question that workers in the developed world have borne a disproportionate share of the cross-border arbitrage that lies at the heart of globalisation. At the same time, I have little doubt that the ensuing disinflation has been key in fostering improvements in purchasing power that boost living standards of the same hard-pressed workers.
Protectionism raises the risk of squandering this critically important disinflationary dividend thereby eroding inflation-adjusted purchasing power. That is the very last thing America's middle class needs.
By going after China and embracing protectionist remedies, the US Congress is reacting to symptoms of much deeper problems especially skillset disadvantages of workers and an extraordinary shortfall of domestic saving. Absolutely nothing is gained on either front by blaming China for problems such as these that originate at home. To the contrary, much could be lost in the US, the global economy, and world financial markets if Congress makes a major blunder on US trade policy. Unwinding the disinflationary benefits of globalisation would borrow a painfully familiar page from the stagflationary script of the 1970s.
By Stephen Roach, global economist at Morgan Stanley, as first published on Morgan Stanley's Global Economic Forum
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