FREE ESSAY ON HYPER INFLATION

HYPER INFLATION

Introduction Hyper inflation has plagued most of the world's developing countries over the
past decades. Countries in the industrialised world, too, have at times duelled with
dangerously high inflation rates in the post WWII era. With varying degrees of success,
all have employed great efforts to bring their inflation rates within acceptable limits.
Generally, a moderate rate of inflation has been the ultimate goal. More recently,
however, a few countries have pursued policies that strive to eradicate inflation
altogether through complete price stability. This has proven to be a contentious
enterprise, which clearly indicates that there is still no universally accepted solution
to the inflation problem. Indeed, there is not even an agreed consensus regarding the
source of inflation itself. The monetarist perception that the root of inflation is
solely the excessive creation of money remains. So too does the belief that inflation
originates in the labour market. And amongst a variety of others, the opinion that
inflation "serves the critical social purpose of resolving incompatible demands by
different groups" is also strong. This last, and more widely accepted, case shows that
the problem is hardly a technical one; but rather a political one. It highlights the now
unquestionable fact that politics and inflation are inextricably linked. And as with all
inherently political issues, consensus is difficult, if not impossible, to achieve. But,
political characteristics do provide flexibility. In some countries, high rates of
inflation have clearly been compatible with rapid economic growth and fast rising
standards of living. In such cases, it is quite reasonable to suggest that higher rates
of inflation are acceptable--perhaps even necessary. In this setting, it is by no means
clear that pursing a policy to stop moderate inflation is either required, or in the best
interests of the mass of the population at all. While inflation guarantees that some will
gain at the expense of others, the redistributions of income and wealth which do take
place can, on normal value grounds, be quite desirable. In other circumstances, it may be
quite desirable to place strict controls on inflation, or strive to keep it at 'zero'
level. Policies aimed at virtual price stability have been in use by central banks in
Europe, New Zealand, and Canada over the past few years. Such policies have been
particularly focused in Canada. As noted by Pierre Fortin, "the only objective the Bank
of Canada has pursued since 1989 has been to establish and maintain the inflation rate at
'zero level', which it sees as a CPI inflation rate that is clearly below two percent"
(italic added). To the surprise of many, it has been incredibly successful, achieving its
objective several years before schedule. Although separated by only a few percentage
points, Canada's policy is a sharp contrast to the moderate and balanced approach used in
the U.S. "Since 1989 the Federal Reserve has been satisfied with achieving an inflation
rate of around 3 percent. In setting the interest rate, it has continued to pay explicit
attention to real economic growth and employment, with the result that the U.S.
unemployment rate is currently in the 5 to 6 percent range." Based on this statistic
alone, it can be argued that the more moderate U.S. approach has enjoyed greater success
than the deflation oriented policy pursued by the Bank of Canada: Canada continues to be
burdened with a higher rate of unemployment. Yet, it continues to believe that the
unemployment costs of low inflation are 'transitory and small' . The directors of most
European Central Banks also continue to support this dogma. Clearly, the credibility of
the "classical idea that the Phillips trade off between inflation and unemployment
disappears in the long run" is still very high throughout the world. But, in Canada, as
in most of Europe, the waiting continues. This is not to suggest that the waiting game
has been silent and entirely pleasant. Indeed, the relative lack (or lag!) of success of
zero inflation policies and strict price controls has spurred much heated debate. As a
case in point, more people are curious why Canada has exclusively focused on inflation
cutting and turned a blind eye to the more balanced, and arguably more successful,
approach adopted by the U.S.. Is it actually desirable, or wise, to aim towards virtual
price stability? Are there real long-term benefits to low, or zero, inflation? What are
the real effects of low inflation? The intensity of the ongoing debate on these issues
provides evidence that there are no straightforward answers. The purpose of this paper is
to probe at these issues in an attempt to cast some clarity on the debate. Appropriately,
it begins with an analysis of the consequences of low inflation on the conduct of
monetary policy. As is well known, these effects are controversial, and this paper in no
way purports to end the deadlock. Bringing the relevant issues to the fore, however, is
