Chapter 2 Inflation and Growth in a Country in Transition

Manuel Guitián, and Robert Mundell
Published Date:
June 1996
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Norbert Walter

In March 1995, China’s first central bank legislation came into effect. It charges the People’s Bank of China with conducting the country’s monetary policy. However, even in the new law there is still no precise definition of the central bank’s duties and responsibilities. I should therefore like to take the opportunity to discuss some general features of a stability-oriented central bank policy.

Price stability as an objective of monetary policy is a cornerstone of the transformation process. It is important because high inflation rates seriously interfere with the function of prices to signal the scarcity of goods and discriminate against people whose savings take the form of financial assets. In turn, this hinders the accumulation of capital and planning for the future and ultimately has an undesirable distributional impact.

Former Bundesbank President Karl Blessing once said, “Inflation defrauds the people; it is the most antisocial system in existence.” The first victims are all savers, with small savers bearing the brunt of monetary depreciation. The same applies to savings held in cash. Negative real interest rates—when nominal interest rates are lower than the inflation rate—also reduce the purchasing power of interest income and thus the incentive to accumulate capital, that is, to save. The normal reaction of savers would be to switch to higher-yield investments or physical assets (real estate, precious metals, jewelry, works of art, consumer durables, and so on).

Switching to physical assets artificially drives up prices in these sectors and feeds inflation, which means that, at the same time, the signaling function of prices is impaired and production structures are distorted. A typical example of this problem in industrial countries with relatively high inflation rates has been the expansion of the construction sector. During the subsequent phase of tight monetary policy and declining inflation rates, many building projects became unprofitable, and production capacity had to be cut. The result was empty buildings and an increase in problem loans held by banks.

Workers who are paid a fixed nominal wage also lose out to inflation. Each delay in adjusting wages to the prevailing current high inflation rate reduces purchasing power proportionately. Companies are affected by inflation in a variety of ways. On the one hand, they alter prices out of line with relative scarcities owing to inflationary confusion. On the other hand, they may be hit by inflation-related pay increases and other costs. Experience shows that some companies have to pay tax on apparent profits swollen by inflation and that their capital base is eroded as a result. Ultimately, the basic concept of the free market is put at risk, because undesirable inflationary developments are blamed—wrongly—on this market system.

Experience in many countries shows that in the long run other economic policy objectives, such as satisfactory economic growth, high employment, and a healthy external current account, can best be achieved while inflation rates are low. For example, in Germany the priority of price stability has been the centerpiece of economic policy since the currency reform of 1948 and was a key factor in the German economic miracle. As long as price stability is not impeded, monetary policy can certainly be designed to support the government’s general economic policy. In Germany, this is provided for explicitly in the central bank law.

Fighting inflation is the only objective that the central bank can expect to achieve using its instruments, because inflation develops only if monetary policy allows it to develop. Inflation may have a variety of causes, but it will not last long without monetary support.

The goal of price level stabilization means that the purchasing power of a currency has to be kept roughly stable. Individual prices, however, must remain flexible in a free market economy in order to signal scarcity to companies and consumers. A high price first dampens demand for a good but then in the dynamic market process it encourages investment and higher production of this good. This process can result in lower prices again if supply increases.

Competition and Monetary Policy

For monetary policy to be successful, prices must be determined in markets where companies compete against each other. Competition limits the scope of companies to raise their prices because customers can switch to another supplier. This means companies must constantly strive to save costs and increase performance to remain competitive. Competition in the markets is a natural ally of monetary policy in the cause of stable prices.

A negatively sloped Phillips curve relationship was observed only during the 1960s and only in a few countries.

In a monopoly, one supplier can charge higher prices for its products than under competitive conditions. Monopolistic structures must therefore be dismantled if price liberalization is to have optimal results for the consumer. A government authority, while necessary to ensure fair and open competition, may not achieve immediate success. Two approaches for promoting competition are conceivable:

• Breaking up large companies and preparing them for privatization. At the same time, private enterprises must be established to enable the creation of competing companies.

• Permitting foreign investors to set up new companies to compete with domestic firms or allowing them to take over domestic companies and bring them into competitive shape.

Besides measures to intensify competition, price distortions caused by subsidies should be removed to the extent possible.

No Long-Term Contradiction Between Price Stability and Employment

To avoid endangering the longer-term positive impact of stable prices on growth and employment, monetary policy should be noninflationary from the beginning and not made the scapegoat for the cuts in production and the workforce that are necessary during the transition to a market economy.

