By W.A Wijewardena –
Principles of Central Banking 13: Is a little bit of inflation necessary for economic growth?
Reduced inflation rate means still more expenditure by consumers
Sri Lanka’s General Price Level, as measured by the Colombo Consumers’ Price Index, commonly known as CCPI, and compiled by the Department of Census and Statistics, is reported to have increased as at end of January 2014 by 4.4% over the price level that had prevailed one year ago. In December 2013, this annual increase in the price level had been 4.7% and therefore, there has been a decline in the rate of growth. This has been the trend which CCPI had shown since February last year when the annual rate of growth in the price level stood at close to 10%. When the change in the CCPI is considered over the last twelve months, the rate of growth at the end of each month over the respective level as at one year ago has continuously declined though CCPI has continued to increase from month to month in most of the period. Thus, CCPI which stood at 170.0 in January 2013 has increased to 177.5 in January 2014. An increase in each one point in the index costs the consumers Rs 279.72 more. Therefore, the increase in CCPI in the previous 12 month period by 7.5 points will cost the consumers Rs 2079.90 more to buy the same basket of consumer goods today. Unless their income has gone up by that cost, their position has certainly deteriorated. This increase in costs is reckoned by many as ‘a little bit of inflation’ which is necessary for an economy to ensure continued economic growth. For instance, the Central Bank of Sri Lanka or CBSL has expressed its satisfaction about the low rate of inflation and gone onto relaxing its monetary policy in a few rounds of policy relaxations to promote, as the Bank has claimed, economic growth.
High inflation and high growth episodes
Over the 8 years from 2005, Sri Lanka had had a high annual inflation on average at 11% coupled with a high annual economic growth of 7.5% according to official sources. This has prompted many to argue that inflation is necessary for rapid economic growth. Encouraged by this outcome, some holding even high positions have questioned whether the country should continue to pursue price stability as an objective of the society. If high economic growth can be attained by a country despite high inflation, why should it be worried about inflation at all? Therefore, they argue, why not inflate the economy – the easiest way to generate financial resources for investment in a resource scarce economy – and increase wealth and wellbeing of the people? Some have even extended this argument further that for a developing country, price stability should not be an appropriate policy goal and governments should mobilise resources through inflation. This ‘easy-to-fix-the-economy-strategy’ has won favour with politicians, bureaucrats and top level policy makers. The result has been a tendency to use bank credit liberally and maintain economic activities at a high level considering economic recessions as public enemy number one and not inflation.
Singapore did not believe in inflation induced growth
The experience in other Asian countries, notably Singapore, has been somewhat different from what Sri Lanka had in this period. They had low inflation coupled with much higher real economic growth. While Sri Lankans have been happy about high inflation and moderate economic growth, policy makers in those countries have been sceptic of the ability of inflation to generate permanently high economic growth and create wealth on a sustainable basis. Goh Keng Swee, the economic architect behind Singapore’s economic miracle recalled in 1992 that his Cabinet colleagues in early 1960s did not believe that printing money could bring prosperity to Singapore. According to him, “diligence, education and skills will create wealth, not Central Bank credit”. Accordingly, Singapore decided to continue with the self-disciplined currency board system, prohibited the Monetary Authority to lend to the government and maintained the strictest fiscal discipline by balancing the budget. Thus, Singapore created an environment conducive to economic growth, namely, the establishment of a low inflation regime, among other policies. The result was that within a matter of about three decades, Singapore could elevate itself to the status of a developed country.
