China's newest export: Inflation

By Jim Jubak

It looks like the United States has seen the end of an amazing period of below-average inflation and above-average economic growth.

The gradual integration of China into the global economy gave us those good times. And now it looks like the Chinese economy is going to take them away.

For better than 10 years, the U.S. enjoyed the gift of low inflation. From 1993 through 2004, inflation averaged 2.5% a year. That was significantly below the long-term U.S. trend of 3.0% from 1926 through 2008. And it was a welcome relief after the above-trend inflation of 4.8% from 1980 through 1992.

Because of low inflation, U.S. interest rates gradually fell during those 10-plus years. Interest on a 30-year mortgage dropped from 8.14% in 1993 to just 5.81% in 2004. Businesses and consumers borrowed that cheap money, with the former spending it on new plants and equipment and the latter on new cars and second homes.

Economic growth during those years, discounting the gains from inflation (what's called "real" growth) averaged 3.19% a year, even counting the slump in growth after the 2000 stock market plunge. That was a huge half a percentage point higher than 1980-92's average real growth of 2.69%.

Defying conventional economics

From 1993 through 2004, the economy grew faster than average, and we all paid a smaller-than-average inflation tax on everything we bought. Win-win.

Conventional economics says you aren't supposed to get this kind of a free lunch. If growth is higher than average, the economy is also supposed to deliver higher-than-average inflation. Lower-than-average inflation is supposed to be forever linked to lower-than-average growth. The persistence of a win-win economy with above-average growth and below-average inflation was one of the great puzzles of Alan Greenspan's later years at the helm of the Federal Reserve.

The likeliest explanation centers on China. The extra growth came from a global surplus of capital -- from savings from increasingly wealthy developing economies (China) and from the export earnings of oil-producing and low-wage manufacturing countries (Middle East and China again).

Pay as you grow

That capital, available for investment in new factories at low interest rates, fueled the global boom in real economic growth. (This low-cost capital also fueled the technology bubble that burst in 2000 and the real-estate bubble that began to deflate in 2007 -- so maybe conventional economics is correct and there is no such thing as a free lunch.)

The lower-than-expected inflation came from low-wage, low-cost manufacturing countries -- China, India, Vietnam, etc. As more manufacturing (and manufacturing jobs) moved from the U.S., Europe and Japan, these developed economies imported larger quantities of low-cost goods. In addition, manufacturers remaining in the developed economies were able to import cheaper subassemblies and cut the cost of their own products.

Economists have dubbed this the Wal-Mart effect. Low prices at Wal-Mart Stores (WMT, news, msgs) and other big-box discounters had a multiplier effect because low prices at these stores acted to depress competitors' prices.

But now it looks like the process has gone into reverse. China is now increasingly exporting inflation.

A case in point

A look at what's happening with the prices of auto parts will show you what I mean. In 2007, China shipped auto parts worth about $8.5 billion to the U.S. That was a 23% increase from 2006. Worldwide exports climbed to $30 billion in 2007, and global exports of auto parts have climbed at a compound annual rate of 57% from 2003 to 2007.

What's driven that growth? It's pretty simple. Price. U.S., European and Japanese automakers and their suppliers could easily lower their costs by buying some of the parts they used to make at home from Chinese companies at prices 25% to 50% less. For automakers looking to cut costs to survive, that was a huge incentive. In 2006, for example, when Ford Motor (F, news, msgs) needed to find $5 billion in cost savings, an increase in the number of parts purchased from China was a key part of the plan. Ford announced it would use $2.5 billion to $3 billion in parts from China in 2006, up from $1.6 billion to $1.7 billion in 2005.

That rush to outsourcing isn't over. For example, Magna International (MGA, news, msgs), a huge Canadian auto-parts supplier that was General Motors' (GM, news, msgs) supplier of the year in 2007, plans to boost outsourcing to China by 65% in 2008.

Continued: Price pressure in China

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