Taking Stock / The Third Story

Even spattered by subprime sludge, most investors feel the U.S. is still the fairest and most transparent market of them all.

It's axiomatic to anybody who reads the business pages: Inflation has reared its ugly head. But it isn't the usual dangerous type of inflation, it's a new animal.

Generally the blame is placed squarely on the spiraling prices of food and energy. In turn, the blame for that is cast at the boom in the emerging giants - China, India and their ilk, which began swallowing vast amounts of food and energy products.

At this point the story splits into two camps. The first claims that the price increases are a one-shot deal and that the food and energy markets will adjust, the increases will stop, and then, inflation will abate. The second camp argues that prices will continue to rise and that our economic leaders are helpless to fight the inflation this creates because this isn't the old type of inflation, it's a new one driven by demand in emerging markets.

No question about it, the story about food and oil inflation, nonrecurring or new, is fascinating. Anybody can embrace this story, tell it to the kids.

But let us tell a third story, rather less innovative and sexy and rather more complex, and not new at all. The wave of inflation in 2008 is the same as any old wave in the past. It begins and ends with cheap money chasing products and services.

The driver behind the 2008 worldwide wave of inflation lies in the monetary policy of the most influential superpower of them all, the United States.

The legendary former chairman of the U.S. Federal Reserve, Alan Greenspan, started the process, and his successor, Ben Bernanke, is continuing it, abetted by U.S. President George W. Bush. The threesome was determined to stop the U.S. from sliding into recession and instituted a policy of cheap money and la dolce vita. The Fed kept interest rates low, sometimes even negative in real terms, and the U.S. government lowered tax and poured money into the economy.

That's a policy that begs inflation, but globalization, the boom in cheap imports from China and rising productivity blunted or deferred the effect of the policy (cheap money and the good life) on prices.

With the advent of Bernanke and the imminent departure of Bush, one might expect the easy-money policy to end. But it seems nobody wants to be the bad cop, not even the central bankers whose job it is to take away the punch bowl at the party.

No, global inflation wasn't caused by soaring food and energy prices. Commodity prices were simply first to react to the roaring floods of money pouring into the international financial markets.

Because money was cheap, the public didn't save and the government spent and spent, the dollar imploded, losing 17.6% of its value over three years against other main currencies. The dollar's collapse drove the "export" of U.S. inflation to the rest of the world.

It also drove the world's central bankers into a dilemma. Local rate hikes would strengthen local currencies even more, hurting exports and slowing their economies. And we see the result worldwide. Inflation is lifting its ugly head in China, India, Mexico, Brazil and even in Europe, but the central bankers are baffled. Some waffle, some gradually nudge up interest rates, but almost all are keeping their real interest rates negative. Global inflation is running at about 5%, but central-bank interest rates are around 4% and the merriest central bank of them all is (naturally) the Fed, which is keeping its rate at 2% against inflation of 5%.

The U.S. policy of easy money and towering deficits combined with the diving dollar are challenging central bankers everywhere. Inflation is roaring in China, but Beijing isn't hurrying to raise interest rates because it's focusing on protecting the local currency. Fear of power-outages during the Olympic Games induced the government to cut subsidies for electricity and gasoline, which just whipped up inflation some more, making life harder for Chinese manufacturers. That in turn makes them raise their prices and exports Chinese inflation to the rest of the world.

The Bank of Israel is in the same trap. The consumer price index has risen by 5.4% in the last 12 months, but Bank of Israel Governor Stanley Fischer settled for tweaking interest rates, raising them 0.25% this week. He has good reason: Just two months ago Israel's manufacturers campaigned against him, calling on him to lower interest rates to save the economy from the shattering dollar.

Rapid rate hikes at this time would mark Fischer as being responsible for the dollar's drop against the shekel, and thus as the culprit behind any future crisis in Israel, which has so far largely escaped the ripples of the global turbulence.

The boom in India and China should weaken American hegemony, they say. The power is gradually shifting to the Asian giants and other emerging markets, and America's economic problems should worry us less, they say.

But the scenario is more complex. Most of the money accrued in the emerging markets because of booming exports and commodity prices continues to finance the gargantuan American deficits. The U.S. economy needs an injection of about $2 billion a day to finance the trade deficit, and 40% of those dollars come from the emerging markets.

Why do China, India, Mexico, Brazil and all the rest continue to stream their surplus money to the sick American economy, even after the subprime crisis, the Iraqi debacle and the Wall Street crisis? Kristin Forbes of MIT, one of Bush's economic advisers, calculated that in the last five years, - "before the recent turmoil in U.S. financial markets" - foreign investors averaged annual returns of only 4.3% on their U.S. investments, a third of the returns U.S. investors earned elsewhere.

The attraction in the U.S. was clearly not returns, concluded Forbes, it was the low risk. Even after Bear Stearns' collapse and the subprime meltdown, most investors believe the U.S. is the fairest and most transparent market of them all. It will evidently take a long time before the international markets truly wean themselves off their dependence on America and meanwhile, we'll just have to keep taking the garbage, like global inflation, from the Americans and their economic policies.