A little bit of pregnancy will grow into a fully blown pregnancy one day
As mentioned above, the argument that developing countries should have a moderate inflation to spur economic growth is very popular among many. This view is held even by some professional economists and academics. It simply says that in developing countries, the private sector is weak; hence, the desired resource allocation through the market system does not take place; the failure of the market makes it necessary for the state sector to step in; however, due to problems in tax systems and the inflexibility in capital markets, the governments cannot raise the required resources to finance the required expenditure programmes; as a result, the governments may mobilise the private resources for investment through inflation. The proponents of desirable inflation further argue that the initial inflation created by the government’s inflationary financing is self-destroying. That is because the consequential increase in goods and services later would eliminate the demand gap in the economy and release the inflation pressures. It is this self-destroying nature of inflation which has in fact made the desirable inflation argument attractive. The late N U Jayawardena, the first Sri Lankan Governor of the Central Bank, counters this proposition quoting a quip attributable to J.K. Galbraith that “a little bit of inflation, like with a little bit of pregnancy, has the awkward habit of growing”. The risk of creating moderate inflation to generate growth is that the moderate inflation can become a high inflation and the high inflation can develop to a hyperinflation. If this happens, the initial gain in output growth is not only completely negated, but also the pillars of long term growth in the economy are totally destroyed.
A society should strive to produce real goods
An economy produces goods and services and the total quantity of such goods and services, known as the national product, determines the welfare level of people. Those goods and services which constitute real quantities rather than designated or nominal values, will enable people to have a higher level of consumption and a higher level of real welfare. The rate of growth in those real goods and services is known as economic growth. If this rate of growth is continuously high year after year, then the real quantity of goods and services available for use by people too expands continuously. As a result, the real welfare level of people too will become higher. The increase in the nominal value of these goods and services, by the same argument, does not lead to an increase in the welfare of people. It simply increases its money value and does not contribute to increase the availability of real goods and services. Hence, what a society should strive to achieve is to raise the real quantity of goods and services and not its nominal value expressed in terms of money.
Real goods are produced with real inputs and not with money
What contributes to increases in real goods and services? Since they are produced by using real inputs like labour, raw materials, equipment, machinery etc., the total quantity of real inputs utilised by a society basically determines the total quantity of real output too. This is known as the level of real resource utilisation. Then the type of technology used for converting real inputs into real outputs too helps a society to produce a larger quantity of real outputs out of a given level of real resources. The level of real resource utilisation and the technology used for conversion are determined by hard work, diligence and innovativeness of people. If this can be achieved by using money, in other words, by inflating the economy, then, inflation is a determining factor of real economic growth. Then the question that arises is whether it is a temporary growth or a permanent and sustainable growth. If it is only a temporary growth, the continuous inflation would certainly bring about a disastrous impact on the economy in the long run. But if it is a permanent and sustainable growth, then, inflation could justifiably be used as a promoter of economic growth.
Governments have to continue to pump money to keep people feel rich
When the government uses money printed by central bank or created by commercial banks to finance its expenditure, whether recurrent or capital, it gives an additional money income to recipients of government expenditure. This new money income makes people believe that they are richer than before. This feeling will incentivise them to work harder, contribute more to the national output and work more innovatively and diligently. Hence, the output will immediately rise and a higher economic growth will be recorded. But for this economic growth to be a permanent and sustainable growth, people should feel that their relative position in the society too has improved. For instance, when they compare themselves with their neighbours, they should feel that they are now better off than the neighbours. But government expenditure programmes raise the money incomes of everyone and therefore, everyone would feel same as before. Soon the feeling of richness which the new money income had initially created in their minds would begin to die out. At that level, the initial hard work they had performed would also die out bringing the growth rate to the pervious level. To incentivise them anew, a government has to continuously inflate the economy by using central bank money or commercial bank credit. But the government would then be caught in an inescapable vicious circle of inflation.
Inflation is a ‘lose-lose’ position for all
Hence, inflation would bring only a temporary outcome and cannot sustain economic growth in the long run. Even the benefits of the initial temporary increase in the real output are negated in the long run due to the disastrous effects which continued inflation would entail on the economy. It may initially seem as a ‘win-win’ situation for both the government and the people. Once the inflation starts to raise its ugly head reducing all real values, it would be a ‘win’ situation for the government because it can still mobilise real resources from the economy and a ‘lose’ situation for people because it erodes their real welfare. Once inflation becomes a long term feature, it would be a ‘lose-lose’ situation for both the government and the people.
People are adversely affected by inflation in the long run due to the following reasons.
