Below is an excerpt from a commentary originally posted at www.speculative-investor.com on 30th January 2011.
Unless you've been unconscious for the past few days you are probably aware that the situation in Egypt is becoming increasingly precarious. Increasingly precarious, that is, for Egypt's government (the dictatorship of Hosni Mubarak). Inspired by the fall of Tunisia's dictatorship two weeks ago, Egyptians have taken to the streets en masse in an effort to bring Mubarak's thirty-year rule to an end. Predictably, the Egyptian government's response to the protests has been draconian. For example, police have assaulted protestors with tear gas, water cannons and rubber bullets, the military has been deployed to assist the police and to help enforce a curfew, and the internet has effectively been shut down.
The financial markets yawned when Tunisia's government was overthrown and then ignored the signs of political upheaval in Egypt...until Friday, when the "safety trade" suddenly came back into vogue. In particular, gold, the US$ and the US T-Bond reversed upward on Friday, while the broad stock market reversed downward. Also, the oil price jumped as traders began to give more serious consideration to the possibilities of the Suez Canal being closed for business and the nascent revolutionary trend spreading to the Arab world's important oil-exporting nations.
As an aside, while the situation in Egypt certainly had some effect on global markets late last week and could have a bigger effect over the days/weeks immediately ahead, the safety theme had become so 'oversold' and the growth theme so 'overbought' of late that some sort of correction was well overdue prior to Friday. It was just a question of what the catalyst for a correction would be. If it hadn't been Egypt it would have been something else.
There will undoubtedly be a lot commentary about Egypt's political situation over the coming days, but we suspect that the bulk of this commentary will either not deal with inflation's role in the crisis or will incorrectly analyse inflation's role in the crisis. Therefore, this is the aspect that we will focus on.
A large proportion of Egypt's population is poor (we've read that about 40% of Egypt's people live in abject poverty). This not only means that there are a lot of people in Egypt who are desperate for a change, but also that there are a lot of people in Egypt who get adversely impacted in a big way by rising food prices (in general, the poorer the person the greater the percentage of their income that gets allocated to basic necessities such as food). As everyone knows, food prices have been rising sharply in terms of most currencies over the past 6 months. This means that for the average Egyptian, the increase in the cost of food probably came close to tipping the scales in favour of physical protest. Events in Tunisia earlier this month probably gave the final push by proving that major political change could be achieved if enough people forthrightly demanded it.
This prompts the question: what caused the so-called "food inflation"?
Most pundits will incorrectly cite grain supply issues, including the climate-related effects of volcanic eruptions and the effects of La Nina. A minority will correctly state that monetary issues are far more important than commodity-supply issues, although they will tend to make the mistake of pointing the finger of blame at the US Federal Reserve. While any story that has the Fed as the villain has some appeal to us, the reality is that the Fed is not to blame for inflation problems that occur outside the US.
The Fed has unlimited power to depreciate the US dollar, but it cannot bring about a reduction in the purchasing power of any other currency. Only the central banks and governments of other countries are capable of depreciating their own currencies. China is a classic example. Due to its shortsighted mercantilist trade policy, China's government chooses to purchase large quantities of US dollars using newly-created Yuan. The resultant rapid growth in the Yuan supply inevitably leads to rapid price rises within China, such as the double-digit rates of increase over the past year in the prices of food and housing. Our point is that China's policy-makers CHOOSE to import US inflation. They do this because of the misguided belief that it's good strategy to maximise the quantity of valuable goods that their countrymen exchange for pieces of paper created by a foreign bank.
Therefore, rather than saying that the US exports inflation, it is more appropriate to say that other countries deliberately import US inflation. In so doing, the governments of these other countries hope to gain a short-term advantage for their exporting industries. The problem is that this short-term advantage for one sector of the economy comes at the cost of a long-term inflation problem for the entire economy.
Just in case it isn't clear, there's an important distinction between the idea that the US exports inflation and the idea that other countries import US inflation. Advocates of the first idea generally portray the inflation importers as innocent, helpless victims, rather than the pro-active inflators (or pro-inflation blackguards) that they really are.
In support of our argument we present the following chart. This chart provides an indication of what the long-term food price trend would look like if food prices were denominated in a currency that was 100% backed by gold. In terms of such a currency the average price of food would have hit a 15-year low (perhaps even an all-time low) in June-2010. It would have bounced over the past 6 months, but there would certainly be no good reason for riots due to high food prices in a country using such a currency.
To sum up: rising food prices have probably helped bring about the political upheaval currently underway in Egypt, and the rising cost of food has been an effect of monetary inflation deliberately caused by Egypt's policy-makers.
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