Carlo Cottarelli, and Gyorgy Szapary
Published Date:
July 1998
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André Icard

It is a great pleasure for me to take part in this seminar and to comment on the paper by Burton and Fischer. This is very much a work in progress, which makes it a little difficult to comment on it. But let me nevertheless try.

The case studies are very rich, and I am sure that many conclusions could be drawn from them in addition to the ones presented in the paper. I would like to comment mainly on four topics.

Inflation and Growth

The paper deals with a very important topic, namely, how to go from moderate inflation—that is, inflation in the 15–30 percent range—to rates below that. Since this draft of the paper does not do so, let me remind you that there is a growing body of econometric evidence (to which, incidentally, Stan Fischer has made an important contribution) that clearly indicates that inflation in this range is harmful to economic growth. By contrast, the statistical evidence that inflation below this range reduces growth is much less clear-cut. Thus, while we can argue about whether 2 percent inflation is too high there is no doubt that 15 percent is far too high, and that ending moderate inflations ought to be at the top of policymakers’ agendas.

Defining precisely where the boundary is located is a difficult exercise. Giving an abstract answer to this very concrete question could be like comparing the benefits of further disinflation and the related costs. The benefits of further disinflation stem from the avoidance of the welfare losses associated with continued inflation. These welfare losses may stem from either the level or the volatility of inflation.

First, inflation depresses economic growth by reducing capital accumulation and productivity growth. In summarizing this evidence, the IMF concluded that a 1 percent reduction in inflation may raise economic growth by 0.02-0.08 percent.

Inflation also reduces welfare through its interaction with the tax system. Because taxes are levied on nominal capital gains and nominal interest income, the net return to saving falls as inflation rises. This in turn induces consumers to save less and consume more than they otherwise would. This distortion of their saving-consumption decision reduces welfare.

Inflation also affects welfare by interfering with resource allocation in the economy. It is well known that, as inflation rises, financial transactions are increasingly carried out through the banking system. Both anecdotal and formal evidence suggest that, as inflation rises, the relative size of the financial sector expands and that this process is more pronounced in higher-income economies. The expansion of the financial sector implies that the part of national income available for consumption and investment is correspondingly reduced.

On the other side of the issue, the cost of further disinflation depends critically on the slope of the trade-off between output and inflation and the speed with which inflationary expectations adjust. If inflationary expectations initially do not adjust as policy is tightened to disinflate, output falls as the economy moves along the short-run Phillips curve. If this curve is asymmetric, which it could be if nominal wages are rigidly downward, contractionary monetary policy may reduce economic activity by more (for each percentage point change in inflation) than expansionary policy raises it.

Case Studies Versus Analytical Framework

The second part of the paper presents the analytical framework, which consists of a pricing equation. The equation makes the point that inflation will fall if

  • the growth of nominal wages is reduced below the rate of inflation of the last period, or

  • the rate of exchange rate depreciation is reduced below the rate of inflation of the last period, or

  • an expansionary supply shock occurs (which increases the supply of goods and thus reduces their prices).

This pricing equation suggests, at least at first glance, three strategies to reduce inflation, which the authors discuss:

  • try to reduce nominal wage growth, for instance, by reducing the extent to which current wages are indexed to past inflation;

  • fix the exchange rate or, at least, reduce the rate of depreciation; or

  • wait for a favorable supply shock to occur.

This approach leads directly to my main problem with the paper: this equation seems to place greater stress on the importance of exchange rate and wage policy in reducing inflation than in restricting aggregate demand. While there are important relationships among inflation, wages, and exchange rate depreciation, I personally would put more emphasis on the role of excessively expansionary fiscal and monetary policy as the underlying determinant of wage growth, exchange rate depreciation, and price inflation and would attach a subsidiary role to wage indexation and exchange rate policy.

To put this another way, while it is possible to reduce inflation by reducing wage growth or fixing the exchange rate, doing so without reducing aggregate demand is not likely to lead to a permanent reduction in inflation.

