Journal Issue

Inflation and Growth

International Monetary Fund. External Relations Dept.
Published Date:
June 1964
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Graeme S. Dorrance

IN A DEVELOPING economy, the government has a grave responsibility to make certain that its financial policies are directed primarily toward overcoming the basic problems which are likely to face a less developed country. These structural problems—so-called because they appear rather as elements in the structure of the economy than as incidents in its history—are often very serious. In most less developed countries, the vast majority of the people are not as yet educated to take their place in a modern technological society. In fact, the most serious problem in many of them is the problem of illiteracy. An inability to take advantage of simple opportunities to fight disease and to overcome poor nutrition is often almost as serious a social problem. Government institutions are frequently inadequate to meet the problems of a rapidly changing society. As populations grow and gather in cities, the basic sanitary facilities become inadequate, and more expensive housing is required than may be the minimum necessary in country districts. In many of the countries where progress has been slow in the past, businesses are not used to taking the risks which must be faced in the development of new products and new methods of distribution. There is also the need to develop basic community requirements, such as roads, bridges, power, and other public utilities.

Mr. Dorrance, Chief of the Finance Division of the Fund, has been a lecturer at the London School of Economics and a member of the staff of the Bank of Canada.

Faced with these and other serious problems, the government of a developing country should consider the basic question of its financial policy so that victory over the fundamental structural difficulties may be made more likely.

About inflation itself various questions may be asked:

Does inflation help ease the problems of a developing country?

Is inflation an inevitable result of rapid development?

Or: Are the effects of inflation so harmful that the government of a developing country should fight it with enthusiasm?

The Background

In a country which is trying to develop rapidly, there are always fewer resources (of goods or skilled workers) than are wanted. If development is to be rapid, there is a tendency for the community as a whole (including the government as well as individuals and businesses) to try to spend more than is currently produced by home industries or available as imports. If a community tries to do this, inflation becomes likely. This happens most frequently when governments have committed themselves to spend more than they receive from taxes, or can borrow from the genuine savings of the population. The competition resulting from the attempt to buy more goods and services than are available raises the prices of goods, and the competition for the services of skilled workers raises wages. Then the government itself, however reluctantly and belatedly, also has to pay higher prices and wages and so has to spend even more beyond its means. As long as people in general—which includes the government—try to spend more money than the production costs of the goods and services available at a particular time, so long will prices tend to rise and an inflation will be present.

Not all price rises are signs of dangerous inflation. Food prices may rise because of a bad harvest, for instance, but if a good harvest follows, the situation corrects itself. The inflation that causes concern is a continuing rapid inflation; in this, there are increases in prices which increase incomes but do not correspondingly increase supplies. In that case, prices tend to continue rising. Common sense suggests and experience shows that the problems created by such an inflation may be so great that they make it impossible for a government to speed development. In fact, if a country embarks on a rapid development program without taking steps to restrain inflation, the end result of the program may be progress less rapid than it would have been if the program had not been attempted. If a severe inflation continues, and prices rise rapidly year after year, not only will development slow down, but the social fabric will be severely strained. In recent years there have been many such occurrences, and even at the present time there are a number of countries where these tensions are apparent. Thus, at the moment, prices are more than doubling every year in Brazil and Indonesia, and rising at a rate which would result in their doubling in less than two years in the Congo, and every three years in Argentina, Chile, Colombia, Korea, and Uruguay, to name only a few such countries. It is not unlikely that similar price rises will appear in other developing countries which are trying to catch up with the more fortunate parts of the world, unless their governments stand firmly resolved to fight inflation with enthusiasm.

Danger Signals

There are two danger signals that inflation has gone too far. One is the appearance of a wage-price spiral. When the cost of living is rising rapidly, wage earners and pensioners justifiably refuse to be satisfied with their lot unless they receive frequent large increases in their incomes. Yet large wage increases raise costs, and hence lead inevitably to further upward price changes. The second danger signal is a distrust of money. Once people lose faith in their money because they see that money savings held in bank deposits, insurance policies, social security funds, government securities, or similar forms, melt away in terms of what they can buy, they cease to hold such things and the entire financial structure of the country is strained. Further, they cease to have faith in the real meaning of money promises; workers fight not for wages high enough to meet the present increase in the cost of living but for wages high enough to meet the expected future increases in the cost of living. Strikes become widespread and prolonged, and struggles between employers and workers embitter the political scene.