equal to carrying a well-stocked toolbox that contains many of the necessities for
well-crafted opinions. The Consequences of Low Inflation on Monetary Policy In recent
years, monetary policy has been promoted to the centre stage of economic policy making
the world over. This is a contrast to the first half of the 20th century when it was
relegated solely to experimentation in the shadows. During these early years, fiscal
policy was solely used; due in part to the depression of the thirties, and the remainder,
to the process of post WWII reconstruction and the Keynesian doctrine that fiscal action
was necessary to prevent deficiency in aggregate demand. By the late sixties and early
seventies however, most of the developed world was witnessing the emergence of a
combination of high inflation and low growth; i.e., stagnation, and the revered Keynesian
analysis was unable to devise plausible responses to the phenomenon. Consequently,
monetary policy emerged as an eminent instrument of economic policy, particularly in the
fight against inflation. Issues related to the conduct of monetary policy worked their
way to the forefront of policy debates during the 1980's as growth and price stability
were the intermediate and long term objectives. Gradually, a loose consensus emerged
among industrially advanced countries that the dominant objective of monetary policy
should be price stability, and from the outset of the 1990's, this belief has increased
in popularity. However, differences continue to exist among central banks with regard to
the appropriate intermediate target. While some consider monetary aggregates and,
therefore, monetary targeting as operationally meaningful, others focus exclusively on
interest rates-even though the inter-relationship between the two targets is well
recognised. Again, as with all inflation-related issues, there seems to be little
consensus. Though it will only be noted in passing here, monetary policy has also gone
through a renaissance in developing economies. Much of the early literature on
development economics focused on real factors such as savings, investment, and technology
as the main springs of growth. Very little attention was paid to the financial system as
a contributory factor. Indeed, through the years countless opinions have highlighted that
inflation is endemic in the process of economic growth and is accordingly treated more as
a consequence of structural imbalance than as a monetary phenomenon. However, with a
growing body of overwhelming evidence, it has become clear that any process of economic
growth where monetary expansion is disregarded also leads to inflationary pressures with
resultant impacts on economic growth. Thus, price stability and monetary policy have
assumed increased importance all over the world, in developing and developed economies
alike. Yet, the widespread use of monetary policy to control inflation does not
necessarily muffle the roars of policy debate. In fact, the extent to which price
stability should be deemed to be the over-riding objective of monetary policy has become
an increasingly heated topic of discussion. The crucial question seems to be whether the
pursuit of low inflation; (i.e., price stability) through monetary policy undermines the
ability of an economy to attain and sustain higher growth. A substantial body of research
occupies the examination of this trade-off, whose roots trace back to the Phillips curve
(1958) which demonstrated the inverse relationship between the change in wage rates and
unemployment rates. It was here that the suggestion of a trade-off between inflation and
unemployment was first laid. Although the 'Phillips' relationship has subsequently been
challenged on theoretical and empirical grounds, it continues to form an important locus
of analysis and it is prudent to look at in some detail below. The Phillips Curve It is
well known, and generally accepted, that the downward slope of the Phillips curve arises
basically because of the presence of money illusion and expected inflation deviating from
actual inflation. Based on this knowledge, and its subsequent critiques, the prevailing
inflation/monetary policy controversy centres on the possible short-run and long run
trade-off between inflation and unemployment. This distinction primarily stems from the
"assumption of 'error-learning' process in the determination of inflationary expectations
- workers do have an anticipation on the inflation, but because they judge the inflation
performance from the past data, the adjustment between the expected and actual inflation
is slow." This implies that in the short-run, nominal wage rise will not fully absorb the
actual inflation, and as such, there is scope for reducing unemployment through
inflation. "As people adjust their expectations of inflation, the short-run Phillips
curve shifts upward and unemployment rate returns towards its 'natural' level. As the
expected inflation catches up with actual inflation, the Phillips curve becomes vertical,
denying thereby a 'trade-off' between inflation and unemployment in the long run." Seen
