The Yangshan Port in Shanghai, China (Photo by In Pictures Ltd./Corbis via Getty Images)
Did globalization bring down inflation in the 1990s and 2000s, and will de-globalization push inflation up in the coming decade? This theory seems to fly in the face of Milton Friedman’s famous dictum that inflation is a monetary phenomenon. But looked at more carefully, de-globalization could affect inflation, but only if the Federal Reserve and world’s other central banks fail to see what’s happening.
To understand globalization and supply chain effects on prices, let’s go back to simple supply and demand. Globalization has meant that consumers can get goods more cheaply from countries with low labor costs or high technology usage. Increased globalization is therefore like an increase in the supply of goods and, to a lesser extent, services. That increased supply means lower prices, all other things being equal.
The price-reduction effect continues as long as globalization increases. If globalization levels off, then the price level stays lower but does not continue to fall. That’s important because inflation is the rate of change of the price level. And a price reduction lowers measured inflation when it occurs, but does not continue to lower inflation unless prices keep falling.
In 2022 businesses around the world are trying to de-globalize their supply chains. Some of this change reflects the vulnerability of long supply chains to disruptions. That’s generally true, as illustrated by the Russia-Ukraine war and Covid-19 lockdowns. Earlier disruptions included 2011’s earthquake and tsunami in Japan as well as Thailand’s floods that shut down hard-drive factories.
Today many companies are willing to pay a little more for a shorter, safer supply chain. This shift is happening gradually. Companies willing to pay a couple of percent higher prices for a product are still unwilling to pay 20% or 30% more. However, suppliers in North America and Europe are seeing more demand, so they will increase productive capacity to meet the demand. That will eventually reverse the current price increases.
Shortening supply chains is not a pure increase in prices. If the effort succeeds in reducing disruptions, then we’ll have fewer price spikes, at the cost of somewhat higher prices in normal times. That will probably net out to an increase, but not quite as severe as it seems at first blush.
Demographic changes can also impact supply. Entry of the baby boom generation into working age from 1970 through 2010 was a huge change, as was the increased labor force participation of women from 1950 through 2000. The increased labor supply from both of these changes tended to lower prices. And they were not solely American phenomena. Similar patterns appeared in many other countries, though the timing varied.
The impact of supply changes does not refute Friedman’s conclusion that inflation is caused by excessive money supply growth. Read his full sentence: “It follows from the propositions I have so far stated that inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output.”
To put words into Friedman’s mouth, globalization and demographics increased output, but that was deflationary only if the money supply grew in line with the old, slower growth of supply rather than the new faster growth of supply. Similarly, today’s de-globalization is inflationary only if money supply increases at a pace aligned with faster growth of supply. In other words, monetary policy is the key, but monetary policy relative to these big changes in supply.
The Federal Reserve and other central banks around the world must keep an eye on global supply issues, which they are doing. It’s certainly hard for anyone—economist or business leader—to know in real time just what’s going on. We must accept that monetary policy cannot be perfect. But persistent high inflation or low inflation must be laid at the feet of monetary policy makers, not blamed on globalization or demographics.
The job of central bankers would be much easier if the economy’s underlying structure did not change. Business leaders should understand that times of larger structural change, as we are currently undergoing, make monetary policy mistakes more likely. Thus businesses should be more prepared for surprises, both upside and downside, in inflation and real economic growth.
