Globalization and Global Disinflation

By Rogoff, Kenneth | Economic Review - Federal Reserve Bank of Kansas City, Fourth Quarter 2003 | Go to article overview

Globalization and Global Disinflation


Rogoff, Kenneth, Economic Review - Federal Reserve Bank of Kansas City


Over the past 10 years, global inflation has dropped from 30 percent to 4 percent.1 Without question, a large part of this breathtaking drop in inflation has to be attributed to improved central bank institutions and practice: enhanced central bank independence, a greater prevalence of more conservative anti-inflation oriented central bankers, better communications strategies, and improved monetary control capabilities. Also, the greater awareness in central bank boards, and among politicians and the public that higher inflation is the wrong instrument to deal with deep-seated structural and fiscal problems has no doubt encouraged central bank efforts. Yes, central banks rightly deserve a lot of credit for todays low inflation rates, but do they deserve it all? Have tailwinds made the political economy of disinflation in the last decade or two easier than commonly recognized? Will factors that for a while may have been exceptionally supportive of anti-inflation efforts be reversed? Improved fiscal policy and the technology revolution are examples of such factors which are popular in many explanations of the recent disinflation trends. I focus, instead, on the increased level of competition-in both product and labor markets-that has resulted from the interplay of increased globalization, deregulation, and a decreased role for governments in many economies.

Obviously, since competition tends to drive down prices, such an interplay should have some direct impact on inflation. However, I argue here that the major influence of competition on prices works through the political economy process that governs long-term inflation trends. Competition not only tends to reduce the overall level of prices, but it also tends to make prices (and wages) more flexible. As a consequence, the real effects of unanticipated monetary policy become smaller and more transitory. Hence, there is less cause for central banks to inflate and less incentive for politicians to pressure them to do so. Perhaps no less important, output and employment tend to be higher in an economy with greater competition. This, too, undermines potential pressures on the central bank to inflate. The net effect of these reduced pressures is that the central bank's anti-inflation credibility is enhanced, and trend inflation falls.

In what follows, the discussion is mostly nontechnical. Toward the end of the paper though, I sharpen my central point with a small mathematical model. Technically adept but impatient readers may wish to turn immediately to section II. By no means is this the only model of how globalization may affect trend inflation. Dollarization, for example, in many emerging markets, forces inflation-prone governments to temper their behavior for fear of having residents flee to other currencies. Regardless, the remarkable breadth of disinflation's shadow and the sweeping range of countries it has touched strongly suggest that there must be deeper political economy causes at work than are commonly recognized.

Whatever the explanation of global disinflation, the raw data are stunning. In recent years, inflation around the world has dropped to levels that only two decades ago seemed frustratingly unattainable. If one takes into account technical biases in the construction of the CPI, as well as central banks' desire to maintain a small amount of padding to facilitate relative price adjustment and avoid deflation then, disinflation has already run its full course in most industrialized countries. In the developing world, if current trends persist-with the emphasis on "if"-inflation will be tamed within a decade. Can the current situation be regarded as stable into the indefinite future? Has the inflation process changed fundamentally?

The story in the advanced countries is well recorded: Inflation averaged 9 percent in the first half of the 1980s, versus 2 percent since the beginning of this decade. Far less well known is the remarkable performance of the developing countries, with inflation falling from an average of 31 percent in 1980-84 to an average of under 6 percent in 2000-03. …

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