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From Global Inflation to U.S. Financial Crisis


——Evolution Logic and China's Countermeasures in the Current World Economic Cycle

By Xia Bin, Research Institute of Finance, DRC

Research Report 001, 2009

2008 was a year of drastic world economic turmoil. While the whole world feared a continued price rise in the first half of the year, the Wall Street financial storm swept across all financial markets around the globe and triggered a visible downturn in the world economy in the second half of the year. In China, the goal set at the conference held by CPC Central Committee on economic work in December 2007 was still. to prevent the fast-growing economy from being overheated, and keep structural price rises from turning into overall inflation In July 2008, the central authorities explicitly pointed out that the primary task for macro-regulation was to ensure a steady and fairly fast economic development and to prevent the prices from rising too fast.

Why did the world economic situation change so fast and why did China change the direction of its macro-regulation so swiftly? This article attempts to answer these questions through the analysis below.

I. Turning Point Appeared in the High Returns of Globalization and Population Dividends

Accelerated economic globalization over the past five years should be the starting point for us to understand the changes in the world economic and financial situation. Economic globalization over nearly 150 years can be divided into two periods. The first period ran from 1870 to 1913. During the four decades or so, economic globalization surged across the world, with the global trade growing at an average annual rate of 4% and the ratio of average global trade growth to global output growth rising from 10% in 1870 to 20% in 1913. The second period ran from 1980 to the present. During this period, global trade grew at an average annual rate of 11%, its ratio to global output rose from 22% to about 42% at present. Spurred by the rapid growth of global trade, global economy also grew relatively fast. While the average GDP growth was 2.1% for 1870~1913, it has been 3.9% since 1998. What has been driving globalization forward? The main force driving the first globalization was industrial revolution and technological innovation. Since steam-powered ship was invented in 1812, the power of steam engines had continued to increase for over a century. The opening of Suez Canal in 1869 drastically cut the cost of fuel and transport. Railways around the world totaled 1 million kilometers in 1913. The flow of population was mainly the movement of European settlers to the United States, Canada, Australia and other countries.

The second globalization has been mainly driven by two forces. The first is information and communications technologies. They have made the world smaller and the economic relations between various countries further closer and brought great changes to the production and supply chains. The second is the changes in social systems. During the Cold War period, the economies of China, the former Soviet Union and some socialist countries in East Europe were largely isolated from the capitalist economic system. In the final two decades of the last century, these countries switched to market economy, with some of them being directly integrated into the capitalist world. Some emerging countries also began to embark upon a fast track to integrate with market economy. That means that many of the formerly closed countries opened their doors to welcome foreign capital. With 3 billion people, China, India and some Asian countries alone accounted for about half of the world population and the bulk of their cheap labor had been in isolation. But in the final two decades of the last century, these countries opened their doors to welcome capital investment around the world. According to the estimate of a Harvard University professor, the world had an additional cheap labor of 500 million people all of a sudden. Meanwhile, the developed countries in the West actively pushed forward globalization strategies to pursue even higher returns on their capital investment. Accordingly, the changes in the supply chains and production patterns enhanced labor productivity and inevitably produced large quantities of cheap commodities.

In particular, globalization further accelerated in the five years before the U.S. sub-prime loan crisis. The world economy at the time was characterized with high growth and low price. During the 1998~2002 period, the global average GDP growth was 3.4% and the average price rise was 4.4%. But during the 2003~2007 period, the global GDP growth reached 4.9%. While economic growth became faster, prices became lower, at 3.6% on average. What deserved special attention in this round of economic globalization?

First, the high world economic growth in this round of globalization was mainly driven by Asia, with China, India, other Asian countries and emerging countries being the main engines of world economic growth. From 2000 to 2007, the average economic growth was 8% for Asia and only 3% for the rest of the world, with the former being 2.7 times the latter.

Second, the United States was the largest economy in the world. In this round of globalization, its economic growth was very fast, but 70% of this growth was driven by consumption. In other words, the United States fulfilled a large chunk of consumption in world economic growth and at the same time fully benefited from cheap commodities.

Third, the sustained high growth of the world economy meant a marked improvement in the living standards of several billion people and a sharp increase in the global demand for various resources. The nominal consumption of the developing countries, which stood at 4.5 trillion dollars in 2000, went up twice as much by 2007, reaching 9 trillion dollars. In other words, while the United States and other developed countries maintained a high growth in consumption, the developing countries posted a rapid growth in both investment and consumption. The rapid growth of global investment and consumption inevitably brought a tremendous pressure on the demand for staple products, including minerals and crude oil.

A logic economic conclusion is that the sustained high economic growth, which arose from the deepening globalization and the rapid improvement in the living standards of several billion people around the world, were bound to gradually drive up labor costs and exert pressure on resources. The dividends of globalization and population gradually declined. Against this backdrop, the prices would not continue to rise if the global demand was excessively strong and the currency supply was under control. Then why did the prices begin to skyrocket and trigger a financial crisis in the United States at the end of last year? To answer this question, we need to examine the other end of commodities – the currencies.

II. Dollar Dominance in Global Price Hikes

In this round of global price hikes, currencies naturally played a decisive role. As the American dollar is the main currency for international settlement, we naturally must begin with the dollar.

Let's first analyze the dollar demand from the static perspective. As we said earlier, this round of economic growth was mainly driven by the Asian countries and some emerging countries. Their fast growth had the following basic features. One, it was export-oriented. Both the past "four little dragons" and "four little tigers" and the present China, India and Vietnam were employing the export-oriented growth model. Two, these countries resorted to a relatively fixed exchange-rate system or the dollar-peg system in order to support their export industries, promote their economic growth and pursue their catch-up-and-surpass strategies. Three, these countries, drawing on the lessons of the Asian financial crisis, willingly accumulated huge foreign reserves. At present, the Asian countries claimed the largest chunk of official foreign reserves around the world. On the one hand, they had to find outlets for their huge foreign reserves accumulated from rapid economic growth. On the other, the growth of their national currencies, after their export exchange earnings were settled by the central banks, produced a heavy pressure on the investment demand and on the prices of general goods and assets.


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