Inflation and the debt burden on Western countries and Japan are two major challenges facing the global economy this year, says Philippa Malmgren, President and founder of the Canonbury Group and Principalis Asset Management.

Global interest rates are rising because of escalating debts in the West and Japan, while the US bond market is selling off as a result, notes Malmgren. Indeed, she finds it 'interesting' that the financial markets are signalling that oil and gas giant Shell is more likely to repay its debts than the British government, and that Berkshire Hathaway has a better credit rating than the US government.

Meanwhile, developing markets in Asia are experiencing fast-rising inflation. For instance the rate of inflation is outpacing the deposit rate in China, which means you're losing money every day you have your money in the bank, says Malmgren. While over in India, the central bank is having to raise interest rates more quickly than the central bankers had anticipated, due to higher input costs of commodities, agricultural products, and mined resources.


So what should governments do in response? Malmgren, who is a former White House financial market advisor and a former member of the National Economic Council, argues that governments in the West need to pay down their debts and accept deflation in the form of lower growth, lower living standards, or face inflation, which Malmgren suspects that governments will permit even though they say they won't. Malmgren adds that governments will think up different solutions and the markets will arbitrage the different choices. A lot of volatility in the foreign exchange and bond markets will ensue as a result, with likely higher interest rates.

On the issue of rampant inflation in emerging markets, Malmgren believes that their tools are very limited, and she isn't optimistic that China will substantially revalue the renminbi. I think they will do a little bit of window dressing but it won't be anything like what would be required to genuinely address the issue.

Asked for her view of the US economy, Malmgren says the recession has turned out to be shorter than expected, with much of the pain localised in the financial community. Indeed, there is an upside to the credit crunch, as companies become more efficient and productive. The survivors are stronger and the losers are gone, says Malmgren.

Notwithstanding widespread fears in the US about the fallout from the global financial crisis, Malmgren says the US government's $700 billion emergency package to stabilise the financial system wasn't necessary. I think they did too much and now we have to pay a terrible price to pay off the debt, says Malmgren. My personal view is that they should have had more confidence in the capacity of the underlying economy to adjust to a new set of prices and new environment. But instead they've used effectively a budget on the scale of a World War Two defence budget and thrown it at a problem that has turned out to be a short-lived recession. And I think that's a mistake.

Malmgren adds it was greatly ironic that the emergency rescue funds that were meant to bolster the real economy went straight into speculation instead. But this is typical. When you give away free money, it always goes to speculation. It never goes to the real economy so I think we've learnt this lesson once again.

Dr Malmgren spoke to INSEAD Knowledge on the sidelines of an event held by the UAE INSEAD Alumni Association, staged at the school's new Middle East campus in Abu Dhabi on April 13.