"All This Need Not End Horribly"

Ken Rogoff says if we don't hit the brakes on global growth soon, we're headed for a train wreck:

Time to put the brakes on this runaway train, by Kenneth Rogoff, Commentary, Project Syndicate: The global economy is a runaway train that is slowing, but not quickly enough. That is what the extraordinary run-up in prices for oil, metals, and food is screaming at us.

The spectacular and historic global economic boom of the past six years is about to hit a wall. Unfortunately, no one, certainly not in Asia or the US, seems willing to bite the bullet and help engineer the necessary co-ordinated retreat to sustained sub-trend growth, which is necessary so that new commodity supplies and alternatives can catch up.

Instead, governments are clawing to stretch out unsustainable booms, further pushing up commodity prices, and raising the risk of a once-in-a-lifetime economic and financial mess. All this need not end horribly, but policy makers in most regions have to start pressing hard on the brakes, not the accelerator. ...

I am puzzled that so many economic pundits seem to think that the solution is for all governments, rich and poor, to pass out even more cheques and subsidies so as to keep the boom going. Keynesian stimulus policies might help ease the pain a bit for individual countries acting in isolation. But if every country tries to stimulate consumption at the same time, it won’t work. A general rise in global demand will simply spill over into higher commodity prices, with little helpful effect on consumption. Isn’t this obvious? Yes, there is still a financial crisis in the US, but stoking inflation is an incredibly unfair and inefficient way to deal with it.

Some central bankers tell us not to worry, because they will be much more disciplined than central banks were in the 1970 s...

But this time is different. ... The historic influx of new entrants into the global workforce, each aspiring to western consumption standards, is simply pushing global growth past the safety marker on the speed dial. As a result, commodity resource constraints ... are hitting us...

Wait a second, you say... Won’t high prices cause people to conserve on consumption and seek out new sources of supply? Yes... But the process takes time...

The ... current expansion is unusual in that ... labour constraints are not the problem. On the contrary, the effective global labour force keeps swelling.

No, this time, commodity resources are the primary constraint, rather than a secondary problem, as in the past. That is why commodity prices will just keep soaring until world growth slows down long enough for new supply and new conservation options to catch up with demand.

This runaway-train global economy has all the hallmarks of a giant crisis in the making — financial, political, and economic. Will policy makers find a way to achieve the necessary international co-ordination? Getting the diagnosis right is the place to start. The world as a whole needs tighter monetary and fiscal policy. It is time to put the brakes on this runaway train before it is too late.

Let's see if I can play along with the train game, but with a different set-up. In this version of the game, if you hit the breaks too hard, passengers can get injured (workers can lose their jobs). And if the train is riding on a shaky infrastructure (meaning the financial system), perhaps it's on a long bridge you aren't too sure about (you are worried the financial system might collapse and bring the economy, or "train," down with it), then slamming on the breaks may not be the best thing to do, especially if there's a hill (recession) beyond the bridge that will slow the train down in any case, or a long straight section that will allow ample room to slow the train down gently. It depends upon how fast the train is going at the time, how likely it is that hitting the breaks while still on the bridge will cause the bridge to collapse, how many passengers will be injured from slamming on the breaks even if the bridge doesn't collapse, how good the brakes are, and what the terrain is like beyond the bridge (e.g., the magnitude of the expected slowdown).

So even with a train that's going too fast, a level speed for the moment followed by a measured level of braking once the train is on solid ground might be best.

I also think it matters whether the inflation is being driven by relative price changes due to world growth, or by excessive demand from interest rates that are too low and from stimulative fiscal policy. Implicit in the argument above, if I read it correctly, is that it's the latter - it's inflation from excessive liquidity and from stimulative fiscal policy, and if so, I agree that the inflation needs to be moderated as soon as it's safe to do so.

But if the run-up in prices that we are seeing is the result of changes in relative prices driven by underlying fundamentals, then the case for active intervention to slow world demand to "sub-trend growth" is not as clear. While there may be reasons to limit the speed of adjustment and reduce the displacement of labor and other resources to a manageable level, trying to limit price changes that are driven by fundamentals mutes the signals that encourage conservation and the development of solutions to the energy problem (there is also the issue of externalities, but that's a long discussion in and of itself).

This is something that's been on my mind lately because it's very clear that rising prices, even those driven by fundamentals, impose costs on people that they cannot avoid in the short-run, but may be able to absorb better in the long-run, so we don't want to allow the adjustment to happen too fast, or we want to find a way to limit the damage by compensating those who are hurt. Hence, the "sub-trend growth" called for above might be optimal. But it's also clear that high prices and the high profits that come with them serve as the markets equivalent of a prize for innovation - there are big profits waiting for successful innovators that are far, far greater than, say, the amounts McCain is talking about for inventing a better battery - and we don't want to stand in the way of that process. The higher the price, the bigger the prize. So the key is, I think, to allow prices to rise quickly so as to encourage the needed adjustments, but be very aggressive in helping people make it through the transition, those who become unemployed, face high gas and food costs, etc. Unfortunately, however, I don't think it's reasonable to expect that the government will provide such help, at least not enough, not in the current political environment, and that means we'll have to take it a bit slower, and look for other ways to encourage the necessary investment in solutions to the energy problem.