in this light, the short term Phillips curve provides a trade-off between inflation and
unemployment when an economy is adjusting to shocks in aggregate demand when expected
inflation is lower than actual inflation. In the long run, the Phillips curve becomes
almost vertical at the (controversial) 'natural' rate of unemployment. Though not
discussed in this paper, the plausibility of this 'natural' rate of unemployment has been
cast into doubt in recent years. For the moment, notwithstanding the critique of the
'natural' unemployment rate, the Phillips curve presents the possibility of lengthening
the short-run 'trade-offs' indefinitely, since inflation surprises in each period can
elongate the long-run perpetually. But, in that case the 'trade-offs' will become sharper
in each successive period. In other words, to maintain the unemployment below the
'natural' rate, policy authorities will have to inflate the economy at higher rates in
each successive period. This has a major policy implication even if the economy does not
operate on the long-run vertical Phillips curve. "Under the rational expectations
hypothesis, as there are no deviations between actual, and expected inflation, both in
the short-run and long-run, Phillips curves are treated as being vertical with no
trade-off between inflation and unemployment." Another policy related question is the
shape of the short-run Phillips curve itself. In reality, wages and prices are sticky as
employment contracts are fairly long and there is also a cost in changing the individual
prices too often, or re-negotiating wages after each price rise. It has been argued that
the nature of stickiness in wages and prices could be different in different economies,
and this could also be a function of the inflation history of the country concerned. If
so, countries with high inflation rates would find themselves steeper on short-run
Phillips curve than low inflation countries, which are more likely to be on the flatter
side. For the purpose of this paper, what is important, therefore, is that the trade-off
between price stability and employment is sharper for countries with relatively high
inflation rates, and lower for those with low inflation rates. Price Stability as the
objective of Monetary Policy Price stability as the objective of monetary policy rests on
the notion that volatility in prices creates uncertainty in decision making. Rising
prices affect savings adversely while making speculative investments more attractive.
Thus, the most important contribution of the financial system to an economy is its
ability to increase savings and allocate resources more efficiently. A regime of rising
prices dampens the atmosphere for promotion of savings and allocation of investment.
Moreover, there is a social element: inflation adversely affects those who have no
protection against inflation; i.e., the poorer sections of the community. The critical
question for policy makers is, thus, at what level of inflation do its adverse
consequences begin to set in? Inflation affects fiscal balance in several ways. "It
adversely affects fiscal deficit when elasticity of expenditure to inflation is higher
than that of revenue. A more significant impact of inflation arises from its effect on
interest rate and the dynamic sustainability of fiscal situation. High rates of inflation
signal weak resolve to control inflation and imply higher expected inflation in future."
Obviously, this results in upward rigidity in nominal interest and leads to high debt
service burden on the budget, thus reducing the flexibility of fiscal management. And as
just noted, it is well known that the adverse implications of inflation are more intense
at high rates of inflation. A moderate inflation rate is usually more desirable, and
manageable as it ordinarily does not imply severe costs. Indeed, moderate inflation rates
are necessary if money is to remain a useful unit of account and if the costs of decision
making are to be minimised. But, there is no consensus as to the optimum rate of moderate
inflation, or even as to what the term 'moderate' means. "International evidence suggests
that the costs of uncertainty tend to rise in a non-linear fashion with the inflation
rate exceeding a threshold. One important caveat in interpreting the threshold of
inflation rate beyond which costs exceed benefit is the provision of inflation protection
measures available in the economy, which tends to moderate the adverse implications to
some extent." In other words, countries with a moderate inflation rate, but an inadequate
indexation provision, may show a higher degree of sensitivity to inflation than those
with lower 'moderate' inflation. For example, as noted above, most of the industrialised
countries in recent years have inflation targets ranging between two to three per cent.
But, among the developing countries, some of the fast growing East-Asian economies have
not only demonstrated low inflation rates ranging between three to five per cent, but the
growth rate at these inflation rates has been fairly high at around eight per cent.
