5 A Note on Inflation

Carlo Cottarelli, and Gyorgy Szapary
Published Date:
July 1998
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Marko Škreb

Inflation has been one of the most discussed subjects in economics in the last three decades, and justifiably so. This seminar on moderate inflation has clearly shown that, in spite of all the work done, there are still many unknowns about its causes, dynamics, and consequences. Personally, I think that all the discussions on moderate inflation during this seminar were most rewarding and enjoyable. Before proceeding, let me mention that I will comment on moderate inflation only from the perspective of a practical central banker. I have decided to try to concentrate my thoughts on the following questions: Is a moderate inflation “acceptable,” especially for economies in transition? What is the appropriate inflation target for transition economies? And, what is the role of monetary policy in anti-inflation policies?

Is inflation “bad” for the economy? In the case of high inflation, there is no doubt about the negative effects of inflation on long-term growth rates. There is a consensus (and well-documented evidence) in economics that inflationary costs are very high, especially at high inflation rates (high double-digit or even multidigit hyperinflationary episodes). However, there is much more debate on whether moderate inflation (defined in this seminar as low double-digit inflation, or inflation in the range of 15-30 percent) should be tolerated or considered negative for the economy. People who favor tolerating moderate inflation usually point out the following: Why aim at low single-digit inflation and bear significant disinflation loss (in the form of lost output and increased unemployment) if we can attain, and sustain, growth with moderate inflation? So, the main point of this argument is, if a country has adjusted to moderate inflation through indexation without apparent losses in output growth, why worry about it? As the excellent paper by Burton and Fisher (Chapter 1 in this volume) has revealed, there are country experiences that confirm the possibility of moderate inflation and economic growth.

People in favor of tolerating moderate inflation also stress the argument that inflation increases seigniorage. But the Burton-Fisher paper argues that increasing seigniorage through inflation should not be overemphasized, especially in the longer run. I utterly agree with them. The next argument in favor of moderate inflation is that ending it may impose high disinflation costs on the economy. In other words, the “sacrifice ratio” (ratio of the loss of output to disinflation) is such that it does not justify the benefits of lowering inflation. Therefore, the argument goes, it is better to live with moderate inflation than to suffer an output loss caused by disinflation policies.

I admit that, owing to the complexity of economic processes, calculating the sacrifice ratio is not an easy task. However, I would argue that there is a flow in calculations of cost-benefit analysis of disinflation. The sacrifice ratio takes into account the short- or medium-term horizon. The point is that the costs of disinflation are permanent. On the one hand, credible, low-inflation policy aiming at price stability will increase the confidence of investors, both domestic and foreign, much more than will the temporary tightening of policies that impose costs on the economy. Long-term investment will be postponed in an inflationary environment. On the other hand, a stable, credible environment will minimize distortions. Thus, if foreign investors are convinced that policymakers intend to maintain a stable (low-inflation) framework in the future, their propensity to invest will increase. Besides, investments in transition economies in Central and Eastern Europe are, to a certain extent, a zero-sum game. For example, a large Asian company, if investing in Hungary, will not invest in the Czech Republic. The argument is that an orientation to low inflation, among other factors, will favor both domestic and foreign investments in a country. Therefore, I consider moderate inflation an unacceptable target in transition economies.

If moderate inflation is bad for the economy (and the country is faced with moderate inflation), two other questions may be asked. First, when is the best time to start getting rid of it, and second, what is the appropriate inflation target for central banks in transition economies? Political cycles aside, I would argue that the sooner one tackles inflation, the better. There is no point in waiting and weighing the pros and cons indefinitely. If moderate inflation is a bad thing, the sooner one starts disinflation, the better. One could paraphrase the famous slogan and say, “just do it.”

If even moderate inflation is bad, as I have tried to prove, then a legitimate question might be, what is the appropriate target for central banks in transition economies to aim for? I favor a clear standard, a publicly announced objective of price stability, as the only acceptable long-term objective for all countries, including transition economies. Therefore, theoretically, the target should be price stability, that is, zero inflation. (I will leave aside a very interesting dilemma between an inflation goal and a price level goal.) However, the “operational” target for the central bank might be different.

Let us start with the issue of the accuracy of price measurement. After the famous Boskin report, the biases in price measurement are much better understood. Although to my knowledge there are no similar reports dealing with transition economies, it is obvious that the biases identified in that report are larger in transition economies than in developed, market economies (or advanced economies, as they are labeled today). Let me briefly illustrate this point. The number of new products in transition economies has increased dramatically, much faster than is usual for new products in the advanced economies. Therefore, the measurement bias is most probably larger than the one estimated for the U.S. economy. The same logic applies to the increase in the quality of existing products. The substitution of a Trabant with a Volkswagen Polo suffices as an example. Most of those changes will taper off as the process of transition advances, but one would expect them to be of greater importance in transition economies.

All those phenomena (especially the increasing quality of products) are probably even more visible in the service sector. It is well known that service industries were underdeveloped in the former socialist countries and that the prices of goods were often distorted in that they were artificially low. We must point out the importance of the Balassa-Samuelson and Baumol-Bowen effects in transition economies (without elaborating on them now).

To make a long story short, I would assume that an inflation target of up to 4-5 percent actually means price stability in transition economies. If relative prices are not too distorted, especially service prices and infrastructural prices, an annual inflation objective of up to 5 percent should not be considered excessive. When defining a specific target, one should bear in mind that, depending on the initial conditions and country-specific factors, this goal might be adjusted slightly (preferably downward).

