Neo-liberals argue that inflation is bad for economic growth as well.[6] Most of them would hold that the lower a country’s rate of inflation, the higher its economic growth is likely to be. The thinking behind this is as follows: investment is essential for growth; investors do not like uncertainty; so we must keep the economy stable, which means keeping prices flat; thus low inflation is a prerequisite of investment and growth. This argument has had a particularly strong appeal in those Latin American countries, where memories of disastrous hyperinflation in the 1980s combined with collapse in economic growth were strong (especially Argentina, Bolivia, Brazil, Nicaragua and Peru).
Neo-liberal economists argue that two things are essential in achieving low inflation. First, there should be monetary discipline – the central bank should not increase the money supply over and above what is absolutely necessary to support real growth in the economy. Second, there should be financial prudence – no government should live beyond its means (more on this later).
In order to achieve monetary discipline, the central bank, which controls the money supply, should be made to pursue price stability single-mindedly. Fully embracing this argument, for example, New Zealand in the 1980s indexed the central bank governor’s salary to the rate of inflation in inverse proportion, so that he/she would have a very personal interest in controlling inflation. Once we ask the central bank to consider other things, like growth and employment, the argument goes, the political pressure on it would be unbearable. Stanley Fischer argues: ‘A central bank given multiple and general goals may choose among them and will certainly be subject to political pressures to shift among its goals depending on the state of the electoral cycle’.[7] The best way to prevent this from happening is to ‘protect’ the central bank from politicians (who do not understand economics very well and, more importantly, have short time-horizons) by making it ‘politically independent’. This orthodox belief in the virtues of central bank independence is so strong that the IMF often makes it a condition for its loans, as, for example, it did in the agreement with Korea following the country’s currency crisis in 1997.
In addition to monetary discipline, neo-liberals have traditionally emphasized the importance of government prudence – unless the government lives within its means, the resulting budget deficits would cause inflation by creating more demands than the economy can meet.[8] More recently, following the wave of developing country financial crises in the late 1990s and the early 2000s, it was recognized that governments do not have a monopoly in living beyond their means. In those crises, much of the over-borrowing was by private-sector firms and consumers, rather than by governments. As a result, an increasing emphasis has been put on the ‘prudential regulations’ of the banks and other financial-sector firms. The most important among these is the so-called capital adequacy ratio for banks, recommended by the BIS (Bank for International Settlements), the club of central banks based in the Swiss city of Basel (more on this later).*
Inflation is bad for growth – this has become one of the most widely accepted economic nostrums of our age. But see how you feel about it after digesting the following piece of information.
During the 1960s and the 1970s, Brazil’s average inflation rate was 42% a year.[9] Despite this, Brazil was one of the fastest growing economies in the world for those two decades – its per capita income grew at 4.5% a year during this period. In contrast, between 1996 and 2005, during which time Brazil embraced the neo-liberal orthodoxy, especially in relation to macroeconomic policy, its inflation rate averaged a much lower 7.1% a year. But during this period, per capita income in Brazil grew at only 1.3% a year.
If you are not entirely persuaded by the Brazilian case – understandable, given that hyperinflation went side by side with low growth in the 1980s and the early 1990s – how about this? During its ‘miracle’ years, when its economy was growing at 7% a year in per capita terms, Korea had inflation rates close to 20%–17.4% in the 1960s and 19. 8% in the 1970s. These were rates higher than those found in several Latin American countries, and totally contrary to the cultural stereotypes of the hyper-saving, prudent East Asian versus fun-loving, profligate Latinos (more on cultural stereotypes in chapter 9). In the 1960s, Korea’s inflation rate was much higher than that of five Latin American countries (Venezuela, Bolivia, Mexico, Peru and Colombia) and not much lower than that infamous ‘rebel teenager’, Argentina.[10] In the 1970s, the Korean inflation rate was higher than that found in Venezuela, Ecuador and Mexico, and not much lower than that of Colombia and Bolivia.[11] Are you still convinced that inflation is incompatible with economic success?
With these examples, I am not arguing that all inflation is good. When prices rise very fast, they undermine they very basis of rational economic calculation. The experience of Argentina in the 1980s and the early 1990s is quite illustrative in this regard.[12] In January 1977, a carton of milk cost 1 peso. Fourteen years later, the same container cost over 1 billion pesos. Between 1977 and 1991, inflation ran at an annual rate of 333%. There was a twelve-month period, ending in 1990, during which actual inflation was 20, 266%. The story has it that, during this period, prices rose so fast that some supermarkets resorted to using blackboards rather than price tags. There is no question that this kind of price inflation makes long-range planning impossible. Without a reasonably long time-horizon, rational investment decisions become impossible. And without robust investment, economic growth becomes very difficult.
But there is a big logical jump between acknowledging the destructive nature of hyperinflation and arguing that the lower the rate of inflation, the better.[13] As the examples of Brazil and Korea show, the inflation rate does not have to be in the 1–3% range, as Stanley Fischer and most neo-liberals want, for an economy to do well. Indeed, even many neo-liberal economists admit that, below 10%, inflation does not seem to have any adverse effect on economic growth.[14] Two World Bank economists, Michael Bruno, once the chief economist, and William Easterly, have shown that, below 40%, there is no systematic correlation between a country’s inflation rate and its growth rate.[15] They even argue that, below 20%, higher inflation seemed to be associated with higher growth during some time periods.
In other words, there is inflation and there is inflation. High inflation is harmful, but moderate inflation (up to 40%) is not only not necessarily harmful, but may even be compatible with rapid growth and employment creation.We may even say that some degree of inflation is inevitable in a dynamic economy. Prices change because the economy changes, so it is natural that prices go up in an economy where there are lots of new activities creating new demand.
But, if moderate inflation is not harmful, why are neo-liberals so obsessed with it? Neo-liberals would argue that all inflation – moderate or not – is still objectionable, because it disproportionately hurts people on fixed incomes – notably wage earners and pensioners, who are the most vulnerable sections of the population. Paul Volcker, the chairman of the US Federal Reserve Board (the US central bank) under Ronald Reagan (1979–87), argued: ‘Inflation is thought of as a cruel, and maybe the cruellest, tax because it hits in a many-sectored way, in an unplanned way, and it hits the people on a fixed income hardest’.[16]
6
For further discussion, see H-J. Chang & I. Grabel (2004),
8
Moreover, neo-liberals believe that government spending is, by nature, less efficient than private spending. Martin Feldstein, the economic advisor to Ronald Reagan, once put it: ‘Increased government spending can provide a temporary stimulus to demand and output but in the longer run higher levels of government spending crowd out private investment or require higher taxes that weaken growth by reducing incentives to save, invest, innovate, and work.’ The quote is from: http://www.brainyquote.com/quotes/quotes/m/martinfeld333347.html
*
This ratio recommends that the total lending of a bank should not be more than a certain multiple of its capital base (12.5 is the recommended ratio).