The great moderation – have we overestimated the structural gains from globalisation?

The recent surge in inflation rates worldwide has central banks reeling on their feet. Especially at a time when growth in the industrial world is slowing appreciably and hefty losses are piling up in the financial sector and threaten to undermine financial stability.  

The scenario that is currently unfolding is the exact opposite of the great moderation that central bankers – perhaps a bit prematurely – claimed to be mostly their achievement rather than structural improvements in the economies or just good luck.  

In this piece we are going to argue that rather than improved monetary policy, that  

a)    it has been the effect of globalisation that has been responsible for bringing about        the disinflation in the industrial world, and b)    this disinflation has been to a large extent of a cyclical rather than a structural nature.  

There is currently very little debate – either in academics or among public statements of central bankers – that the recent rise in global inflation rates is mostly due to a rise in food and energy prices. The contested point between different participants in the debate about how central banks can or should respond to this is whether the global rise in commodity prices is a one-off shift in relative prices, or the starting point of a general upward pressure in the price level. In the former case, central banks just have to accept the transitory rise in inflation. In the latter case central bankers should raise interest rates and accept the resulting economic slowdown or even lower medium-term growth. I.e. central bank policy, when sticking to current inflation targets, would be forced to accept that the growth-inflation trade-off has worsened on a more permanent basis.  

In order to tackle this question analytically, we have constructed a measure of aggregate capacity utilisation for the G3 economies and five representative Emerging Market economies (Turkey, Mexico, South Korea, Chile and Hong Kong), henceforth called EM5. Aggregate capacity utilisation in our context is defined as the standard deviation of either unemployment rates or industrial capacity utilisation from their respective long-term average. We have then weighted individual country scores by respective GDP using constant exchange rates (2003 averages) for the regional aggregation. As we are ultimately interested in any evidence for broad-based wage-price spirals, the availability of longer-term data for capacity utilisation, wages and consumer prices has limited significantly the number of countries we were able to include in our sample of emerging markets. However, we suppose that the inclusion of at least one country from Latin America, Asia and the European periphery should make any evidence derived from this sample sufficiently representative not to lead us to completely wrong conclusions.  

The following two charts show both the aggregate measures for the G3 and the EM5 countries and their respective components. milleker200807a1_640_01.gif

milleker200807a2_640_01.gif

The first point to meet the eye is the fact that from the start of our sample in 1995 up to 2001 the aggregate measures of capacity utilisation in both regions are negatively correlated. However, this changes completely from 2001 onwards, when rising rates of capacity utilisation are found in both regions with only slight differences within them.  

Effectively, this argues not quite for a complete reversal of the beneficial disinflationary effects of globalisation but highlights the fact that it has been – at least in part – more of a cyclical than of a structural nature. It could well be that after 1980 recurring emerging market debt crises have kept rates of capacity utilisation at very low levels relative to those in industrial economies and thus created global disinflation via the export price channel.  

In recent months, more and more commentators have pointed to the risks of a wage-price spiral that may be setting in within emerging market economies as their authorities are unable or unwilling to stem the tide by employing both restrictive fiscal and monetary policies.  

At least with respect to our country sample, this kind of conclusion is so far without empirical basis. The following charts shows both price and wage developments for the two broader regions. The evidence is quite clear: The surge in inflation rates is compressing real wages in both industrial as well as emerging economies.

milleker200807a3_640_01.gif Further evidence in this respect can also be found from the IMF’s Direction of Trade-statistics.  The following chart plots the aggregate trade balances of all developing countries, oil exporting economies and non-oil exporting developing countries for up to February 2008. It is quite obvious that the surge in oil prices has already clearly depressed the non-oil exporting countries’ trade balances back into the red and reversed the general upward trend they exhibited since the Asian crisis.

milleker200807a4_640_01.gif Let’s sum up our findings so far: 1.    Rates of capacity utilisation around the world are currently generally high which might be a good explanation why commodity prices have surged right up to the present. 2.    So far, there is virtually no evidence for a wage-price spiral even in emerging markets. 3.    Since 2001 the negative correlation between rates of capacity utilisation in industrial and emerging economies has come to an end so that the link between globalisation and disinflation at least for now.  

The key question going forward for monetary policy will be whether the third point of our observation will continue in the future or not. If it were to last globalisation’s main outcome would be a much more synchronous business cycle that would tend to exacerbate cyclical swings in inflation rates. I.e. there would be a distinct source of macro volatility rather than stability.

One Response to "The great moderation – have we overestimated the structural gains from globalisation?"

  1. Guest   July 17, 2008 at 3:09 pm

    Very interesting analysis. Looking at the EMs trade balances, oil exporters will definitely feel the pressure to depeg from the dollar.