Empirical evidence on the relationship between the inflation and growth in cross-country
framework is therefore somewhat confusing. Several studies make it clear that the
negative impact of inflation on growth is more severe at unmistakably high rates of
inflation, there is no consensus about the threshold inflation rate beyond which, or
under which, the negative impacts of price stability become pronounced. The term
'moderate' or 'low' inflation is clearly relative and dependant upon a number of
circumstances. In part, this fact also obscures the analysis of policies that seek zero
inflation, or virtual price stability. The effects of virtual price stability Most policy
makers generally worry about inflation, however moderate, because if not held in check, a
little inflation can lead to higher inflation and ultimately affect growth. Several
central banks believe that the "economic benefits of reducing inflation, say, from 4 per
cent to 2 per cent, are 'many and large' and the unemployment costs are 'transitory and
small' by comparison." This perception rests on the Friedman's "classical idea that the
Phillips trade-off between inflation and unemployment disappears in the long run, and
even in the short run if the central bank's commitment to zero inflation is made credible
and has a direct downward effect on expected and actual inflation that minimises the
unemployment costs of disinflation." Yet, this appears to be more plausible in theory
than in practice. As a case in point, the Bank of Canada has argued that the country's
"inflation could not have been minimised without a short-term rise in unemployment and
government debt." Thus, they concede that there are indeed short-term costs, although
they hope that they will be outweighed by the long-term benefits. According to this view,
benefits will accrue because of Canada's resultant low-inflation environment, which will
promote both the stability and competitiveness of the Canadian economy. This should
result in a protracted increase in business investment. Yet, the economy continues to
feel the short-term effects. It seems as though the short term is actually a very long
one. Not surprisingly, this lag time has engendered a host of critics of such a narrow
monetary policies. Perhaps most notably, P. Krugman has argued that while the belief that
absolute price stability is a 'huge blessing' with large benefits and few drawbacks, the
concept rests entirely on faith. Empirical evidence actually indicates the opposite. The
benefits of price stability are elusive and the costs of achieving it are large. And zero
inflation may not be a good thing even in the long run. Critiques focused specifically on
the Bank of Canada's policy further argue that the Bank has been overly obsessed with
reducing inflation to the detriment of other concerns. Bringing down inflation in the
early 1990s required a harsh contractionary monetary policy, with extremely high
short-term interest rates. For these observers, the Bank's tight monetary policy was
badly mistimed, since it was applied during the recession of the early 1990s and the
precarious recovery that followed. Critics also suggest that the Bank of Canada's policy
surely has important long-run costs. Their argument relates to so-called 'hysteresis',
which refers to the case where a variable that has been shifted by some external force
does not return to its original state once the external force has been lifted. In the
Canadian macroeconomy, it is argued that hysteresis took place when the recession
increased the 'natural' unemployment rate by creating new structural unemployment. As
such, the economy's self-stabilising tendency was hampered which damaged the economy
because its potential level of real output decreased. To some degree, this explanation
helps explain the stubbornly high rates of Canadian unemployment in the 1990s. Critics
are also quick to point to another important cost of the Bank of Canada's contractionary
policies during the early 1990s. High short-term interest rates have caused the interest
bill on outstanding government debt to increase. And , by pushing down both real income
and employment, the Bank has reduced government tax revenues. A vicious cycle has been
the consequence, with the federal government's added interest obligations and sagging tax
intake forcing it to run higher yearly deficits which have increased public debt even
further. Thus, despite the success of reaching low inflation targets, low inflation
monetary policy does tend to raise unemployment, either directly or indirectly. This can
occur through its effects on investment or otherwise, unless the policy generates a great
increase in confidence and public expenditure cuts. As the Canadian case demonstrates,
this may not be possible. The danger of a narrowly focused monetary policy, then, is that
if unemployment rises more than expected, which may well happen, political pressures are
likely to be generated leading to the abandonment of the experiment. In Canada, the
pressure is increasing, and though virtually independent of the government, the Bank of
Canada may not be able to withstand the costs of the experiment for much longer.
Abandoning the policy, however, would also be very costly in that, by undermining
confidence in the authorities' capability and determination, it would make it almost
impossible for the Bank's future policies to have beneficial direct effects on
expectations. The alternative strategy of defining a target path for unemployment, though
liable to be condemned by the public as 'cold-blooded', might minimise this risk and thus
lower the expected unemployment cost of the ultimate reduction of inflation. But, this
too may prove to be different in practice. Empirical studies have shown that, contrary to
the prevailing beliefs of many economists and central bankers, in the "long run, a
moderate steady rate of inflation permits maximum employment and output. Maintenance of
zero inflation measurably increases the sustainable unemployment rate and correspondingly
reduces the level of output." Zero inflation inflicts permanent real costs that are much
larger than envisaged by present-day policy makers. Following Canada's path to zero
inflation, empirical modelling demonstrates that the instigation of a policy of zero
inflation immediately reduces employment, and it continues to decrease until the third
year of the zero inflation 'experiment'. "The effects of wage rigidity mount as inflation
approaches zero, increasing the incremental unemployment cost of reducing inflation
further. The zero inflation rate target is not reached until the 6th year, at which point
unemployment has reached 10.8 percent. Unemployment declines gradually from that point,
nearing its steady state rate of 8.4 percent after a decade." Without much surprise, this
does very closely reflect the effects of the zero inflation monetary policy pursued in
Canada. Policy makers should not be satisfied with an ultimate unemployment rate of 8.4%.