Diversion of Investment

In these circumstances, people see that it is foolish to hold money in bank accounts, savings deposits, life insurance, government securities, or similar forms. Rather than trying to work for a better future for themselves and their families by saving in these forms, they will use in other ways what savings they may already have. It must be remembered, however, that for the vast majority of people in every country there are relatively few ways in which they can hold savings. They can hold such things as savings deposits and insurance policies, gold and foreign currencies, or real estate. Unless they own their own businesses, it is difficult for them to buy other assets which are likely to rise in price. One of the important roles of banks and savings banks (including government development banks) and insurance companies is to gather the relatively small savings of individuals and enable them to be used in the relatively large blocks that are required for productive investment, while providing protection to the small individual which he can use at a time of family crisis or can build up in the hope of providing a better future for himself and his family. However, if prices are going to rise, he will not entrust his money to such institutions. He may feel that the future is so uncertain that he might as well spend his money now and let the future take care of itself—in which event, savings will fall. Or, if he saves, he can protect his future by buying gold or foreign currencies. As the Fund said in its Annual Report for 1962: “A particularly unfortunate feature of the international scene in the last decade has been the large flow of private capital from those less developed countries which have tolerated inflation to countries, frequently wealthy, which have maintained monetary stability.”

These same reasons which lead people to wish to buy foreign currency when they expect prices to rise will lead foreigners to be less anxious to invest in the inflating country, because they are running the risk of their investment losing value through deterioration of the exchange rate. The net result of this two-way process is a loss of capital in the inflating country. A developing country wants the rest of the world to invest in it; but an inflating country tends to be a net investor in the rest of the world.

A private individual may also build up his savings by buying real estate. Insofar as he merely buys land from someone else there is no serious problem. It is the use made by the former landowner of the receipts from the sale of his land that raises problems. However, in cities the purchase of real estate usually means the purchase of a house or an apartment. An individual can see a house or an apartment not only as a place to live in but also as a possession which is likely to rise in price as long as inflation continues. He may well buy a house or an apartment as much to provide protection for his future as to provide shelter for his family. In doing so he will try to buy the biggest house or apartment that he thinks he can possibly afford. That is, he is likely to buy a house or an apartment larger than that which would fit his needs if there were other forms of saving which he trusted. Thus, with an inflation, resources will go into the building of houses and apartments on a greater scale than would otherwise happen. Resources which could have been used to increase the community’s capacity to meet its wants will be wasted on the building of houses and apartments larger and more luxurious than people really want. The real satisfaction of the community will be less than it would have been if price increases had not been expected. It might be thought that instead of building a larger house than he desired, a small individual might put his savings in a house or apartment which he could rent. However, in modern societies, when inflation occurs, governments quite rightly try to protect the small individual from the worst effects of the inflation. It is common for the government to impose rent controls in an attempt to protect individuals from profiteers. Unfortunately, one of the effects of these controls is that they treat the small individual who buys a house to rent in fact as a “profiteer,” and as a result such houses or apartments become no better than bonds or insurance policies as protection against the future.

Hoarding of Stocks

In the business world there is a parallel to the accumulation of real estate by individuals. The businessman will expect that prices and wages are going to rise in the future. However, he cannot be certain whether they will rise more in the immediate future than they have in the recent past, or whether they will rise somewhat less rapidly; and there is always the ever present chance that the government will have the courage to stop inflation. It must be remembered that governments universally view inflation in the same way that people view sin: they are opposed to it and never do more than accept it as an “inevitable evil.” Further, the businessman will be most uncertain about the rate of increase in the prices at which he can sell his products compared with the rate of increase in the prices he must pay for his supplies, and also about the rate of increase in the wages he must pay, or the bonuses he must grant, to his workers to keep them in his employment or to satisfy government decrees intended to protect workers from the worst effects of inflation. While he may be certain that prices will rise, he may be most uncertain as to what his immediate prospects are. As a result, he will be hesitant regarding the future, but will wish to hold some things which he expects to rise in price. He can do this by accumulating stocks of goods, either by buying raw materials which he is likely to need at some time in the future, or by being unenthusiastic about selling all the goods which he produces, in the expectation that he can get a better price for them than their present price. Thus resources which might be used to provide goods to satisfy the desires of the people will be used to build up hoards by businesses, and the general welfare of the community will be worsened.

Government Expedients

In addition to controlling rents, the government may seek to limit the inflation by fixing the prices of socially important goods and services. These expedients deal with symptoms, not with the root trouble. Unless the government subsidizes the production of these controlled goods and services, businessmen will be frightened away from their production, and will strive to produce those goods and services which are not controlled—usually the least important. At the same time, the very fact that the prices of some goods are controlled when the prices of others are rising makes the controlled goods more attractive; people will try to buy more of them. Unless they are subsidized, lines will form in front of shops when small deliveries arrive, black markets will develop, and social dissatisfaction will be common when people are unable to obtain goods that they think should be theirs by right. Some of these problems are most evident in countries where transport and public utility services have deterioriated because fares and rates have been held down while costs have risen. In these circumstances, the economic structure becomes distorted in such a way as to necessitate painful adjustments when inflation is eventually brought to an end. If the government subsidizes the production of essential goods, the problems are avoided. However, equally severe ones take their place. The payment of subsidies will eat up the government’s revenues and leave less available to finance development, or lead to further inflationary financing.

