Leading commentators such as Martin Wolf in the Financial Times and Paul Krugman in the New York Times argue the problem facing the global economy is lack of sufficient demand; the remedy is some combination of fiscal and monetary expansion. But sharply rising commodity prices suggest global growth is already hitting supply-side limits. The problem is not aggregate demand but its distribution.This is the implication of the syndrome I christened misflation the other day (and since I haven't see any other term in general circulation yet, I'm going to stick with mine for now).
Until firms significantly raise productivity, especially resource efficiency, the painful remedy is likely to involve increased competitiveness and reduced living standards across North America and Western Europe (through a combination of commodity price inflation, weaker exchange rates, higher import prices and falling real wages and incomes).
There is not much Keynesian demand management can do in the face of this sort of structural shift. Central bank policies are simply shuffling costs around (from borrowers and banks to savers and pension funds) while stoking further increases in food and energy prices.
Anyway, Krugman responds:
The argument is that while high unemployment and low inflation may prevail in advanced economies, the rest of the world is facing accelerating inflation, together with rising commodity prices. And that is, indeed, a fair picture of what’s going on.and
What’s more questionable is the assertion that “The problem is not aggregate demand but its distribution.” In fact, it’s both.
But what this says is that if global aggregate demand were redistributed, so that more of it fell on advanced countries, we could expand further without putting pressure on capacity worldwide. And there’s a simple way to get such a redistribution of demand: an appreciation of emerging-market currencies against advanced-country currencies. It’s the fact that the emerging nations aren’t willing to let this happen that is causing them to face inflationary pressures, even as it helps keep the advanced economies depressed.I don't think this is right, and the reason is that Krugman is conflating two things that are different: A) inflation in final goods prices in emerging countries (esp China), and B) rises in global commodity prices. These are different in their causes, and different in their implications.
It's quite true that China is having some final price inflation, and I agree that this a symptom of the fixed exchange rate they maintain to the dollar, causing them to inherit a monetary policy quite inappropriate to their economic conditions. So this is a monetary problem and has a monetary solution.
But commodity price inflation is not a monetary problem, it's a real problem (something Krugman seemed to partially recognize a few weeks back). The very simplified way I think about it is to consider the global economy as a three stage thing: resources (and their extraction capital), goods manufacturing capacity, and final demand. To illustrate with a crude analogy, let's suppose we had a simplified one commodity economy. There are potato farms that grow potatoes, restaurants that turn them into french fries, and then everyone eats french fries at the restaurants. Historically, there were plenty of potatoes, and hence the restaurant owners were able to screw the farmers for every dime possible - potato prices were low but restaurant owners made a good profit. As a result, two things happened: there was a boom in building more restaurants, and consumers had trouble paying for their french fries and started to pay for lunch on their credit cards, running up unsustainable debts.
Now, the situation has gone bust in two different ways at about the same time: 1) consumers have run up to their credit limit and need to cut back on their french fry consumption, but also 2) long underinvestment in the potato farms, combined with some farms having depleted their soil, has caused potato production to fall. So now, we have french fry prices falling, but potato prices rising.
Note that here,
- there are too many restaurants for final demand (causing the drop in french fry prices)
- there are too many restaurants for the available potato production, but, crucially,
- there is also too much final demand for available potato production.
The last point is critical to understand: potato prices wouldn't be high unless this were true, and it has big implications for the correct fix, that Krugman doesn't seem have recognized. Under this circumstance, he has essentially been saying (for the last three years over and over): consumers are overleveraged and can't buy enough french fries, the restaurant owners are laying people off, the government needs to buy more french fries, and/or print more money to help people pay down their credit card debt so that they'll be able to buy more fries.
And that would be true, but for this other problem: there aren't enough potatoes. French fries can only be made out of potatoes, and, in the short term a certain number of french fries require a fixed number of potatoes. If, one way or another, you induce people to eat more french fries, it requires potatoes that just aren't there, and that can only exacerbate the potato price problem.
Under this circumstance, in order to increase final consumption of french fries, steps need to be taken like buying better equipment for the farms, opening more farms, replacing inefficient old machines for making the french fries with more efficient ones that can make more fries out of a given potato (ie with less waste), restoring the soil, etc.
This is exactly Kemp's point, and something I've been saying for about five years now in the context of oil specifically - in the peak oil zone, further growth in the economy can only come from improving the efficiency with which resources are used. Increasing final demand without doing this will just lead to exactly the situation of misflation that we are in.