Monday, 30 June 2008

Inflation and the Dutch Disease of the Gulf

For over a year now the hottest topics in many cities of the GCC have been the rising cost of living and the depreciating value and purchasing power of the local currency, both of which link directly to the issue of inflation. But why is any one surprised? This is a most natural phenomenon in a region know for its artificiality. Did we not want double digit growth? Did we not want to populate our cities faster than we can say “Who needs to think of macroeconomic policies when you can ignore them for another decade or two?”

This is a direct result of being not only complacent but very much ignorant of the simplest economic truths. When there is excessive demand for a certain commodity, the price goes up; when there is a monopolistic scenario where greedy traders control the market and don’t allow competition the prices will go up; when the local governments outsource their monetary policy to 20th Street and Constitution Avenue, Washington DC in a country that is experiencing a recession and is cutting interest rate to boost demand, the prices here will naturally go up. When there is no liaising between the local governments in the GCC and especially within the UAE on a fiscal policy (how much to spend, where to spend it) the prices will naturally go up. The truth is that the GCC has dug such a big hole for itself that there is nothing that it can do to break loose of this cycle of rising demand and rising inflation. In a vicious circle, the trillion riyal GCC building frenzy will need millions of people to populate the offices and the residential units, this will in turn increase demand exponentially for basic commodities, seats in schools, hospital charges, airplane tickets and other factors that go into the monthly expenditure of individuals. The truth is inflation and frantic paces of development go hand in hand. The only way to slow inflation is to slow demand and as one can see with the fantastical projects being announced on a daily basis throughout the Gulf this day will not be too far away.

In the UAE a UBS report found that the real estate sector that currently contributes about a quarter of the county’s GDP will swing into oversupply at around 2010 and that a crash will significantly affect not only the real estate sector but that of banks, investors and households as well[1]. This is the same bank that has taken a $38 Billion write down recently[2], which is roughly the size of the booming economy of Dubai despite having over 3,400 personnel in their credit risk department who get paid to predict risk. As the UBS example illustrates, no one really can predict the future, and all one can do is plan for the worst and hope for the best. The worst is as follows: inflation continues to increase close to 20% throughout the GCC and the local governments continue to downplay it to single figures. Several property developers will go bust, leaving incomplete buildings and in certain cases, projects that never started in the first place along with desperate investors who have been promised returns of as high as 196% in giant billboards in the lurch. This will also lead to even more uncontrollable riots such as those in Dubai, Sharjah and Ajman in the past few months harming the UAE’s reputation in the short and medium term. The best case scenario is that the real estate boom will continue for ever and inflation will decrease to 2%, but that is unlikely to happen.

Dutch Disease

Another factor influencing inflation is the several fold increase in oil prices. Former Federal Reserve Governor Alan Greenspan’s insightful autobiography “The Age of Turbulence” hits the nail on the head with the issue known as Dutch Disease. In the 1960’s Holland discovered vast deposits of natural gas which when exported created a sudden increase in wealth and increased purchasing power exponentially thereby leading to high inflation. This also caused the local currency to increase making it easier to import and harder to export non-oil products which resulted in the economy slowing down.

Basically, the one dozen fold increase in oil prices from $9 a barrel to $110 in under a decade created a “Super Dutch Disease” scenario that the GCC will be unable to shake off. The irony is that at this present time if the GCC decides to break the currency peg then the value of the local currencies will increase so much that it will paralyze the non-oil economy as it will drive exports down and make it much more expensive to sell property.

Keep in mid that if 3,400 credit risk professionals failed to detect a problem, this author could as well be mistaken.

What was the best case scenario again?




Ivo Cerckel said...

Dear Sultan Al-Qassemi,

You are saying in part:
The truth is inflation and frantic paces of development go hand in hand.
if the GCC decides to break the currency peg then the value of the local currencies will increase so much that it will paralyze the non-oil economy as it will drive exports down and make it much more expensive to sell property.

I reply:
The truth is that inflation is an increase in the quantity of money (in the broader sense of the term, so as to include fiduciary media as well),
that is not offset by a corresponding increase in the need for money (again in the broader sense of the term)
so that a fall in the objective exchange value of money must occur.
(Ludwig von Mises, “The theory of Money and Credit”, Indianapolis, Liberty Classics, 1980, p. 272)

It is important that when the GCC de-pegs, “we” make sure that frantic paces of development do not lead to new business cycles, eventually leading to new bubbles.

Business cycles are caused by government frantically manipulating the money supply, thereby setting the stage for the “boom-bust” phases of the modern market.

In the last 25 years, we first had the dollar bubble with the dollar at 3 German mark.
This ended with the 22 September 1985 Plaza Accord whereby France, West Germany, Japan, the United States and the United Kingdom agreed to, amongst others, depreciate the US dollar in relation to the Japanese yen and German Mark by intervening in currency markets.
Then we had the 2000 Nasdaq/Easdaq-bubble, also totally engineered by the frantic manipulation by the dollar-regime fraternity.
Now we are faced with the housing bubbles and the oil and food bubbles.

In order to prevent the bursting of the present bubbles being followed by new business cycles, eventually leading to new bubbles and to the Greater Depression,
it is of the utmost urgency that we realise that
the inflationary policies of the central bank of the USA, the Federal Reserve, from 1921 to 1929 are evidence that the depression was essentially caused not by speculation,
but by government frantically manipulating the market.

By the same token, it is of the utmost urgency that we revise John Maynard Keynes’ explanation of the (first) Great Depression as being caused by capitalism being incapable of saving itself, on the one hand, and by government doing little to rescue an intellectually bankrupt market system from the consequences of its own folly, on the other hand.

Then it will become clear that the severity of the 1929 crash was not due to unrestrained licence of a freebooting capitalist system, but to government insistence on keeping a bubble going artificially through frantic manipulation by pumping in inflationary credit.
(Paul Johnson, “Introduction to the Fifth Edition”, in: Murray N. Rothbard, “America’s Great Depression”, Auburn, Alabama: Ludwig von Mises Institute, 2000, 5th edition, extract quoted on the cover)

Do you want to keep the frantic paces of development, that is, the bubbles, going in order to protect the non-oil economy?
How long do you think this fraud will be possible?
Isn’t it about time that the real culprit for the present crisis be designated?
Or are we all Keynesians now and do we advocate government frantically manipulating money by pegging it to the (soon-to-be worthless) US dollar?

Best regards,

Business said...

Well said and well observed,but remember history cannot always be a guide to the future.Economics principles that have been quoted are based on theories that may have been true than but may no longer be relevant especially with so many financial innovations.We need to explore further the situation that prevails and make conclusions in light existing macro environment.