STAGFLATION FEARS LOOM LARGE OVER EUROPE AND ASIA

The OECD's early warning signal is pointing towards clear signs of economic weakness across the world, with mounting evidence that China, India, and Brazil may soon succumb to the downturn.The closely-watched gauge -- known as the Composite Leading Indicators (CLI) -- has picked up a sharp deterioration in the eurozone in March, notably in Italy and France where the advance signals are falling even faster than in Britain. The measure tends to anticipate the industrial cycle by about six months. While growth continues to power ahead in most emerging markets, rampant inflation is starting to damage business confidence. "The latest data point to a potential downturn in Brazil, China, and India," said the OECD, the club of rich nations.
Russia is the only country still in full boom among the so-called BRIC quartet of rising powers, but the country's inflation rate reached 14.3pc in April as oil and gas wealth the flooded the economy. Price pressures across the emerging world are reaching levels that may soon threaten stability unless governments jam on the brakes. Inflation rates have reached: Venezuela (22pc), Vietnam (21pc), Latvia (18pc), Qatar (17pc), Pakistan (17pc), Egypt (16pc) Bulgaria (15pc), The Emirates (11pc), Estonia (11pc), Turkey (9.7), Indonesia (9pc) Saudi Arabia (9.6pc), Argentina (8.9pc), Romania (8.6pc), China (8.5pc), Philippines (8.3pc), India (8.1pc).Many of these countries are now suffering the worst prices spiral in thirty years, setting off widespread riots. India's government has suspended futures for a clutch of key commodities as states resort to draconian measures.
While the soaring cost of food and energy is the key driver for the poorest countries, others are ensnared by their own currency pegs. Most Gulf states are linked to the dollar, forcing them to shadow the US Federal Reserve's super-loose interest rate policy, with inevitable over-heating. China operates a semi-fixed rate.Stock markets have already fallen sharply in China, India, and Vietnam as the authorities rein in credit. Morgan Stanley has advised clients to cut their holdings of emerging market stocks, warning that surging prices have started to queer the pitch -- at least in the "near term".Europe faces an incipient "stagflation" as inflation of 3.3pc combines in a nasty cocktail with slowing growth. The mix poses an acute dilemma for the European Central Bank. It fears that 1970s-style inflation could become lodged in the system as workers push for higher wage deals.
Jean-Claude Trichet, the ECB's president, warned of a return to "mass unemployment" if Europe repeats the errors of first oil shock. "We would make an enormous mistake, which is precisely the mistake we made in the first oil shock. We are calling on all economic agents, whether corporate or social partners, to be as responsible as possible," he said.Industrial output fell in Italy, France, and Spain in March. April manufacturing orders fell at the fastest rate since the dotcom bust in Italy and Spain.
It is understood that the meeting broke down into a fierce exchange of national views, ignoring the EU treaty requirement that the ECB focus on the eurozone as a whole. EU officials have begun to ask whether Mr Weber is committed to monetary union. A senior German advisor told a closed group of investors in London last week that "it wouldn't matter in the least if Spain left the euro".David Bloom, currency chief at HSBC, said the single currency was likely to fall from near record highs as investors woke up to the realities in the South."The euro has been trading on the German export story. The market has conveniently ignored the collapse in Spain, and the near recession in Italy," he said.
Critics say the ECB has been fretting too much about inflation and not enough about the risk of a severe slowdown later this year and into 2009 if monetary policy is kept too tight. The bank has held rates at 4pc since the credit crisis began, even though its own credit survey points to a lending squeeze.
US is already in a slowdown and dollar weakness has seen the US CPI increase to uncomfortable levels. According to The Economist, CPI inflation over the past year has risen from 2.6 per cent to 3.9 per cent in the US. US Federal Reserve in May cut its 2008 US economic growth forecast and signaled that mounting concerns over inflation. Top American bankers have hinted towards a slowdown and a huge spike in inflation.
It now appears that we are entering a new inflationary, and according to some economists, potentially hyperinflationary phase. This was not fully captured in CPI data since the price of commodities rose even as the price of manufactured goods declined consequent to productivity gains arising from the integration of China and India in the global market for goods and services. The price of non-fuel primary commodities that showed an average annual decline of 2.7 per cent between 1989 and 1999 rose by 9.4 per cent annually between 2000 and 2006. Oil prices that declined by 1.2 per cent annually between 1989 and 1998 rose on average by 20 per cent annually between 1999 and 2006.
This sharp increase in commodity prices was fuelled by hypergrowth in emerging and developing economies whose real GDP growth spurted from an average of 3.8 per cent between 1989 and 1998 to 6.2 per cent between1999 and 2006. Advanced economies continued to average annual growth rates of below 3 per cent over both these periods. Commodity price inflation was exaggerated by the steep fall in the international value of the dollar, the currency in which commodities are traded internationally.

Excessive monetisation was inherent in the manner in which the fundamental global imbalance, which saw developing countries run huge current account surpluses, has played out. Emerging market and developing economies taken together, but excluding the newly industrialised Asian economies, still ran a current account deficit of $21.2 billion as late as 1999. This deficit was turned around dramatically into an annual surplus of $544 billion by 2006. Their cumulative surplus in the seven years from 2000 to 2006 was $1.43 trillion. These surpluses led to counterpart capital flows to developing countries; but instead of letting their currencies appreciate as a consequence, their central banks bought up these flows as part of their strategy of export-led growth. This released a tsunami of domestic currency into the system, only part of which could be sterilised. The weighted average of broad money growth in emerging and developing economies consequently rose from 15-16 per cent between 2000-03 to about 20 per cent in 2005 and 2006, way above their average nominal GDP growth of 13 per cent.
A loose monetary policy in emerging and developing countries was supplemented by a loose monetary policy in advanced countries, especially the US, which accounts for about one-fifth of global demand.So solution lies in a prudent economic policy of the likes of Paul Volcker which sucks out excessive liquidity.Policy action should also stimulus to increasecommodity production.Else stagflation could become a reality and world may see a re-run of the 1970s crisis. And this time even Milton Friedman is not around.