The International Consequences

Serious inflation does not limit its ravages to those on the home economy. It also leads to a worsening of a country’s international position. It has already been pointed out that constantly rising prices lead to a flight of money abroad and discourage an inflow of capital. This is bad enough, but inflation also encourages people to import goods from abroad and discourages them from exporting. Because domestic prices are rising, imports available from countries with stable prices will become more attractive. Hence people will buy them, rather than goods produced at home. At the same time, a country’s exports will suffer when prices are rising, partly because home demand is diverted to them and partly because they become too expensive to be sold in foreign markets.

The only way to avoid these trading disadvantages is to let the exchange rate worsen as rapidly as, or more rapidly than, prices rise. However, a worsening exchange rate tends to encourage the export of capital, so that the government of an inflating country finds itself in a dilemma. If it allows the exchange rate to fall, capital will flee the country; if it does not, the country will sell fewer exports and buy more imports. What often happens in practice is that the exchange rate is supported for a time, and then allowed to deteriorate sharply to a lower level, where it is pegged again. This tends to combine the two disadvantages. As long as the exchange rate is better than is appropriate for prices, the balance of payments will be under pressure. The fact that it has once been altered will induce wary owners of capital to expect it to be changed again.

As long as the exchange rate is pegged at the wrong level, it is necessary to cut down imports as far as possible. Restrictions of various kinds are accordingly placed upon them. This exclusion results in yet another misdirection of effort within the country. In order to replace the goods which formerly were imported, facilities have to be created or diverted. Clearly this must be costly to the inflating country, since if it had been economic to produce the goods at home this would already have been done. The goods which are substituted for the former imports accordingly rise in price.

When all the worst factors combine, an inflation may move very rapidly. Developments combine to depress the exchange rate; and as it declines fresh pressures develop at home, since imports now cost more, and this adds to the forces raising domestic prices.

It Can Be Stopped

Though an inflation tends to be cumulative, and may eventually move with great rapidity, it can be stopped, although the task of stopping it is always difficult and even in the earlier stages is liable to cause a temporary fresh dislocation. Suppose, however, that by one means or another the excess of purchasing power over current prices is eliminated—whether by equating government expenditures with revenues, or by borrowing abroad enough to purchase imports sufficient to fill the gap between demand and supply. What might be called the mechanical result will then have been achieved: there will be no pressures left to raise prices. But the psychological result will not have been achieved until people are convinced that the mechanical one has been, and here there is a gap. For some time to come people will expect prices to continue to rise, and they will continue to act as though prices were going to do so, which in itself may prove an obstacle to price stability. To instill a conviction that the end of price increases has really come is one of the government’s most difficult and most important tasks. What adds to the difficulty is that some prices—of food, of transportation, and of public services (such as electricity)—will have to be raised from the artifically low level at which they have been held. But a firm declaration of intent, backed up by effective steps to prevent prices from rising—by avoidance of wage increases and probably by changing the exchange rate sufficiently to close the gap in the balance of payments—will sooner or later achieve the desired results. The inflation is brought to a standstill—or at any rate near enough to a standstill to be no longer a threat to development. There is still an aftermath. All the effort that has been misdirected throughout the inflation has now to be redirected. This second step is difficult. For the immediate result of instilling a conviction that prices will stop rising is to discourage all those types of investment which have expanded as a result of the inflation. However quickly people realize that in the new conditions there will be a growing demand for production appropriate to stable incomes, it takes time to organize the production of such goods; meanwhile, there will be a shortage both of the goods and of jobs. Moreover, those who have been holding stocks of goods as a safe form of investment realize that the prospect of continuing profits from increases in their prices has now been brought to an end, and as the storing of these goods is a costly matter they try to dispose of them, at the expense of current production of the same goods. In the same way those who have been producing exportable goods, and selling them at home, find that the demand for them is much lessened. They withdrew from the export market because they found it difficult in comparison with the home market, and markets which are fairly difficult to retain are naturally exceedingly difficult to re-enter. These are some of the dislocations which hamper and embarrass a government that is trying to stabilize its economy.

The only alternative is to let the inflation continue, and this is worse. Only in a stable economy can effort be effectively directed to the kinds of long-run investments which are needed for economic growth. It is therefore a matter of the most vital importance for governments to persevere in the measures that will end inflation and maintain stability. The measures themselves depend to some extent on the country concerned. But the avoidance of a government deficit, the encouragement of savings, and the control of bank credit will most certainly all be necessary. None of these is easy to administer, but economic growth is a difficult objective which becomes a mere mirage without stability from which to grow. Once the initial difficulties of stabilizing are overcome, true growth can begin, and investors will not be long in taking advantage of the new opportunities which stability affords, provided they are convinced that the government is resolved to push forward resolutely with programs designed to foster development in an atmosphere of financial stability.

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