A NEW THINKING IS REQUIRED

If emerging economies diverge from America's, monetary policy also needs to break free POLICYMAKERS in Washington and London have been losing sleep over the risks of financial meltdown and recession. In sharp contrast, the biggest worry in Beijing, Moscow and other emerging-market capitals is rising inflation. China's inflation rate has jumped to 8.3% from 2.2% in early 2007; Russia's is running at 13.3% (see left-hand chart). HSBC forecasts that the average inflation rate in emerging economies will rise to 6.6% this year, its highest in ten years. One reason is the surge in food and energy prices. Food accounts for a bigger slice of spending in poor countries than in rich ones, so rising grain and meat prices have a bigger impact on inflation. But this is only part of the story: core inflation rates are also creeping up, and lax monetary policies are to blame. As America stumbles, growth in emerging economies seems to be holding up well. HSBC forecasts average GDP growth of 6.5% this year, more than four times as fast as in developed countries. The problem is that although economies may have decoupled, their monetary policies have not. Whereas the greater resilience of the emerging world is a source of stability for the global economy, the monetary linkages between rich and poor economies complicate matters. Emerging economies were partly to blame for America's housing and credit bubble. As China and Gulf oil exporters purchased American Treasury bonds in order to hold down their currencies, this pushed down bond yields and helped to fuel the housing boom. Low yields also encouraged investors to seek higher returns in riskier assets, such as mortgage-backed securities. That bubble has burst, prompting the Federal Reserve to slash interest rates. Now, those same exchange-rate policies that helped to cause America's financial crisis are leading emerging economies to run overly loose monetary policies. Apart from the Gulf states, few countries still peg their currencies to the dollar, but most try to limit the amount of appreciation. This means that as the Fed cuts rates there is pressure on emerging economies to do the same, to prevent capital inflows pushing up their exchange rates. Saudi Arabia, the United Arab Emirates, Qatar and Bahrain have all followed the Fed's April 30th rate cut. In the face of rising inflation, emerging economies should be lifting interest rates, not cutting them, but their rigid currency policies make this hard. In turn, continued surging demand in emerging economies boosts commodity prices, which reduces Americans' spending power and so encourages the Fed to cut rates further. The more the Fed cuts, the bigger the risk of inflation in emerging markets. The right-hand chart shows just how loose monetary policy is. Joachim Fels and Manoj Pradhan, of Morgan Stanley, have made a stab at estimating neutral interest rates, ie, the short-term rates that would keep GDP growing at its trend pace and inflation on a stable path. The results are startling. In China and Russia, actual real rates are negative, against estimates of neutral real rates of 8% and 5% respectively. In India, real rates are close to zero—still far below the estimated neutral rate of 6%. Only in Brazil are real rates positive and above the neutral rate. Admittedly this ignores other tightening measures that central banks use, such as banks' reserve requirements (both India and China have been steadily increasing them). Nevertheless, it is no coincidence that Brazil has the lowest inflation rate of the four countries. Russia, with the lowest real interest rates, has the highest inflation. Not so easy The usual advice given to overheating emerging economies is that they must let their currencies rise. This would help to curb inflation by reducing import prices, and a flexible exchange rate would create more room for an independent monetary policy. Currency appreciation thus seems the obvious solution. However, Stephen King and Stuart Green, economists at HSBC, argue in a recent report that it raises many awkward questions. How far should currencies rise in order to keep inflation in check? China has allowed the yuan to rise by 18% against the dollar since 2005. Brazil's currency has appreciated by more than 100% since 2003, yet even this has not stopped inflation from picking up. At 4.7%, the rate may be lower than other big developing countries, but it is still up from less than 3% a year ago, partly because of excessive growth in domestic demand. In the past two years real interest rates have fallen sharply (although they are still the highest in the world) and public spending has surged. In April the central bank raised interest rates for the first time in three years, but this is likely to lure in foreign capital. Should Brazil let its exchange rate rise further—when its current account has already moved back into deficit? The danger of allowing these currencies to float is that they could overshoot as foreign capital floods in, eroding competitiveness and leaving economies vulnerable to a future reversal in capital flows. Another concern is whether it is wise to allow exchange rates to rise sharply when emerging-market exports are being hurt by an American recession. There are no easy solutions. One alternative to a free float is a one-off appreciation. The danger is that this could encourage the expectation of further appreciation, attract even bigger capital inflows and so exacerbate inflation. To work, the revaluation would need to be so big that speculators no longer expected a further rise. But a big increase might not be politically feasible. Another solution is to tighten fiscal policy. This would cool domestic demand without the need for a big rise in interest rates. The snag is that it would boost domestic saving and hence lead to larger current-account surpluses—the opposite of what America requires. The third option, and the one most likely to be pursued, is to do nothing apart from slapping on some temporary price controls, and hope that inflation pressures will soon ease. The risk is that if inflation continues to rise, policymakers will eventually have to slam on the monetary brakes. IF GILBERT AND SULLIVAN were looking for the very model of a modern intellectual, they would surely pick Jeffrey Sachs. He is so “right on” that when Time magazine featured him in its global list of people who influence the world, his profile was written by Bono, a rock singer. His job titles—director of the Earth Institute and special adviser to the United Nations Secretary-General on the Millennium Development Goals—seem almost tailor-made to get up the noses of conservatives. Nor is Mr Sachs lacking in ambition. His previous book was called “The End of Poverty”. Now he has moved on to tackle a wide range of other challenges facing the planet, from climate change through to disease eradication. His goals include stabilisation of the world's population, a move to sustainable energy use and “a new approach to global problem solving”. If the above makes Mr Sachs sound like an impractical dreamer, that would be rather unfair. This densely written book is packed with statistics and carefully worded arguments. Nor is the author a left-wing ideologue. He recognises that the private sector and market-based solutions have a vital role to play. He cites, for example, the success achieved by public-private sector initiatives in tackling acid rain and chlorofluorocarbon emissions. On population control, he makes the good (if counter-intuitive) point that improvements in infant mortality are an important part of the solution. When families know that more of their children will survive into adulthood, they have fewer kids. Reduced fertility in turn leads to improved living standards and, eventually, by cutting the numbers of idle and impoverished young men, reduces the potential for conflict and terrorism. As he remarks, this makes the Bush administration's negative attitude towards family planning even more difficult to understand. Courageously, Mr Sachs does not ignore costs. He reckons the bill for tackling the issues he raises will come to a total of 2.4% of rich-world economic output (about one year's growth). That seems a reasonable price to pay, provided of course that you are not paying it. Indeed, the book's rather jaunty tone plays down some of the hard choices that will need to be made if the world's problems are to be tackled. On climate change, Mr Sachs is very enthusiastic about carbon capture and sequestration, a technology that is unproven on a large scale and will be difficult to adapt to existing power plants. One must also doubt whether all the world's cars could really be converted into gas-electric hybrids by 2026, as he suggests. This brings us to the main problem with the book: it is unremittingly worthy and expects other people to be so too. When the author writes that a post-Kyoto agreement on climate change “should include all actors, not just the rich ones, and not just the rich ones who are willing to reduce emissions”, one wonders how many real people would vote for that. Similarly, he says blithely that “in order to combat poverty and inequality, it is also essential to combat racism and intolerance.” If everyone in the world were as reasonable as Mr Sachs, his solutions would be easy to implement. However, if everyone were that reasonable, there would not be so many problems in the first place.