Inflation is widely viewed as the number one problem facing the country – even Donald Trump’s continuing efforts to relegate American democracy to the dustbin of history takes a distant back seat – and barely a quarter of the public apparently believe that the Inflation Reduction Act passed by Democrats in Congress will do anything to help get inflation under control. And when the federal Bureau of Labor Statistics – the official inflation record-keeper – published data for July that indicated that the annual rate of Inflation had dipped to 8.5% – down from 9.1% in June – people just shrugged.
After all, at 8.5%, the year-over-year rate of inflation for July remained the highest rate since December 1981 – except, of course, for the 9.1% rate in June. But it was a big deal, and may well turn out to have been a sign of things to come. Why? Because while the 8.5% rate of inflation was the composite of the preceding 12 monthly rates, the rate of inflation for the month of July actually came in at zero.
For anyone who has filled up their gas tank recently, this should not have come as a surprise. After all, while global oil prices peaked this past March at $120 per barrel in the wake of Vladimir Putin’s invasion of Ukraine, and the price of gasoline peaked two months later at over $4 a gallon nationwide, oil and gasoline prices have each declined by 25% from those peak levels.
And it’s not just gasoline prices that have come back down. The price of wheat, which was similarly impacted by the war in Ukraine, nearly doubled in March, but has since fallen back to where it was last year. Lumber and eggs, prices of which made headlines as inflation surged, have each tumbled 70% and 50%, respectively, from their peaks. Even the cost of air travel is coming down.
And financial markets have taken notice. Market expectations of the rate of inflation over the next five to ten years – calculated by comparing the trading relationships between traditional fixed-rate US Treasury securities and “inflation-indexed” securities – have fallen back to 2.5%, just a bit above the Federal Reserve Bank’s 2% target.
Arguments abound about the confluence of events that have brought inflation roaring back to 1970s levels. Putin’s invasion of Ukraine upended global markets for oil and natural gas, as well as agricultural commodities. Covid-19 has had wide ranging impacts, roiling labor markets at home and global trade abroad. Millions of Americans, who may have previously given little thought to business or economics, have been forced to grasp the implications of “global supply chains.”
And there are those who reject all of those factors, and assert instead that the singular cause of the sudden spike in inflation was the massive printing of money by the Federal Reserve Bank in the face of the collapse of economic activity at the onset of the coronavirus pandemic. This view – held by “monetarists,'' a school of economics that argues that inflation is primarily a function of money supply – is straightforward. As the economic activity shut down in early 2020, the Fed responded by flooding money into the economy with the hope of forestalling an economic collapse. Once the Fed did that, it was only a matter of time before that flood of new money flowing through the economy drove up prices. Forget Putin’s war and global supply chains; inflation, in the monetarist view, is simply about the money.
We may never know whose explanations are correct, but we will know in a few short weeks if the zero percent rate of inflation in July is matched again in August, and whether the evidence begins to suggest that inflation is indeed moderating. But whichever way it turns out, the impacts of the war, the pandemic, and the Fed’s printing of money may only be the first chapters in a larger inflation story.
As we debate the causes and trajectory of inflation today, the common expectation is that it will in relatively short order be brought back down to the 2% range, as reflected in financial market expectations. After all, low inflation has been with us for decades now, dating back to Fed Chairman Paul Volker’s determined success in taming post-Vietnam War inflation.
But an essential underpinning of the low inflation environment that we have come to take for granted since the 1990s was the fall of the Berlin Wall, the end of the Cold War, and the steady integration of Russia, China and other nations into the world economic order. Since the end of the Cold War, US foreign policy toward our Cold War adversaries has been built around a military policy of containment – implemented through regional military alliances – coupled with economic policies promoting rule-based, free trade and global economic integration, generally referred to as globalization. While economists disagree on the extent of the impact of globalization on inflation, it is generally viewed as having kept inflation in check by engendering global labor competition that suppressed wage growth and reduced the costs of manufactured goods.
Enthusiasm over the entry of China and Russia into the World Trade Organization went beyond the potential economic benefits. In his 2005 book, The World is Flat, Thomas Friedman argued that free trade and economic interdependence would be the key to preventing future conflicts. In what he dubbed the "Dell Theory of Conflict Prevention," Friedman argued that "No two countries that are both part of a major global supply chain, like Dell’s, will ever fight a war against each other as long as they are both part of the same global supply chain." And others took the geopolitical case for globalization a step further, arguing that economic integration would necessarily bring in its wake political liberalization in Russia and China and other, smaller, authoritarian countries.