Besides, a long-term target does not mean that short-term changes—for example, external or internal negative supply shocks and cyclical changes—are excluded. Economic history abounds with cases where adjustments in relative prices were necessary (for example, oil price shock, war). But, onetime price adjustments should not be confused with periods of moderate inflation. In transition economies, the factors that justify a higher inflation target than in advanced economies will disappear in time. In due course, transition economies should adopt a “normal” 0-2 percent target.

One question concerning disinflation policies in transition economies is, what is the role of a central bank—that is, of monetary policy? Central banks are usually regarded as guardians of stability. Common wisdom would have it that central banks should be independent of short-term political influence, have a clear mandate to achieve and maintain price stability (or an explicit inflation target), publicly announce their goals, and be accountable for their actions. Taking this into consideration, it is obvious that central banks have a very important role in both disinflation policies and in keeping prices stable.

What type of monetary policy is appropriate for disinflation and for keeping prices stable? For a small open economy, it is basically a choice between the pegged and flexible exchange rate system, including all variations between those two extremes. From what we have heard in the seminar, pegging the rate when tackling inflation might be an appropriate response, while later on more flexibility seems to be warranted. However, the important point that I wish to make is that no exchange rate regime can substitute for overall sound macroeconomic policies. If we analyze the experience of transition economies, we will see that they achieved disinflation by relying on different exchange rate regimes. But, without support from other macroeconomic policies, and without political support for such policies, the results were usually not sustainable. It is clear that monetary policy alone cannot do much, as noted long ago. Without a sound foundation, monetary policy can achieve only short-term results.

And it is not only sound macroeconomic policies, with fiscal stance first and foremost, but also structural measures that are necessary for long-term sustained growth. The usual recipes include opening up the economy, decreasing the fiscal bite, curbing monopoly powers, and increasing competition. However, this discussion is beyond the scope of this note on moderate inflation.

To conclude my discussion, I have to address an additional question on inflation. After achieving relatively low inflation, a country sometimes gives stability low priority on its list of economic policy goals, or neglects it completely. This might be dangerous in the long run. Inflation must be dealt with before it appears, and not only after it is spotted. Once inflation has resurged, it is usually too late to avoid significant inflationary (and later disinflationary) costs to the economy.

Price stability is a very important policy objective. Without stability, there can be no efficient financial intermediation and high growth. So, my strong belief is that moderate inflation is not acceptable as a goal of economic policy. Besides, once achieved, stability should not be neglected. It is equally true that stability in itself is not sufficient to deliver increasing welfare—that is, growth and equity. If transition is to be successful (which means that it should end as soon as possible), there is an obvious need, first, to sustain sound macroeconomic policies and, second, to link macroeconomic policies with structural measures to achieve sustainable economic growth.

If what has been said is true, why then are high and moderate inflations still so prevalent in transition economies and in other economies as well? In my opinion, the reason falls utterly within the domain of political economy and is not a strictly economic cost-benefit analysis. Without clear political support, disinflation policies can hardly be effected. Any budgetary allocation of public resources (to alleviate disinflation costs in the short run by financing the social safety net) cannot be achieved without political approval from the parliament. Therefore, there might be a discrepancy between political and economic goals in the short run. Ultimately, good economic policy is good politics, and it is therefore important that the political economy of policymaking be well understood and that the goals and consequences of low inflation be made clear to politicians and the general public.

Besides, there are always groups within the decision-making body who benefit from inflation and who will always strongly resist stability. Vested interests in inflation do exist and must not be neglected (redistribution factor, which was mentioned earlier). Even if the government is fully committed to the goal of achieving low inflation, disinflations are often postponed. Governments seldom act quickly and decisively. It does happen that, once political decisions are taken, their full implementation is postponed for various reasons: lobbying from interested parties to overturn the decision, forthcoming political elections and fear of disinflation costs (rising unemployment), simple corruption, obstruction from bureaucracy, lack of qualified staff to implement reforms, and so on. Two problems may arise: (1) Delay—when the government observes the need to get rid of inflation, but does not immediately take any measures (because of a lack of human capital and/or a lack of broad political support). Implementation is equally important, as is taking the optimal decision. (2) Dilution—when measures undertaken to disinflate are not radical enough, and the disinflation exercise must be repeated over and over again.

One big lesson that can be learned from the experience of transition economies is that transition is not a short-lived, one-shot effort, but a long-standing battle, a marathon for which one must be well prepared, both psychologically and physically. Given that transition has no alternatives (at least no reasonable ones), it is better to be ready for it. Although significant results have been achieved, formidable obstacles still lie ahead. It is equally true that economic reforms will be rewarded in the future with the increased well-being of the population at large in the increasingly global world economy.

Within the framework of fostering economic growth, it seems legitimate to ask if central banks can foster growth. Most economists would probably answer “No,” because the role of central banks in the economy today is clearly defined. And, besides, by fostering growth, central bank policymakers would simply be promoting a significant relaxation of monetary policy stance, which ultimately leads to higher inflation. Central banks can deliver higher economic growth and prosperity by ensuring the necessary long-term stability of the currency and of the financial system, which is essential for higher savings and investment and for efficient allocation of those investments, both necessary ingredients for a sustained growth path.

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