Recession or inflation?

What is going on? Commodity markets are surging as if the world was taking off for mad growth, whilst corporate debt and equity markets are falling, with people worried that there will be a major recession. They can’t both be right.

It is true that there is a big shift in relative economic power underway from the USA and Europe to Asia, and to commodity producing economies from the rest. The transition has been speeded up and made more painful for the West by the credit excesses in the major western economies. We have just lived through a long period of substantial borrowing by governments and customers in the USA and Europe. Much of this money has been spent on buying the cheap manufactured goods pouring out of China and the other Asian centres. Volumes have reached such a pitch that commodity prices are now exploding to feed the great factories of Asia. After years of ever cheaper competition, prices are on the rise in Asia, and those price rises are spilling over into the western countries that have been buying these goods. Agricultural products are in demand, as some are diverted for fuel use at the same time as the Asian dinner tables are filled with more meat and grains.

Some people now think the debt excesses have been so great, and the actual losses recorded by banks so large, that the USA will plunge this year into outright recession. This should mean a sharp slowdown in growth in Europe as well. It will also hit Asian export industries which have been feeding the USA debt burdened monster.

If this does come to pass, it is difficult to see a continuation of the commodity surges that we are becoming accustomed to. Whilst Asian demand is now an important component of global demand, the USA and Europe still represent over 40% of world output, so a move into recession in these two giants should take the heat out of the demand for commodities.

It is true that western banks have lost significant sums in the debt crisis. It is difficult to know how long it will take for them to mark the prices of all the debt instruments they hold down to realistic levels, and when the debt markets will start to function at better levels again. It is also true that there are huge sums available for investment in China and in the commodity producing economies. Both Russia and the Middle East have generated vast cash pools for private individuals, companies and states out of the soaring price of oil. Some of this money will be spent on large construction projects and on putting in more capacity to their growing industrial and service sectors. Some will be spent on recapitalising western banks and buying equity investments in western markets, dragged lower by the credit crunch.

So there are three possible scenarios from here for the world economy. One is the doomsters are right. There will be a further ferocious leg to the bear market, as the credit crunch intensifies. The USA will go into recession. Europe will grow very slowly if at all, western property markets will become more distressed, and China and India will slow as the USA engine seizes. In these conditions commodity prices should keel over just as share prices already have.

The second is the muddling through scenario. The US authorities will do enough to prevent the collapse into recession. The US economy will splutter but it won’t decline. The big falls in the dollar experienced so far will allow more competitive US firms to export more, and to replace some imports with domestic production. The European economy will slow, but the Asian economies will continue to expand based more on internal demand. China in an Olympic year will have a great party and ensure her growth carries on. Her currency will strengthen further, helping her control domestic inflation a bit. The warning yesterday that inflation is serious in China and growth will have to be slower should still leave China growing quickly by world standards. The big money held by the commodity producers will gradually be used to recapitalise the west and to expand their own economies. People will start to buy shares again.

The third is the recurrence of inflation possibility. Some think the US is being too bold in cutting rates and making cash available to the banking system. They think we will soon be back to excess liquidity, which in the short term could power shares as well as government bonds higher along with commodities, until a proper bear market set in when the Fed realises its has overdone it and has to hike rates to try to control price increases. That, they argue might well be delayed until after the Presidential election at the end of this year.

Any of these is possible. To me it feels more like muddling through. Most economists expect 4% growth worldwide this year, whilst allowing for a sharp slowdown in the USA. The banks may have more to write off, but there are signs that the larger US banks are taking strong action to acknowledge past mistakes, appoint new management, and bring in new capital. The quicker they do that, the better the prospects for continued growth. The large moves in currency values will help US industry export and will bring the US balance of trade deficit down further. The higher level of the Euro will add to the forces producing slower growth in Euroland.


