Hey, Ben Bernanke, it's the 21st century. Wake up! We -- and that includes the U.S. Federal Reserve -- live in a global economy now.
Because the Federal Reserve and the other big central banks in the developed world continue to behave as if their jobs were to manage economies that stop at their borders, they are about to drive us all off a very steep cliff.
In typically terse statements after meetings of the Federal Reserve's Open Market Committee, the group that sets short-term U.S. interest rates, Bernanke and Co. often issue a statement summing up the risks to the economy. Here's the one issued after the March 28, 2006, committee meeting:
"The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives."
Wrong. Wrong. Wrong.
The worst that could happen
I understand how somebody, especially a banker, can say that it may be necessary to raise interest rates further in order to keep risks to economic growth and price stability roughly in balance. But I can't for the life of me fathom how anybody, even a banker, looking at the globe today can see price stability and economic growth as roughly equivalent goals.Here's how the world looks to me.
On the one hand, if inflation creeps upward from its current 2% to 3% range, bondholders and lenders would see a steady erosion of their capital. They might demand higher interest rates in that situation, making it tougher and more costly to raise capital, and slowing economic growth.
What's the worst than could happen? At some point in the future, we might release the genie of inflation expectations from its prison. People might start to expect price increases and demand wage increases that lead to more price increases which then produce more wage increases. Before you know it, we're headed right back to the 1970s with double-digit inflation and interest rates and stagnant growth. Been there. Done that. Don't especially want to go back.
Slowed corporate profit growth?
On the other hand, if the Federal Reserve, the Bank of Japan and the European Central Bank raise interest rates and reduce economic growth, corporate profit growth might slow, stalling the stock market. Instead of growing slowly, average wages might actually go into retreat for us all. More people would be unable to find good jobs, decent-paying jobs, or just any jobs at all.What's the worst that could happen? How about this one: The developed world's central bankers could squeeze a little too hard and slow growth too much. Squeeze hard enough and that might produce a recession in the United States, the worry seems to go, because the U.S. economy is already slowing, home buyers took on too much debt to buy over-priced homes, and higher energy prices have left U.S. consumers feeling tapped out.
But that's only the worst if you insist on the same kind of parochial, border-bound thinking that I think is so dangerous when the Federal Reserve does it.
The worst-case scenario doesn't involve mortgage holders or consumers in the U.S. at all.
Scenarios facing China and India
The worst case involves two little countries called China and India. To keep even with the population growth and the number of new workers entering the workforce each year, these two economies have to grow by something like 7% a year. That's 7% a year, year-in and year-out, just to stay even.To give their burgeoning populations a bit of hope that the future might be better than today, they have to do better than 7%. To defuse the social tensions that arise when some people receive more of the benefits of growth than others and receive them sooner rather than later, they have to do better than that. To put away a little bit for the day when these huge populations begin to retire, they have to do better than that. To put away a little bit so there's something to invest in providing clean air and clean water, they have to do better than that.
If they don't, the cost isn't just grinding poverty for tens of millions of people. Growth of less than 7% a year stresses the social fabric of countries where the material is already looking mighty strained. It's likely to produce political extremism in India. Blame your neighbor, especially when that neighbor practices a different religion (or the same religion but with less fervor) is an age-old response to hard times.
China's wealth gap
It's likely to produce even greater regional conflict in China between rich and poor provinces. And a failure to produce the goods undermines the ruling Communist government's only remaining foundation of legitimacy. If the Beijing government can't put a light bulb in every village house and the hope of a car in every city dweller's daydreams, then what exactly is the reward for toeing the line and not asking too many questions?The Organization for Economic Co-operation and Development pegs China's growth at 10% in 2005 and India's at 8.5%. Projections for China are 9.7% in 2006 and 9.5% in 2007. For India, 7.5% in 2006 and 7.1% in 2007. Those are huge numbers. But the margin for error is less than the top line suggests.
And if you're looking at costs, a possible global train wreck caused by a failure of growth in China and India and then political upheaval in those countries far exceeds the impact of 1970s-style runaway inflation. Especially since the choice between growth and 1970s-style inflation is a false dichotomy. The nature of the global economy makes the old wage-price spiral that central bankers fear a very, very unlikely outcome.
