Thursday, February 21, 2008

Inflation from China?

I have been reading a few comments lately about how inflation in China, running quite high in the 7% range, is not causing inflation in the US. Paul Krugman made this point and points to a WSJ commentary that does the same on his blog. The reasoning is that our total imports from China account for only 2% of our GDP, so it would take astronomical inflation in China to have an impact on inflation in the US. Unfortunately I think this analysis misses the point.

What is causing inflation is primarily the cost of raw materials such as oil, copper, metal, etc. These costs are rising because of the incremental demand from China and other developing countries for raw materials for both production and infrastructure development. The same is true for food – as incomes are raised around the globe the demand for food increases. These trends are, of course, exacerbated by the decline in the value of the dollar that drives up the price of imported materials such as oil, but without that decline we would likely be in a much worse economic condition right now than we are. I have not done any specific research on this topic, but I have heard many executives from the various mining and metal companies come on CNBC and explain that the demand from China is one quarter to one third of their total demand and until they can gear up to meet this demand prices will be higher. Others imply that speculators may be driving up prices as well, perhaps even creating the next bubble – commodities.

So in the end, inflation in China is not causing inflation in the US, but this analysis misses the point. The point is that because of the increase in demand for raw materials from China and other developing countries (and perhaps some speculation) the prices of materials for everyone, including China and the US, are going up and that is causing inflation in both countries. Perhaps some of the commentators can do a bit of numerical research on this in their spare time. If I find some perhaps I will.

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Palermo's Blog said...

In my opinion, if a well known economist like Paul Krugman (who I respect) or a business paper like The Wall Street Journal (which I read) decides to discuss this issue they should not end with the point that China is not causing inflation in the US because we don't import enough from them to have that impact. They should go on to explain why we and the Chinese are experiencing inflation. So this is my 2 cents.

Lawrence D. Loeb said...


You are correct in pointing out that demand from China (and India) is pushing up the costs of raw materials.

To a certain extent, this will be alleviated as more capacity comes on line. A global recession or reduced global growth would likely have a significant impact in reducing some of the raw material demand.

Given that basic industrial production has migrated to China (as would be expected from newly developing countries), their increased demand is normal.

The food issue is a bit more complicated. You are right about the increased demand for higher quality food. There is also competition for agricultural products from alternative energy projects.

There are other causes of Chinese inflation that cut our costs of capital.

The Yuan does not yet float, although it has appreciated measurably over the last few years.

Since the Yuan continues to be undervalued relative to the dollar, China's authorities are aggressively working to avoid importing the inflation that would be the normal result of the undervaluation.

China's Central Bank issues debt securities to "sterilize" the money supply and absorb the excess currency that results from the undervaluation of the Yuan. They then buy foreign currencies (Dollars, Yen, Euros, Pounds, etc.) and invest the funds overseas. This helps to maintain the lower Yuan, but also provides a flood of capital that has been a significant contributor to lower interest rates in the developed world.

To a certain extent, this excess capital helped to cause the housing bubble and many of the problems we are seeing in structured financial products.

The bubbles were an unexpected consequence, and had many other causes (I don't want to give the impression that China directly caused the bubbles - they didn't determine where the excess capital would flow to).

As China develops its own internal economy and builds out its infrastructure, that capital will return to China to fund those projects.

Anyway, just wanted to point out that only economists can point to isolated reasons for events (they always preface with "all else held constant" and hedge with "on the other hand").

I believe it was Truman who facetiously sought a "one handed economist" to avoid such hedging (although it's also been attributed to FDR).

dd said...

Do you really think commodities are going to burst? I called it early and I wanted to move all my assets into Gold - and completely missed the boat. Then I wanted to move into Silver instead - missed that boat too. Then Palladium - and that boat took off as well.. Now I'm thinking about Uranium.

But anyway, I think Gold is valued high right now and ridiculous. Thats why I'm considering this:

DZZ - Deutsche Bank Gold Double Short ETN

But our currency has to regain its footing. The main problem is the currency valuation as I've suggested in my blog posts - I heard about some fed actions recently to reduce monetary supply to combat this. It doesn't help when you just helicopter dropped money through some sort of stimulus package.

Palermo's Blog said...

dd - I have been, I admit, scared about what the markets will do. I have been short in my personal portfolio but left my long term retirement investments alone. I am now questioning that decision as well.

I don't know what to do about commodities. I think it depends on how bad the economy gets. I have been through a lot of the gyrations you describe too. I have kept my allocations heavily on the side of treasuries and FDIC insured deposits. Low return, but low risk. Until I see a bottom I am staying away from anything long other than my very long term retirement assets.