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Tuesday, July 8, 2008

Apply the fiscal brakes to this runaway train


CAMBRIDGE, Mass. — The global economy is a runaway train that is slowing, but not quickly enough. That is what the extraordinary runup 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 United States, seems willing to bite the bullet and help engineer the necessary coordinated retreat to sustained "subtrend 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 policymakers in most regions have to start pressing hard on the brakes, not the accelerator.

Don't look to the U.S. for leadership in a presidential election year. On the contrary, the U.S. government has been handing out tax-rebate checks so that Americans will shop until they drop, and now Congress is talking about doing more.

Don't look to emerging markets, either. Desperate to sustain their political and economic momentum, most have taken a wide variety of steps to prevent their economies from feeling the full brunt of the commodity price hikes. As a result, higher commodity prices are eating into fiscal cushions rather than curtailing demand.

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 checks 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 U.S., 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 1970s, when the world faced a similar commodity price spike. This time is different, though. The commodity price problem has sneaked up on us, despite notable institutional reforms in macroeconomic policymaking worldwide.

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 that we once expected to face in the middle of the 21st century are hitting us today.

Wait a second, you say. Why can't our wonderfully flexible market economies roll with the punches? Won't high prices cause people to conserve on consumption and seek out new sources of supply?

Yes, and that eventually happened with energy supplies in the 1980s. But the process takes time, and because of the rising weight of relatively inflexible emerging market economies in global consumption, adjustment will probably take longer than it did a few decades ago. Oil exporters and China have been accounting for two-thirds of global oil demand growth in recent years.

Rich-country consumers' responses to higher energy prices helps. New York City, for example, has seen a reduction of perhaps 5 percent in private vehicles entering the city over the past six months. Gridlock has abated, and you can almost get around the city by car these days.

But the response is slower elsewhere. It certainly is not getting any easier to drive around in places like Sao Paulo, Dubai, and Shanghai. For a variety of reasons, mostly related to government intervention, few emerging market economies can be categorized as having flexible resource demand, so commodity price spikes are not having a particularly big effect on demand.

The central bankers who tell us not to worry about inflation point to relative wage stability. Expansions usually start collapsing when labor gets too scarce and too expensive. But the current expansion is unusual in that, due to unique circumstances, labor constraints are not the problem. On the contrary, the effective global labor force keeps swelling.

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 policymakers find a way to achieve the necessary international coordination?

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.

Kenneth Rogoff is professor of economics and public policy at Harvard, and was formerly chief economist at the IMF. © 2008 Project Syndicate (www.project-syndicate.org)


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