During this transitional phase, there may well be a conflict—though only temporarily—between monetary stabilization and the maintenance of jobs. Stable social conditions, however, are the key to the success of the reform process and the longer-term restructuring of the economy. To attain the objective of price stability, the central bank must keep monetary circulation tight and ensure positive real interest rates; that is, nominal interest rates must be higher than the inflation rate. Positive real interest rates, however, increase the financial burden on companies, which may initially limit production and eliminate staff redundancies. But even without a tight money policy, job losses are unavoidable during restructuring. The central bank must not be forced into pursuing a cheap money policy. Only under a stability-oriented monetary policy can inflation be reduced and monetary stability permitted to produce its positive longer-term impact on, among other indicators, growth and employment. Support for the jobless should be provided through transfers that are low enough not to cause moral hazard.

Significance of Central Bank Independence

Genuine independence safeguards the central bank’s long-term orientation toward stability and protects against political temptations to use monetary policy to support other aims, such as a short-term increase in employment.

Experience shows that countries with an independent central bank have lower inflation rates over the years. The independence of the central bank makes possible a long-term stance in monetary policy. The central bank should resist the temptation to subordinate fighting inflation to short-term political objectives, which often result in higher inflation and interest rates some time later. Such pressures may be exerted prior to elections, for example, to prevent higher unemployment in the short term through lower interest rates. There exists also a major risk of political pressure on central banks to grant favorable refinancing conditions for bank loans to individual sectors or large public sector companies (selective monetary policy). Succumbing to such pressure would reduce the effectiveness of monetary policy and should therefore be avoided.

Independence is also an important shield against possible misuse of the central bank for financing the government budget. The independent central bank can refuse to allow access to central bank credit without regard to political pressures and can inform individuals and companies of the dangers to monetary stability posed by the use of this instrument.

Even when a central bank is independent, monetary policy is not conducted in a political vacuum. The central bank law can be amended. In a democratically organized market economy, the central bank’s monetary policy is scrutinized by the public, the media, and the financial markets. An independent central bank as a rule advises government on important economic policy decisions. Conversely, in some countries—Germany, for example—members of the government can participate in meetings of the decision-making committee of the central bank but without the right to vote.

Monetary Policy Versus Budget Policy

The central bank’s monetary policy and the state’s budget policy are two different core areas of economic policy. Although both policies must contribute to the objective of stabilizing the currency, they otherwise have different duties to perform. Whereas monetary policy is designed mainly to ensure stability of the price level (and a correspondingly tight money supply and lending policy), it is through budget policy that the government raises the revenue, mainly in the form of taxes, that it needs to carry out its varied duties in a market economy. The budget must pay for all those tasks that the population considers necessary and that private companies cannot carry out or can only partially carry out. They include social services, defense, the legal system, and schools and training institutions. The budget is the government’s political program in figures. Monetary policy uses its instruments to pursue its objectives and the interest rate as a control mechanism, whereas budget policy operates on the basis of taxes, borrowing, and expenditure.

High budget deficits have considerable negative macroeconomic consequences that must be avoided, especially with regard to the stability of a country’s currency, including the following:

• Budget deficits suck scarce savings into the public sector and crowd out private investors. Because of the greater efficiency of the private sector, this hinders future GDP growth, the very cause that a dynamic private enterprise sector is meant to promote.

• High budget deficits raise macroeconomic demand and encourage imports, which may lead to a worsening of the trade and current account balances. If a trade deficit widens, for example, it represents a burden on the exchange rate.

• High budget deficits often lead to tax increases at a later date and therefore dampen future productivity and growth prospects.

Steps to Support Monetary Policy

A stability-oriented monetary policy requires protective flanking from other areas of economic policy, particularly from government budget policy. Without support, every long-term central bank policy is bound to fail. Support from other political sectors can include, in particular, the following:

• A cautious pay policy, based on trends in productivity, would allow greater wage differentiation and thus create increased work incentives. This implies—because of limited mobility of labor—restricting the power of unions and employers’ associations to negotiate binding wages.

• Phasing out subsidized prices and changing to market pricing.

• A banking system that efficiently transmits the impact of central bank monetary policy measures to the real economy by setting conditions for lending and investments that conform with the ideas of the central bank.

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