Not only is this rate of unemployment still high, but the costs involved in securing the
target are certainly not worth it. Observations and Conclusions Inflation, both high and
low, clearly poses great problems on the macro and micro economy. In higher doses,
inflation erodes people's savings, endangers economic growth and propagates social
instability. So, it has been argued, "why not in these more disciplined times try to
eradicate the disease altogether, just as the world has gotten rid of smallpox? Why not,
some central bankers and economists are asking, aim for zero inflation - at least in the
industrial countries?" Only in recent years has this question even been feasible.
Previously, if inflation was single digit, it was quite acceptable. "Now, however, the
world is entering an era of low inflation that brings more ambitious targets within
reach. According to the International Monetary Fund, average inflation in the industrial
countries is running at only just over 2 percent a year, and although the rate is much
higher in the developing countries, it is falling quickly." As shown in this study, the
proliferation of low inflation monetary policies to pursue virtual price stability is at
the root of this phenomenon. However, as shown in this paper, zero inflation objectives
are not wise: Central banks and governments may be trying to kill something that is not
capable of being made extinct. This is particularly true in the era of globalisation.
"Fiercer global competition and freer world trade, low oil and commodity prices, the
declining power of labour unions, the growing resistance of consumers to price increases,
and the heavy penalties imposed by financial markets on undisciplined governments" are
working to complicate monetary policies, and further make zero inflation impractical.
Thus, even if 'zero' or low inflation is readily achievable, as it seems to be, it does
so in the face of very powerful variables. But, there are several additional reasons to
end zero inflation policies. Above all, this paper has demonstrated that the
macroeconomics of low inflation is a delicate science. Macroeconomic performance is very
different when inflation falls lower half of the 1-3 percent range than in the upper-half
of the 2-4 per cent range, particularly in the long run. Numerically small, but
effectively huge, differences arise from the sharp non-linearity of the long-run Phillips
curve at low inflation rates. "Wringing the last drops of inflation out of the system has
painful consequences for growth, jobs and investment that are neither politically
acceptable nor economically desirable." Though central banks are reluctant to see the
logic of this argument at the moment, the time may soon come when the credibility of
giving up zero inflation experiments will be greater than their continued pursuit. A
prerequisite to this, in all likelihood, is that the least unemployment costly path for
stabilising prices must be found. And, unfortunately, this is a difficult, if not
impossible, pursuit. From all of the confusion, what is clear is that a little inflation,
perhaps 1 to 3 percent, is a far more efficient policy choice than zero inflation. Such a
moderate inflation target would allow real wages to decline where necessary without firms
having to impose wage cuts or fire workers. Thus, "rather than misusing their energy
pursuing zero inflation, governments should be exploring the other policy options now
available. In today's low-inflation environment, central banks can afford to be less
restrictive than they have learned to be over the past two decades and allow greater room
for growth. Exchange rates can, if necessary, be nudged downward without automatically
provoking the wage and price spirals they did in the past." Such examples are not
necessarily a panacea for the damage caused by zero inflation experiments so far, but
they are certainly less harmful. As argued by Pierre Fortin, public opinion is starting
to reflect the reality that "promised 'large benefits' from zero inflation are actually a
mirage and that the 'small' unemployment costs are actually huge." This opinion has been
voiced particularly loudly by Japan and France. And unless the elusive benefits of zero
inflation soon manifest themselves, it is only a matter of time before the rest of the
'no inflation' pack realises they are barking up the wrong tree.