Exploring globalisation's net effect on inflation
Globalisation has come a long way fast, but the process has slowed. On the basis of the Fraser Institute’s Economic Freedom Index, more than 98% of the world’s population has lived in a capitalist society since 2005, up from just 30% in 1985 (figure 9).
The average tariff charged on imported goods in advanced economies has more than halved since 1980 and tumbled by more than two-thirds in developing ones, but again the process was largely over by the mid-2000s (IMF, 2016).
Global exports measured as a percentage of global gross domestic product (GDP) are no higher today than they were 10 years ago; the World Trade Organization’s quantification of global supply chain integration also seems to have peaked. The incentive for developed economies to offshore production has also eroded. In 1990, the average hourly manufacturing wage in the UK or Germany was 18 times the average hourly wage in China; today it is just four times. Whatever effect globalisation has had on inflation to date, its impact seems likely to be much smaller in the future.
But what effect has globalisation had on inflation? In the previous section, we touched on the impact globalisation has had on labour markets. As new workers have been brought into global supply chains, the effect on richer countries is analogous to a boom in the working-age population, decreasing workers’ ability to negotiate higher wages and increasing the slice of the pie going to capital, which has increased savings at the expense of spending (IMF, 2017).
A global market
Capital markets have also been globalised, which has also pushed down prices. Since a company in Germany has been able to raise investment from a company in Hong Kong, themselves backed by investors in the UK, the cost of capital has decreased as the available supply has effectively increased. In particular, globalisation has lowered the cost of capital in capital-scarce emerging markets, facilitating more investment and expanding the network of lower-cost operations in emerging economies producing goods for export. Investment here from advanced economies may pass on knowledge, improving efficiency and thereby lowering prices further.
Figure 9: The Fraser Institute Economic Freedom Index
The proportion of the global population living in a capitalist society has increased from 30% in 1985 to 98% in 2005.
Most recognisably, global integration has combined to lower production costs and this pushes down prices both through imported goods and through the lower cost of imported components and parts and ancillary services (such as help desks in Bangalore).
There are also indirect effects. Globalisation increases competition, which has the potential to spur productivity growth and possibly reduce inflation. There is some evidence of this in the US in the 1990s (Chen et al, 2009). Productivity growth makes it easier for central banks to allow inflation to fall because output growth will continue to be rapid nevertheless. Again this may have been the case in the US in the 1990s, but the surge in productivity did not seem to spill over into other advanced economies. This casts doubt on whether globalisation really did accelerate innovation across borders and indicates that maybe the US was just doing its own thing (Mishkin, 2008).
The increased purchasing power of wages induced by lower import prices might also dampen demand for wage increases. At the same time, however, lower import prices free purchasing power for other goods and services, which exert upward pressures on inflation elsewhere.
Lower prices here, more demand there
Let’s stick with the idea that lower prices here may mean more demand over there. As globalisation brought hundreds of millions of citizens in emerging markets into the middle classes, their incomes compete for many of the same goods and services that fill advanced economies’ inflation baskets. In particular, China’s rapid development led to a soaring demand for commodities and agricultural products. During 2004 to 2006 the region accounted for 40% of the growth in the global demand for oil and more than 70% of the global growth in copper and zinc. Toys and gadgets may be cheaper, but that has been at least partially offset by the rising cost of food, fuel and building materials.
Indeed, if utility bills account for such a large share of the under 30s’ annual expenditures, globalisation may have actually increased the rate of inflation experienced by younger age groups. Analysis by the Federal Reserve Board of Governors has weighed the downward effects on US inflation from cheaper manufactures against the upward effect from higher commodity prices and found that the net effect is close to zero (Mishkin, 2008). Research by the Organisation for Economic Co-operation and Development has reached a similar conclusion, finding a net effect of 0 to -0.25% on annual inflation in both the US and the eurozone.
This may come as something of a surprise — it certainly goes against the popular narrative — but when we step back to consider the bigger picture, the logic is rather obvious. If the next phase of globalisation becomes about emerging markets capturing larger shares of the global trade in services, the deflationary impulse may be a little stronger. While the global trade in services has grown more strongly than the trade in manufacturing, emerging markets have captured very little of that growth. China has just a 4% share of global services exports, and that share hasn’t grown at all since 2000. So there’s plenty up for grabs.
Tradeable services (such as computer programming, design, accountancy and call centres) are far less capital intensive than manufactures. They do not require such large investments in structures, equipment and supporting infrastructure to get them up and running. They do not need kilometre-long factories, expensive precision instruments or transport to get their goods to market. All that’s required are basic offices, computers and fast broadband. As such, the offshoring of services to emerging markets would be unlikely to exert the same upward pressure on commodity prices. An interesting hedge against one of the possible drivers of lower inflation over the next decade might be a basket of Indian companies exporting services.
Globalisation has undoubtedly globalised the forces that act on inflation, even if they may act in opposing ways and the net effect is up for debate. Consequently, central banks have less control of the forces that drive the domestic rates of inflation under their respective wards. As we shall see in the next section, this has altered the relationship between unemployment, wages and prices. We know that central banks take this lack of control into account.
Between 1998 and 2006, goods inflation (excluding energy and food) averaged around -1.5% a year in the UK, while the monetary policy stance supported +3.7% annual inflation of services prices, which are largely determined by the evolution of domestic costs, in order to meet the Bank of England’s (BoE’s) 2.0% inflation target
(Carney, 2015). But it is perhaps no surprise that central banks are turning their attention increasingly towards financial stability. In other words, if price shocks are now global in nature and they can’t prevent them, they can make sure that the buttresses are as sturdy as possible. Expect the regulation of financial services to become even more severe.