Saturday, August 25, 2007

Have Globalization Increased or Decreased Inflation

In light of the increase in commodity prices in recent years as a result of increased demand from China, India and other emerging economies many people have doubted the argument from me and others that globalization has kept down price inflation. The argument, endorsed by Ben Bernanke and others, is that the increase in commodity prices will cancel out the effect of the entry of cheap finished goods from China and others.

Yet there are at least two good reasons to believe that the net effect from globalization is to keep down prices, even though higher commodity prices will somewhat limit the effect. First of all, globalization means that competition is a lot tougher than it would have been under national self-sufficiency. Secondly, globalization also means increased efficency as production for a global market increases the possibility of economies of scale, which will allow companies to lower prices. Thirdly, so far particularly China buys a lot less than it sells, as is reflected in its huge trade surplus. That means that China is increasing global supply of goods and services a lot more than it increases global demand. And if supply increases more than demand, this implies a downward pressure on prices.

Note however that argument three only applies in today's world. If China's politicians were to realize that a much stronger yuan is in their national self-interest, then this means that the price cutting effect of cheap finished products from China would be greatly reduced, while on the other hand commodity demand from China would increase as commodities are cheaper in yuan terms, putting an upward pressure on commodity prices in dollar and euro terms. It would also reduce factor one, as the competitive pressure from China would be reduced. If U.S. politicians were to have their way and the yuan is significantly revalued, this would greatly increase price inflation in the U.S., reducing the room for the Fed to cut interest rates and thus likely destroy a lot more jobs than reduced import competition would save.


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