I spent last two weeks on holiday in Tuscany, Italy, in lovely Montaione area. Great food, great weather, the only negative were mosquitos, which bite real bad at night. I was surprised as mosquitos were much worse that in Cambodia or Myanmar, where I spent two weeks last November. Anyway, I was cut off from news and internet, so when I came back I found the world moving in direction I anticipated. US subprime problems are spreading, eating into other asset classes, equities now seem to caught the virus as well. Despite these developments IMF has upgraded its global growth forecast for 2007 and 2008 to 5.2%, versus 4.9% in April WEO, raising the credit and other financial risk profile.

I also noticed that there was a deluge of analytical work arguing that globalization no longer reduces inflation, on the contrary it adds to inflation. Some analysts conclude that this is the end of great moderation, and we should brace for a period of higher inflation, higher interest rates and rock-and-roll on financial markets. While more financial volatility is certainly ahead of us (subprime, credit derivatives, more fund closures) I disagree with those who predict globalization will push inflation up. See below why:

People and companies do respond to incentives, adn in XXI century this response is much faster than in previous centuries amid ICT deepening. In brief I expect the following:

  • there is rising likelihood of disruptive innovation, that would tend to reduce the energy price over the medium to long run (in the short run I would not be surprised to see oil trading above 100 or even 200 dlr/b, which would accelerate innovation process even further
  • the next big cost-cutting offshoring trend will be from Asia (China) to Africa. Europe and US will miss this one, so the new wave of cheaper manufactured goods will benefit consumers globally, and benefit companies mostly in Asia.
  • ICT deepening will make consumer electronics cheaper every year, in couple of years you will not pay for devices only for services provided via these devices (think of Microsoft products for “free”, but paying small amount for watching something, listening, or making transfer with the use of such products).
  • China entry into the automotive sector will reduce prices and improve overall quality. Imagine in 10 years a car similar to today BMW 500 series or Mercedes E class selling for 10,000 todays euros.
  • All of the above will reduce inflation ex food significantly
  • In the medium run I expect food prices to rise amid rising living standards (shift from food commodity to processed food), rising demand for biofuels) and supply disruption amid global warming. It could lead to agflation.
  • In the long run Africa (with China help) will be able to follow Jeffrey Sachs virtous circle and will massively improve its agriculture output, moving from subsistence farming to world food exporter. It will stabilize food prices after a period of agflation.
  • Return to education will continue to rise for some time, creating incentives to study and invest in human capital. War for talent will continue for a few years, and then supply of talent will outstrip demand for talent.
  • After a brief rise of global unit labor costs, new wave of offshoring/outsourcing/networking will stimulate innovation of business processes (and knowledge processes in particular) and productivity will surge again. Robert Lucas great convergence story will finally kick off in the XXI century, with Europe and US slowing and Asia/Africa keeping high single or two digit growth.
  • Asia will continue to develop its financial markets, within next 10-20 years financial markets will also be developed in most African countries. In 2020s rating agencies will have to change their rating methods, as almost all countries will move to investment grade. It will be achieved via massive productivity improvements and associated unit labor costs declines.

I have listed just few points on my very long ist of arguments suggesting that in the long run globalization will keep inflation low. Actually if you study history of inflation you will find that periods of low inflation/deflation dominated over periods of high inflation, and this was especially true in periods of accelerated globalization. So in my view the serious inflation threat may emerge not because of globalization, but when globalization slows amid protectionism adopted by developed countries, in particular with respect to capital account transactions. Recent initiatives in US and Germany unfortunately take us in this much undesired direction. I hope Asian and oil-based SWFs respond by increasing transparency before it is too late.