Inflation is a debilitating force that can ruin the whole economy because of the uncertainties it brings. Inflation can easily turn into a vicious upward spiral because everybody expects and behaves as if higher prices will continue. A 10% rate of inflation generally means an equal decline in purchasing power of the people. To illustrate its devastation, the German hyperinflation around 1923 led to a ridiculous exchange rate of one US dollar to 4.2 trillion German marks, showing how worthless the German currency had become. Everybody with savings in German marks at that time was wiped out. This explains why the German government is very sensitive to inflation after that catastrophic experience.
The previous high inflation in the US occurred in the late 1970’s as a result of a second oil crisis due to the Iranian Islamic Revolution. The Federal Reserve took extreme measures to clamp it down by raising interest rates to an unbelievable 19%, which in turn triggered a deep recession. Since then, inflation has been tamed to below 5%. Politicians are quick to claim credit for having done the right thing. In fact, three new factors have emerged which are beyond their control: global competition, the Internet, and environmental limits.
The dawn of the 21st century saw the tidal-wave effects of globalization. The consumer markets of the developed world are flooded with goods made in China and other low-cost countries. In other words, foreign competition has dampened the prices of most consumer goods. This in turn wipes out many domestic industries, causing job losses and stagnant wages. Globalization is a dirty word for the affected workers in the developed world, but an economic boom that has lifted millions out of poverty in low-cost countries. The impetus of globalization comes from multinational companies, which outsource production to foreign lands in order to cut costs.
Another dynamic force of competition originates from the electronics industry that continues to produce higher-technology products at lower prices. The Internet plays a major role in dampening prices with the creation of online shopping where buyers can make objective comparisons. The result is that retailers have lost their power to set higher prices because of intense competition from all sides.
Note that cheap consumer products are mainly a result of cheap labor cost. The costs of materials have not come down. The trend of low labor cost will continue because there exist billions of people in the developing world who are satisfied with relatively low wages. They are willing to take over production of any product that can no longer be economically produced in other countries. The multinational companies will seek out the best places to outsource production.
Why don’t material costs come down? This brings us to the third new factor of environmental limits. The earth has a fixed size, so is the limited tolerance of a healthy environment. Adding to this fact is that all raw materials such as oil, coal, iron and aluminum are extracted from the ground. As time elapses, the depletion of raw materials near the surface will require the digging be deeper, wider, and in areas more remote. This will eventually lead to higher material costs. Furthermore, we need more and more raw materials to fulfill the demands of increasing consumption worldwide. We cannot escape from rising raw material costs although we keep on deluding ourselves that limitless quantities exist.
In conclusion, inflation at the dawn of the 21st century depends mainly on the interplay of lower labor costs and higher material costs across the world, with environmental costs largely ignored. As time goes by, material and environmental costs will exert increasing pressures on prices to make inflation worse. What can be done? I think three words are in order – reuse, recycle, and reinvent. The first two cut down the demands for more raw materials. The third one involves employing renewable energy such as solar and wind to ease the environmental pressure that is gaining momentum.