I remember a popular sticker in Germany during the 1970s, designed to ridicule the opponents of atomic energy. It read: "Nuclear power? No thanks! We get electricity from our power sockets."
Our current debate on inflation sometimes reminds me of this absurd statement. When someone says inflation is caused by higher oil prices, he or she might as well say that electricity comes out of the socket. Since inflation measures the changes of weighted prices in a basket of goods and services, there is always one price that rises the fastest. But this is of course not the cause of inflation. We want to know what causes those prices to rise.
Excessive global demand may be the next element in the chain, but something must have caused that too. At the end of the chain we find economic policies - some combination of undervalued exchange rates in some newly industrialised economies or excessively low interest rates. If that explanation were true, it would not be a bad start if the world's 15 or 20 largest economies agreed to make exchange rates more flexible and to tighten global monetary policies.
But this would confront us with an unfamiliar collective action problem. The Group of Eight (G8) leading industrial nations, at the level of which such crises were dealt with in the past, is too narrow to solve this particular problem. Jean Pisani-Ferry, the French economist, pointed out in a recent article in Le Monde that, since developing economies have accounted for 80 per cent of the increase in global oil demand since the year 2000, excessive policy tightening in the west is not going to solve the global inflation problem. But as nobody is in a hurry to turn the G8 into a G13, to include China, India, Brazil, South Africa and Mexico, there is an acute danger that there will be no such co-ordination.
The most likely alternative is even higher global inflation. Not all central banks will allow it. Among those that will not is almost certain to be Sweden's Riksbank, which has already raised interest rates twice since the start of the crisis and hinted at further rate rises.
In the euro area, I would expect a partial accommodation of higher inflation. The European Central Bank (ECB) probably does not have the stomach for several further rate increases, which would be needed to get inflation back towards the target of "close to, but less than" 2.0 per cent. So there is a risk of a moderate, but permanent increase in inflationary expectations. A 3.0 per cent inflation rate, for example, would be no disaster but still represents an unnecessary hit to living standards that would have been entirely avoidable.
In large parts of the developing world, and in the US, I would expect much higher inflation to be tolerated. In particular, a large number of emerging economies will accept it as a price worth paying to maintain their unsustainable development strategies. Among them will be China. One of the possible consequences would be further volatility in global exchange rates and further upward pressure on the euro.
Judging from some recent comments from senior European officials, I would not be surprised if the European Union (EU) were to link further trade liberalisation to exchange-rate liberalisation - or to link the absence of exchange-rate liberalisation to a crackdown on free trade. This is economically one of the least desirable ways to take care of the problem of excess global demand. We would be solving what is essentially a cyclical demand problem through a structural supply shift.
In the US, support for free trade has been falling for a long time, but in the end I would not expect the US to be the main driver of global protectionism, irrespective of who is the next president. The weak dollar will take care of the problem, as it always did in the past.
The real problem will be Europe, where protectionist pressures have been rising at an alarming rate among the political elites. President Nicolas Sarkozy of France defines the role of the EU as one of protecting its citizens. Giulio Tremonti, the Italian finance minister, has produced a best-selling booklet in which he expressed deep scepticism about globalisation. And in Germany, the word "locust" has become a widely used synonym for global financial investors.
The most important point about Mr Sarkozy's recent criticisms of Peter Mandelson, the EU trade commissioner, is not the content of the allegations. Mr Mandelson is clearly not to blame for the Irish No vote on the Lisbon treaty. But Mr Sarkozy's confused ramblings serve as a warning that he may be preparing to push one of his cronies to take over the trade portfolio in the new European Commission (EC) next year. In any case, I would expect the EU's trade policy to change next year - not for the better.
So if we do not solve the problem through macroeconomic policy co-ordination, we may solve it through a trade war or some other suboptimal policy response. Waiting for cheap alternative energies is the right response in the long run but without a short-term answer we may never get there.
The prerequisite for collective action at the global level is a recognition that, first, inflation is a problem and, second, that it is caused by a policy-induced rise in global demand. Alternatively, we may keep on having visions about the causes of inflation -- and electricity. (FT Syndication Service)
