Thomas Pally has nailed down the feedback mechanisms at work and also highlights the influence of stock and property asset bubbles that are working against current Chinese efforts to curb inflation.
It is inconceivable that China is not aware of these issues - the question then is how much more will the currency appreciate and will it be too little too late.
China's inflation policy stirs the world [Asia Times Online]
China's government recently announced that inflation hit a 10-year high of 6.5% in August. This increase in inflation is directly related to global trade imbalances, yet China is trying to control inflation without addressing that problem.
That carries two consequences. First, it is doubtful this strategy can work, which likely signals rising Chinese inflation. Second, the strategy aims to shift the onus of global trade adjustment on to the United States, which may come back to haunt China and the global economy.
China's current inflation is a textbook case of prolonged undervaluation of a fixed exchange rate in tandem with export-led growth. As such, significant exchange rate revaluation should be a central element of its anti-inflation policy.
However, instead of making such an adjustment, China's authorities are hoping to control inflation by exclusive reliance on tighter domestic monetary policy. It is doubtful this strategy can succeed because it leaves intact the inflationary impulse from China's trade surplus and undervalued exchange rate.
One important contributing factor in China's inflation is the rise in global commodity prices, including oil and base metals, which are now feeding through into prices. Food prices are also on the rise because of increased global prices for wheat and corn. Furthermore, China has been hit by a virulent outbreak of swine flu that has decimated its hog population, driving up the price of pork, which is China's favored meat.
In coastal areas, which have been the hub of China's export-led growth, wages have started going up in response to rising living costs and to the gradual elimination of extreme surplus-labor conditions.
Most important, China is beset by significant asset-price inflation that borders on an asset-price bubble. This asset-price inflation is the product of massive expansion of the money supply caused by China's trade surplus and foreign-investment inflows.
Dollars earned by Chinese exporters have flowed back to China and been converted into local money by the central bank, which has bought them at the fixed exchange rate to prevent appreciation.
Holders of these money balances have then bought stocks and real estate to gain higher returns and to protect against potential inflation. This has driven up real-estate prices, triggering a massive construction boom that has in turn caused inflation.
The implication is clear. China is suffering from imported inflation caused by higher global commodity prices, domestic-demand inflation caused by excess demand in export industries, and asset-price inflation due to an increased money supply caused by China's trade surplus.
The undervalued exchange rate is a key culprit, since it contributes to excess demand in export sectors, and it also drives the money-supply increase via the trade surplus - which has hit record highs in 2007. That suggests significant exchange-rate revaluation should be a central component of China's anti-inflation strategy.
Moreover, revaluation would also diminish the impact of global commodity-price inflation because commodities are priced in US dollars, so that a revaluation lowers their domestic price in yuan.
Instead, China has chosen to rely exclusively on monetary tightening, raising interest rates and reserve requirements on bank deposits. This strategy is unlikely to work. First, there is already significant asset inflation and extensive debt-financed speculative investment, which means the monetary authorities are constrained from sufficiently meaningful tightening for fear of triggering a financial collapse.
Second, raising reserve requirements on bank deposits lowers the return on deposits and makes them less attractive. That provides an incentive for depositors to spend their money or invest elsewhere, which spurs more inflation.
Third, and most important, continuation of China's undervalued exchange rate means continuing trade surpluses and large inflows of foreign direct investment, which means further monetary expansion in China.
Putting the pieces together, the picture is one of rising Chinese inflation, and with that comes the risk of inflation-triggered social and political problems. In this regard it is worth recalling that the Tiananmen Square disturbances of May 1989 were in part caused by industrial-worker unrest over erosion of living standards by inflation.
As for the global economy, China's anti-inflation policy and continued refusal to adjust its exchange rate place the burden of trade-imbalance adjustment squarely on the US. This adjustment will likely happen via recession, and there are signs that process may already be under way. This is a sub-optimal approach that could injure all.
Thomas Palley is founder of the Economics for Democratic and Open Societies Project.