We're in the midst of a huge global labor glut. One result of integrating economies such as China, India and Vietnam into the global economy is a vast supply of young, cheap workers, many of them with superb technical skills, which puts significant downward pressure on wages in the developed economies of the world.
Need evidence? How about this? In the past five years, productivity as measured by real GDP per hours worked has climbed in the United States by about 14%. But the real wages of non-managerial workers in the manufacturing and service sectors have climbed by just 2%. If workers can't even collect more than a paltry 2% wage hike out of a 14% gain in productivity, is there any real danger that they'll be able to successfully demand the kind of wage hikes that an inflationary wage-price spiral requires?
Of course not. And to anybody willing to look beyond the borders of the United States, the reason is awfully clear. We're still shipping enough highly visible, highly paid jobs offshore that asking for a wage increase that exceeds the rate of inflation seems an act of hopeless naiveté.
What the central banks should do
The arguments among economists and labor statisticians about whether the global economy is destroying or creating jobs in the United States is beside the point in this context. When we can all see workers at Delphi (DPHIQ, news, msgs) being asked to take $15-an-hour pay cuts and see the company shut factories here and open them in China, it makes an impression that goes deeper than any statistics.So what should the Federal Reserve, the Bank of Japan and the European Central Bank do?
Stop obsessing about 2% inflation. Enough already with all this talk about how inflation above 2% is above the bankers' comfort zone. Who cares what their comfort zone is or even if they have one? There's nothing magical about 2% or any other number. And it's time that the central banks realized that in today's global economy we need to cut the developing world some slack -- even at the cost of inflation in the developed world -- so that growth in the global economy doesn't plunge as a result of political upheavals caused by slow growth.Come clean on the inflation numbers. The Federal Reserve's own economists know that because of the way that the Bureau of Labor Statistics calculates increases in housing prices, the Consumer Price Index was understated by somewhere around 0.5 percentage points during the housing boom, and it's overstated by about the same amount now. That means that the alarming increase in inflation is a lot smaller (and therefore less alarming) than the official numbers indicate. (The problem comes from the bureau's use of equivalent rents -- the rental income that a homeowner gives up by occupying his or her house rather than renting it out -- as a measure of changes in housing prices rather than the price of houses themselves. In the boom, when everybody was buying, equivalent rents were depressed. Now that fewer people are buying and more are renting, equivalent rents are on the climb. This wouldn't be such a big deal except that equivalent rents make up 30% of the core Consumer Price Index.
Admit that even if you have a hammer not every problem is a nail. If energy costs are the major culprit in increasing inflation and in worries about future inflation, then raising interest rates seems a strange way to fight energy-produced inflation. To reduce energy prices by hiking interest rates you have to raise them high enough to slow growth across the entire economy. Wouldn't it be better to try to reduce energy demand -- which would reduce energy prices -- by using programs that increase the efficiency of energy use in the economy? That way we might get lower inflation and economic growth, too.
Of course, I can rant on this page all that I want -- so can you from any soapbox you can commandeer -- and the Federal Reserve doesn't have to do a thing or even listen. These bankers don't stand for election. They're appointed for 14-year terms. They're never accountable to voters. For that matter, they aren't even accountable to the people we do elect.
What we've done is put some of the most important decisions about how our country is run in the hands of officials over whom we have no control.
It's a lousy way to run a democracy.
New developments on past columns
China's banks await discipline from abroad: It was expected, and some innocent bystanders paid the price. On June 16, the People's Bank of China raised its reserve requirements effective July 5. Banks will be required to keep an extra 0.5 percentage points for a total of 8% of their capital in reserve. This will have the effect of taking about 150 billion yuan (or about $20 billion) in liquidity out of the banking system.The measure was a direct response to May statistics showing that money supply had climbed by a red-hot 19% from a year earlier. I doubt that the move will do much to slow China's growth or the rampant speculation in real estate and other assets that so concerns Beijing. Many banks are likely to ignore the order or cook their books to show compliance. But global stock markets disagreed. Stocks of commodity producers that provide raw materials to China sold off after the move.
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E-mail Jim Jubak at jjmail@microsoft.com.
At the time of publication, Jim Jubak did not own or control shares in any of the equities mentioned in this column. He does not own short positions in any stock mentioned in this column.