Over the past decade, in events that foreshadowed what we have watched over the past year, Friedman’s theory was dealt severe blows, as Russia and China each demonstrated that rather than economic interdependence moderating their behavior in the world, it would be used as a weapon against their trading partners.
In China’s case, in 2012, during the months leading up to Xi Jinping’s appointment as General Secretary by 18th Central Committee of the Chinese Communist Party, anti-Japanese demonstrations spread across China, ostensibly related to a dispute over uninhabited islands held by Japan, and Japan’s occupation of China in the 1930s. In response to the public outcry, and in violation of WTO rules, China halted the sale of critical rare earth metals that were essential to Japan’s electronics industries. The Japanese government has since warned Japanese companies of the political risks of investing in China and relying on it as a supply chain partner, and Japanese investment in China is now less than its investment in most other, far smaller, Asian nations.
For his part, Vladimir Putin has proven adept at using the dependency of European nations on Russian natural gas as a weapon in international affairs. In 2014, he cowed European nations into quietly acquiescing to his first war with Ukraine and annexation of Crimea out of fear that Russia would shut off natural gas supplies.
When Xi Jinping and Vladimir Putin met in Shanghai on the eve of Russia’s invasion of Ukraine, they effectively put a nail in the coffin of the Dell Theory. In a paraphrasing of Tip O’Neil’s dictum that “all politics is local,” they declared in no uncertain terms that the pursuit of national interest – which really meant their own political interest – would henceforth prevail over whatever rules of conduct the United States and other nations might seek to impose. Ukraine and Taiwan were clearly in the cross-hairs, economic interdependence be damned.
Three months after the Shanghai declaration, no doubt shaken by the harsh western sanctions levied against Russia in response to Putin’s invasion of Ukraine, Xi sought to tamp down rising geopolitical tensions and focus international attention instead on solidifying and expanding trade under the auspices of the WTO.
But the horse had already left the barn. This past June, Apple Computer announced plans to diversify production away from China, notably to Vietnam, as well as India and Brazil. Apple’s decision mirrored recommendations from the Biden administration a year earlier that companies carefully consider geopolitical risk exposure in order to increase the resilience of their global supply chains.
In the wake of Apple’s announcement, the words “Reinventing Globalization” were emblazoned across the cover of The Economist, and the magazine editorial observed that Apple’s migration away from China is becoming the norm, rather than the exception: “The pandemic and war in Ukraine have triggered a once-in-a-generation reimagining of global capitalism in boardrooms and governments… This new kind of globalization is about security, not efficiency: it prioritizes doing business with people you can rely on, in countries your government is friendly with.”
With the devastation of Ukraine continuing unabated, and Xi’s Taiwan rhetoric escalating by the day, advanced industrial nations that have long promoted unfettered globalization now have been given a clear vision of its downside: A move by China against Taiwan, which Xi appears to be suggesting is inevitable, if not imminent, would wreak havoc on the global supply of critical semiconductors. In the near term it would force the shutdown of Taiwan-based TSMC – the world’s largest supplier of advanced microchips – and, should China succeed, it would leave a geopolitical adversary in control of 90% of global advanced chip production.
Globalization has always been a two-edged sword. In purely economic terms, the global search for low cost labor and profit maximization engendered an era of economic growth and the low inflation world that we have come to take for granted. Along the way the outsourcing of production from advanced economies to emerging economies across the globe contributed to a dramatic reduction in the percentage of the world population living in extreme poverty, most notably in India and China.
But globalization did not come without costs. Here at home, placing American workers in direct competition with low wage workers across the globe eviscerated the manufacturing heartland of the United States. It contributed to the rising tide of income inequality. And, as exemplified by Donald Trump’s rise as the avatar of the aggrieved American working class, it ultimately contributed to the fracturing of our political system, and shredding the image of the United States as a beacon of democracy in the world.
As we wait to see what lies ahead in the inflation reports for the next few months and learn whether this round of inflation is behind us, under the radar screen of much of the media, a reconfiguration of the global economic order is underway that could have far more lasting ramifications than the rate of inflation from one month to another. The era of globalization, characterized by the global search for low cost labor and profit maximization above all other considerations, is clearly coming to an end. The question that remains, as the editorial in The Economist asked, is whether the next era of globalization, which prioritizes security over efficiency, and doing business with people and nations you trust, can be accomplished without a new descent into protectionism and worsening inflation.
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