Wednesday, October 17, 2007

Sources of China's Inflation... A Menu

Chinese aggregate output distortions has lead to a disequilibrium in the food sector which has thus affected the core-CPI measures. From a proverbial "bigger picture", there are three categories into which one can source these fluctuations into: Bio-environmental, Structural and Monetary.
  1. Bio-Environmental: Whether this be the massive dust-storm or porcine disease or avian flu or environmental degradation -- the chain of events are fairly similar. In the short term, there is a spike in demand by consumers, anticipating a decline in supply (thus worsening the actual shortfall) -- coupled with hoarding and supply chain mismanagement --. (See pictures.)
  2. Structural: The intervention of the State-planners in financing and investment decision (the prototypical infinite horizon, infinitely lived Planner at work) results in suboptimal allocations. Given this mismatch between agricultural output, capital expenditure and urban agglomeration -- over the intermediate to long term, the decline in productive usage of resources is inevitable.
  3. Monetary: This is perhaps the most obvious and easiest to "fool around" with to induce distorted outputs. See this, for a basic example -- and the temptation to increase output is particularly relevant when the size of the sacrifice ratio (loss in output to obtain a permanent reduction of 1% inflation) is high.

Policy makers can most easily affect #3. To affect #2, it involves a substantial change in the political climate -- and to affect #1, a societal commitment is required. To varying degrees of satisfaction, China has predictably decided to tackle #1, #2 and #3 simultaneously. The flip side to this multi-pronged tackle is that the cost of getting things wrong is a rise in the number of events characterized by disequilibriums. (Bubbles in Food, Asset, Housing etc.,)

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