Why geopolitical tensions don’t threaten a fresh surge in inflation

It’s an intuitively appealing and somewhat alarming thesis. The globalisation of the past 30-odd years pushed down inflation across the world, as cheap imports from China cut the cost of clothes, toys and electronics to rich-country consumers. But the geopolitical fracturing of the world economy is now putting all that at risk. Christine Lagarde, European Central Bank president, warned in April that an escalation of US-China tensions could damage value chains and push global consumer prices up by 5 per cent.

In reality, things aren’t that bad. There’s no doubt that a big dose of disorderly widescale economic decoupling would hit growth and raise prices. But current geopolitical tensions are unlikely to be cataclysmic, while globalisation (and, specifically, cheaper goods) has had less to do with holding down inflation than intuition suggests. More concerning is the possibility that deeper global structural forces will raise prices for years, perhaps decades, into the future.

The coexistence of the rise in post-cold war globalisation and the “great moderation” — low inflation and stable growth — is superficially plausible. In practice, though, economists have found only a modest link and point instead at changes in monetary policy, lower inflation expectations and reduced uprating of wages in line with prices.

For one, the periods don’t quite match. The “hyperglobalisation” period when world trade and global value networks grew most rapidly ran from the late 1990s until shortly before the global financial crisis began in 2008. By that point the fall in inflation in the rich world had largely already happened.

Second, given that goods are much more highly traded than services, you’d have expected rising inflation differentials between the two. In fact, the gap remained constant until after the financial crisis, when services inflation actually fell while goods inflation rose.

As a rough sense check of the impact of cheaper imports, those goods subject to low-cost Chinese competition like clothing, shoes and electronics make up quite small parts of the consumer price basket. In the eurozone, apparel and footwear are about 5 per cent of the total, compared with 15 per cent for housing and utilities (and that’s using a narrow measure of housing costs) and 10 per cent for restaurants and hotels.

Nor does the integration of the big middle-income countries automatically push inflation down. It means increases in demand as well as supply. During the global food crisis of 2007-08, one very common story was that wealthier households in countries like China were increasing commodity prices by eating more resource-intensive fare, particularly meat.

This brings us to Lagarde’s warning. A 5 per cent global uplift on top of existing inflation sounds gruesome. But on examination, the underlying estimates, while thorough and interesting, read like a thought experiment rather than a serious prediction.

The ECB economists model the world breaking into geopolitical blocs putting up non-tariff barriers such as regulations and standards against each other. But those groupings are based on past voting records in the UN. Largely cost-free political posturing does not equal joining one gang to take an economic hit from the other.

In this scenario India, for example, is in a China-centred camp. In practice it is highly unlikely that New Delhi, while it may be sceptical of the US and EU’s military and foreign policy support for Ukraine, is going to throw in its trading lot with a geopolitical rival like China — especially given India’s ambitions to export manufactured goods to Europe. Currently, the big emerging markets — India, Indonesia, Brazil — strive to remain economically non-aligned.

Moreover, the estimates are based on an initial shock, without economies finding new import sources and export markets from within their own geopolitical sphere. A flexible response drastically reduces the price increase from 5 per cent to 1 per cent.

So, all back to low-inflation normal soon? Not so fast. Other global forces are in play. One is demographics. The ageing of populations worldwide is likely to reduce labour supply and may increase workers’ bargaining power, meaning that higher inflation may lead to wage-price spirals. The cost of the green transition, too, with vast investments to be made in new technologies and the scrapping of old ones, creates a mismatch between demand and supply which is likely to increase prices.

These structural forces are probably more important than the threat of geopolitical fracture and damage to the global goods trading system — absent, of course, a cataclysmic supply shock like a Chinese invasion of Taiwan. How such price level shocks feed into medium-term inflation depends on how central banks, workers and employers react. But those anxiously watching geopolitical tensions and mapping them on to the cost of living are probably looking in the wrong place.