Light at the end of the tunnel?


In the past few years we have seen record rice prices, historic spikes in the global oil markets and surging costs for food and other essential products, such as palm oil.

Any subsidies or incentives, like Thailand’s THB2,000 cheques, or the US’s millions of dollars of tax refunds, are of course totally overshadowed by the greatest subsidy of all – the trillions of dollars pumped into failing developed economies to bail out banks or shore up debt-ravaged nations such as Greece, Ireland and Portugal. However, the side effects of the continuous printing of money and increases in indebtedness by the US Federal Reserve, Bank of England, Bank of Japan and European Central Bank are both far-reaching and potentially devastating.

Economists firmly believe any form of subsidy is inefficient.

Subsidies paid to suppliers or producers, in reality, encourages overproduction of goods at artificially high prices – anyone from Europe will remember how EU incentives for farmers resulted in vast mountains of beef and butter that towered over wine and milk lakes which had to be stored every year at great expense and then destroyed at yet more cost.

On the other hand, subsidies paid to the consumer spurs over-consumption which, in turn, creates artificial, excessive demand, unnecessary shortages and lower profits. These forms of wastage are often dubbed “dead weight losses” and “misallocations of capital”.

Since 2009, the global demand trend has been massively distorted by the excessive liquidity created by the responses to the global financial crisis and subsequent sovereign debt crisis in the EU. The support given to struggling Western economies has created a mountain of artificial demand. This, in turn, has also driven up the prices of marginally priced assets like commodities, where a small difference in supply and/or demand results in a big difference in price.

In this environment, asset pricing is far from normal. This abnormality is why the current situation is the exception to the rule about subsidy inefficiency; partly because I believe that this price manipulation/distortion is temporary and partly because I think the consequences of not trying to fight fire with fire are worse than the inefficiency of subsidies. Subsidies used in this exigent way are generally referred to by economists as Pigovian subsidies (named after pioneering work in the topic of managing externalities by English economist Arthur Cecil Pigou, and not because they are particularly used for lowering the price of pork and lamb!).

Either way, liquidity has driven up the prices of most assets everywhere (inflation is running at over 13 percent a year in places like Egypt right now) and it has a greater impact in emerging markets, where consumers spend a larger proportion of their salaries on food and where there is greater demand for commodities. The inflation also reflects the weakening of the US dollar’s purchasing power in commodity markets.

Taking a local perspective, these trends have led the Thai government to renew many of its subsidies on diesel and more than 20 foodstuffs this year, to ease the burden on a large proportion of the Kingdom’s 65 million inhabitants. But the price rises in these various commodities were not driven by normal economic activity – they can be directly traced to the liquidity that flooded the global economy as a result of Western government policies of quantitative easing, aka printing money. This liquidity has driven up the prices of commodities everywhere, including eggs, palm oil and sugar. To make matters worse the hike in fuel prices has been exacerbated by political tensions in the MENA region (Middle East and North Africa).

That means the current high prices are mainly due to externalities, either artificial economic conditions or, hopefully, short-term political factors. However, the fact that Thailand is about to hold a general election means that we can expect subsidies to be a major domestic political football in the coming months. In such situations normal economic reasoning goes out of the window. If the subsidies are not maintained until a time when Western governments start behaving (or more likely are forced to start to behave) more rationally and slow down the printing presses, then local inflation rates could shoot up at a much more dramatic rate than the 3 percent year-on-year increase reported in Thailand last month.

In Thailand’s current situation of rebounding economic growth, this increase in the cost of living could spark a round of demands for pay increases that could lead to the more serious problem of long-lasting inflation. Once wages start to increase it is almost impossible to prevent a structural inflation spiral, something of which there is next to no risk in the anaemic developed markets now.

If this was to take place, the situation could very easily spiral out of control and prove disastrous for Thailand’s economy. Inflation would result in higher interest rates at a time when a supportive policy is needed. The weakness in the global economy resulting from deep-seated over-indebtedness in the Euro zone, UK and US, could easily see resurgent emerging markets pushed into recession with disastrous impact for any investors who have not seen the potential train wreck coming.

So, to fight fire with fire, Thai policymakers should focus on temporarily controlling prices and on placing more cash into the pockets of lower-income earners. Interest rates should be lowered, not raised, as Thailand needs to support growth but control inflation.

Structural inflation remains subdued on a global level. The temporary flood of liquidity will almost certainly dissipate. Therefore, this is one of those very rare occasions when subsidies and spending checks combined with price controls are justified. When you are being manipulated, it is permissible to push back and do some manipulating of your own. However, a fine balance must be maintained to prevent the creation of long-term economic inefficiencies. This is a big ask from the authorities. So far Finance Minister Korn Chatikavanij and his team appear to have risen to the task. Maybe with a combination of good fortune and some inspiration from the writings of Arthur Pigou, global events will not derail these efforts as the light end of the tunnel will, hopefully, show it is the other end as opposed to a train going full steam ahead.

The above data and research was compiled from sources believed to be reliable. However, neither MBMG International Ltd nor its officers can accept any liability for any errors or omissions in the above article nor bear any responsibility for any losses achieved as a result of any actions taken or not taken as a consequence of reading the above article. For more information please contact Graham Macdonald on [email protected]