Low interest rates dry out savings flows and promote scam savings schemes
First, those who are not in a position to increase their money income along with inflation will find that their real wealth and income are getting eroded year after year making them poorer. This situation becomes worse if interest rates are not adjusted upward adequately to compensate for inflation. In that case, real interest rates become negative because money interest rates are lower than the inflation rate. This in fact creates a peculiar situation in the sense that savers or lenders are not adequately compensated, while borrowers are more than remunerated. Hence, it is tantamount to savers or lenders paying interest to borrowers. The end result is the drying up of both saving and lending and the proliferation of borrowing. It also drives unsuspecting savers to savings scams offering them with high interest incomes.
Investments in bubble assets
Persistent inflation is also anti-growth and people would lose on that count too. If interest rates are not adjusted adequately, the real value of financial assets would get eroded by inflation. People in a bid to insulate themselves from inflation would convert investments in financial assets into unproductive real asses such as property, buildings and bullion. These investments do not bring new incomes and outputs, but simply kept as idle assets to benefit from increases in their prices. Further, inflation distorts the resource allocation function of the market system leading to a failure of the market economy. It creates confusion among market participants thereby creating a chaotic situation. Everyone would only be concerned about the short run and therefore much needed long term investments would dry up. This retards the long term economic growth.
Inflation taxes exports and subsidises imports
An undesirable development of persistent inflation is the tax it imposes on exports and the subsidy it pays on imports. When domestic inflation is high, selling export commodities in the domestic market becomes more profitable. Similarly, inflation favours imports because imported goods become cheaper than domestic goods. This would discourage exports and encourage imports creating a trade gap which in turn would exert pressure on the foreign reserves and the exchange rate. In the long run, the country’s competitiveness is eroded bringing serious implications on the foreign trade sector.
The poor are the biggest victims
Inflation is also an anti-poor phenomenon. This is because the poor with their lower bargaining capacity are unable to get themselves adequately compensated for inflation. The most vulnerable groups in this sense are pensioners, housewives, students and government servants whose salaries are not indexed to inflation. However, the well-to-do are able to have their asset structure readjusted to avoid losses and increase profits in addition to raising their incomes along with inflation. Hence, inflation redistributes income from the poor to the rich. Inflation is the worst enemy of people because it exerts fear, helplessness, destitution and hopelessness in them. Irrespective of age, sex, wealth, creed or race, it impoverishes everyone, if people have not indexed their income to inflation. It creates uncertainty and uncertainty creates confusion in everyone. It reduces people’s action to very short run goals making them creatures without hope or a future.
Governments also lose
Governments also lose due to inflation. Apart from having to pay a higher interest expenditure on its borrowings, high inflation will make a government less popular politically. It, therefore, prevents a government from pursuing whatever the long term objectives it may be pursing. When the domestic savings flows dry out, a government may be driven to raise money from international markets, often at high interest rates. The ensuing debt trap will make the government vulnerable to international lenders as one would find today in Argentina, Cyprus, Greece and Spain.
N U Jayawardena’s wisdom not heeded to
The late N U Jayawardena has this wisdom to impart to politicians and his successors at the Central Bank wishing to inflate the economy to promote growth: “If domestically induced inflation prevails, a policy to restrain the necessary exchange rate depreciation for political reasons will prove to be not only futile, but also more costly in terms of both the level of the exchange rate adjustment eventually necessary and importantly the scale of required structural adjustment of the national economy itself. The moral, amply confirmed by historical experience, is that sooner the exchange rate is adjusted to conform to the changed conditions confronting the economy, the sooner will it be able to achieve recovery and stability” The recent rounds of exchange rate depreciation has been a testimony to what NUJ had predicted a long time ago.
Tamper inflation numbers at your own risks
A government can tamper the inflation numbers and fool its citizens into a false belief that it has delivered stability in prices to them. But that strategy is short-lived as has been shown in the recent cases in Argentina, Venezuela and Turkey. When the real economic crisis hits a country, the irony is that its central bank which has supported the government in short-lived policies will not be able to rescue the respective economy with policies available to it. The result at that stage will be a resort to ‘economic oppression’ that would further damage a country’s ability to come out of a man-made economic malaise.
*W.A Wijewardena, a former Deputy Governor of the Central Bank, can be reached at firstname.lastname@example.org