I should stress here that I am not arguing that wage and exchange rate policies do not matter, only that the exact way they are conducted is probably less important for the success of a disinflation program than whether fiscal and monetary policy are tightened.

My view of the relative importance of tight demand policy and indexation is perhaps best captured in the discussion of Chile in Appendix I of the paper, where it is apparent that tight fiscal and monetary policy brought down inflation even though indexation was widely used in the country.

It is clear from the other case studies that the bulk of the countries that ended moderate inflation have implemented fiscal and monetary policy with the goal of reducing aggregate demand. However, none of the countries with continued moderate inflation has done so in the long run: many of these countries (Costa Rica, Ecuador, and Israel) achieved some success in the fight against inflation only when they implemented strict fiscal policy.

Role of Fiscal Policy

Fiscal policy is essential for controlling aggregate demand and for addressing the capital-inflow problem. This emphasis on sound fiscal policy leads naturally to a number of questions that could potentially be explored through the case studies in this paper.

(1) There is some evidence from the countries of the Organization for Economic Cooperation and Development that fiscal programs that emphasize reducing spending are more likely to be successful than programs that focus on raising taxes. This evidence leads to the question of whether, in countries that have successfully made the transition from moderate to low inflation, the improvement in fiscal policy stems mainly from reductions in government spending or from increases in tax revenue.

(2) Another issue is whether changes in the composition of government spending have played a role in disinflation programs. For instance, it seems plausible that disinflation programs that entail shifting from government consumption toward investment in infrastructure may be more successful, because government investment may promote growth.

(3) A third question that arises is the role that loss-making state-owned enterprises play in the disinflation process. How important is it to get them off the budget? On occasion, large subsidies to sustain loss-making state-owned enterprises may have played a role in fueling moderate inflation.

Inflation and Seigniorage

Although it is clear from the country experiences reviewed in the paper that fiscal deficits play a role in moderate inflation, what is more important is how deficits are financed. More precisely, deficits that are financed through borrowing from the public are less inflationary than deficits that are financed through borrowing from the central bank, that is, through seigniorage.

To see how important reducing seigniorage actually is for reducing inflation, consider Figure 1, which is constructed using the data from the 20 countries covered in Tables 3, 6, 8, and 9 of the paper. The vertical axis shows the change in inflation from its peak to its level in 1996.1 Because inflation fell by several thousand percent in some cases, a log scale is used. The horizontal axis shows the change in seigniorage as a percentage of GDP. To understand the graph, consider the data point for Iceland. Between 1985 and 1996, inflation in Iceland fell from 31.7 percent to 2.3 percent, or by 29.4 percentage points. At the same time, seigniorage in Iceland fell from 1.7 percent to 0.7 percent of GDP, or by 1 percentage point.

Figure 1.Improvement in Inflation Versus Reduction of Seigniorage

(Logarithmic scale)

Source: Bank for International Settlements staff estimates.

If seigniorage as it is perceived through the data represents mainly the ability of a government to get credits from the central bank for financing its fiscal policy, countries with moderate inflation would have to consider two main directions.

(1) If the need for seigniorage explains the occurrence of persistent moderate inflation, one wonders how important increasing central bank independence and legal restrictions on central bank lending to the government are in successful transitions from moderate to low inflation.

(2) My second question concerns the importance of establishing financial markets. By establishing markets for government bonds, the government’s need for central bank credit can be reduced. I understand that this process played some role in Iceland’s successful transition from moderate to very low—2 percent or so—inflation. Has this been the case elsewhere?

In conclusion, let me say that I enjoyed the paper very much. Its analytical framework is stimulating, and the case studies it presents are extremely rich and informative. I think it leaves open the possibility of longer discussions on the role of contractionary fiscal and monetary policy, ways to reduce central bank financing of public deficits, and the usefulness of restricting seigniorage.

For a few countries, the reference year is 1995 because of data availability.

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