  1. Stuart Fairney
    March 5, 2008

    This is a really decent analysis of current economic issues. It stands in rather stark contrast to Mr Darling running around a la Corporal Jones of Dad's army fame shouting "Don't panic"

  2. mikestallard
    March 5, 2008

    It is very comforting to know that there is a chance that China is not going to wreck the Anglophone settlement. Thank you for the encouragement.
    Surely, though, in the long term, if all the work is being done by China, won't the balance of power shift there too? Soon they will be able to manufacture weapons for their beloved army and also, once skilled occupations get going, people will flood in from the increasingly poor West.
    To be honest, I cannot really see why UK is so rich at the moment. Is it because we are desperately over valued?


  3. Tears for Tier 1
    March 6, 2008

    Well done Mr Redwood for this analysis.

    I just can’t make up my mind which scenario is most likely.

    In my view the Labour Government’s economic “miracle” is nothing more than them claiming the credit for the decade of the English speaking peoples.

    The UK’s position on 10 year growth in a table of the English speaking economies is, of course, bottom (including the honorary members of The Netherlands, Sweden and India).

    Brown is taking credit for the decade when the Internet was in English. That benefit is now going as Google catches up with other languages and benefits the non-English speaking economies.

  4. adam
    March 6, 2008

    certainly real inflation rate is not 2%

    if there was a sterling economic crises, or even just problems, we would see worms coming out the woodwork suggesting we join the euro.

  5. David Eyles
    March 6, 2008

    I suspect that you are right and it will amount to a muddling through. But a comment or two on commodities – as a livestock farmer, I am acutely aware of a couple of things:

    The first is oil. I don't see demand, and therefore price, of oil dropping on world markets at all for quite some time. The total demand for energy is not really going to slacken. For the UK, where everything that you buy is transported by lorries, this means that food in particular will be subject to inflation from this commodity alone. Add to that the fact that the take of VAT per litre continues to rise because of the rise in the basic price of oil, and you have a double whammy in fuel and therefore transport costs. Of course, an intelligent and nimble footed chancellor could reduce this inflationary pressure by reducing fuel duty on white and red diesel respectively. However, as Alastair Darling does not fall into either of these categories, fuel inflation will be set to deepen in the UK over and above that of our competitors.

    The second is food itself. You have mentioned rising prosperity in the Far East as a factor in increasing prices, as well as the use of grain as a biofuel. But you have not mentioned the rising world population, which is set to increase by about about two-thirds over the next three or four decades. It is to be hoped that the Australian drought will end soon and allow that country to export grain once again, which will help matters. But the underlying trend for demand in food is definitely up. Furthermore, as climate change bites deeper, supplies from climatically marginal countries like Australia will become increasingly uncertain.

    Furthermore, increases in oil prices have multiplied prices of fertilisers and pesticides dramatically over the last year and, again, I don't think these are going to drop. It means that the productivity per hectare will be increasingly difficult for farmers to maintain – scarcity bringing us another source of inflation.

    Food price inflation started off at the begining of 2007 at about 5 or 6%. It finished the year at about 12%. Whilst graveyards are littered with the corpses of pundits who have predicted this or that doomsday scenario, my guess for what it is worth, is that food price inflation will continue to be in double figures for the next half decade.

    And as China purchases wool in (weak) US dollars and we sell the stuff in (relatively strong) UK pounds, I fully expect my Wool Board cheque to be substantially less than the cost of shearing the sheep, for the second year running. The only negative inflation in sight is prices at the farm gate.

    Sorry to be so cheerful……

  6. Puncheon
    March 6, 2008

    I think what we are seeing is a dichotomy between the credit and stock markets. The banking sector has problems of its own, and of its own making, which it is still trying to come to terms with. Certainly not all Banks have fessed-up to their exposure to the US sub-prime fiasco, and until they do we will not know the full scope of the damage. Of course, the idiocy of the Brown/Darling intervention in the Northern Rock affair does not help, since it just muddies waters that are already murky. The stock markets, as they always do, think they have already discounted the credit downside and are thus fairly comfortable. Whether that view is justified remains to be seen.

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