Stagflation: Logistics, globalization, and you.

Jim Jubak over at MSN Money has an interesting article on the failure of central banks to understand globalization. The Bank for International Settlements has been arguing that globalization has been keeping prices low by replacing higher priced domestic goods with lower priced foreign goods. Central Banks, who's main job is controlling the money supply, have not been properly factoring this globalization effect into their calculations and have as a result flooded the market with money.

A simple definition of inflation from wiki states that inflation is "is a fall in the market value or purchasing power of money." Economics 101: Supply increase, no change in demand = lower prices. The central banks mistakenly "print" too much money, the value of all the money as an aggregate stays the same, so each unit is worth less.

The effect of globalization has been dramatic. A pair of jeans that used to cost $30 when produced in the United States now costs $15 because it is made in China. A great example from my own life of this is the Chevy Aveo, a product of GM factories in South Korea that I rented a few weekends ago. A similarly featured domestically produced car, the Chevy Cobalt, costs at least $1,200 more and is thus more expensive to rent. The central banks haven't taken this effect seriously - to them, it makes no difference where the item is produced as long as the consumer can buy it. This ignores the "global economy" almost completely.

Imagine you are a central banker. You want low inflation and a red hot economy. You do this by opening and closing the spigots of money. Open them up, and more buying takes place, heating up the economy. Close them down and higher credit risks can't get money and thus can't buy - cooling the economy. One of the indicators you watch is the cost of living for Joe Blow, the average guy.

Year 1: $10,000
Year 2: $10,200

Wow, only 2% inflation! That's about right. Open the spigots! Let's get that economy moving!

Year 3: $10,404
Year 4: $10,612

Still only 2%. Open the spigots further! Jobs for everyone!

You don't really care that a breakdown of Joe's spending looks like this:

Year 1: Food, $2000. Housing, $2000. Goods, $4000. Medical care, $2000.
Year 2: Food, $2040. Housing, $2300. Goods, $3660. Medical care, $2200.
Year 3: Food, $2081. Housing, $2645. Goods, $3258. Medical care, $2420.
Year 4: Food, $2122. Housing, $3042. Goods, $2786. Medical care, $2662.

Food is rising at 2%, thanks partially to globalization. Housing is rising at 15% due to a housing bubble - money is cheap and everywhere, anyone can get a huge mortgage (sound familiar?). Medical care is rising at 10%. The price of goods is actually falling; the new TV you bought is 12% cheaper than the one before.

Now lets say something catastrophic happens. Like a sudden jump in the price of oil. Consumer goods stop falling in price and instead rise rapidly at a 15% pace (It takes a lot of oil to push a cargo ship across the pacific afterall.) Food is also affected, rising at 6% thanks to higher costs moving it to consumers and in other oil based farm needs such as pesticide.

Year 5: 11,880 - a 12% jump.
Breakdown: Food, $2250. Housing, $3498. Goods, $3204. Medical care, $2928.

Oh my god, what happened!!! Turn off the spigots! Retract the money supply! Raise interest rates!!!

The result is that spending drops and economy slows. People lose their jobs, companies close their doors. Consumers make that car last an extra three years instead of getting a new one. But even worse, the massive oversupply of money doesn't retract quickly enough and high inflation bodyslams the already reeling economy. Stagflation - a stagnant economy combined with insidious inflation.

This reliance on foreign goods is also a reliance on cheap oil. For many of our imported goods, the cost of shipping is more significant than anything else. If the cost of shipping a container from China to the US triples, outsourcing manufacturing of some goods might stop making sense. Yet, we won't have the capability anymore to produce those goods ourselves. Supply will drop, but not nearly as quickly as demand, and prices will JUMP.

Oil drives the global economy. Virtually everything we consume uses oil at some point in production and delivery. And the demand for oil is growing enormously thanks to China and India. I believe that oil is becoming highly price inelastic. Until we discover an alternate source of energy, like a diabetic and insulin, we simply don't have a choice but to pay whatever it costs for oil.

Outsourcing is a serious negative for our economy. It has increased our dependence on oil a great deal because the jobs aren't here and the factories are 10,000 miles away. It looks like our central banks have made some big mistakes and now our entire lifestyle is vunerable. If the oil supply is disrupted, the US and world economy will be hit very hard until supply and demand are able to return to a point of balance.