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Greater Macroeconomic Stability Has Not Made The World Economy More Stable

Inflation may have been tamed, but the world economy has become considerably shakier.

What they tell you Until the 1970s, inflation was the economy’s public enemy number one. Many countries suffered from disastrous hyperinflation experiences. Even when it did not reach a hyperinflationary magnitude, the economic instability that comes from high and fluctuating inflation discouraged investment and thus growth. Fortunately, the dragon of inflation has been slain since the 1990s, thanks to much tougher attitudes towards government budget deficits and the increasing introduction of politically independent central banks that are free to focus single-mindedly on inflation control. Given that economic stability is necessary for long-term investment and thus growth, the taming of the beast called inflation has laid the basis for greater long-term prosperity.

What they don’t tell you Inflation may have been tamed, but the world economy has become considerably shakier. The enthusiastic proclamations of our success in controlling price volatility during the last three decades have ignored the extraordinary instability shown by economies around the world during that time. There have been a huge number of financial crises, including the 2008 global financial crisis, destroying the lives of many through personal indebtedness, bankruptcy and unemployment. An excessive focus on inflation has distracted our attention away from issues of full employment and economic growth. Employment has been made more unstable in the name of ‘labour market flexibility’, destabilizing many people’s lives. Despite the assertion that price stability is the precondition of growth, the policies that were intended to bring lower inflation have produced only anaemic growth since the 1990s, when inflation is supposed to have finally been tamed.

That’s where the money is – or is it? In January 1923, French and Belgian troops occupied the Ruhr region of Germany, known for its coal and steel. This was because, during 1922, the Germans seriously fell behind the reparation payments demanded of them by the Versailles Treaty, which had concluded the First World War.

Had they wanted money, however, the French and the Belgians should have occupied the banks – after all, ‘that’s where the money is’, as the famous American bank robber Willie Sutton allegedly said, when asked why he robbed banks – rather than a bunch of coal mines and steel mills. Why didn’t they do that? It was because they were worried about German inflation.

Since the summer of 1922, inflation in Germany had been getting out of control. The cost of living index rose by sixteen times in six months in the second half of 1922. Of course, the hyperinflation was at least in part caused by the onerous reparation demands by the French and the Belgians, but once it started, it was entirely rational for the French and the Belgians to occupy the Ruhr in order to make sure that they were paid their war reparations in goods, such as coal and steel, rather than in worthless paper, whose value would diminish rapidly.

They were right to do so. German inflation got completely out of control after the occupation of the Ruhr, with prices rising by another 10 billion times (yes, billion, not thousand or even million) until November 1923, when Rentenmark, the new currency, was introduced.

The German hyperinflation has left big and long-lasting marks on the evolution of German, and world, history. Some claim, with justification, that the experience of hyperinflation laid the grounds for the rise of the Nazis by discrediting the liberal institutions of the Weimar Republic. Those who take this view are then implicitly saying that the 1920s German hyperinflation was one of the main causes of the Second World War. The German trauma from the hyperinflation was such that the Bundesbank, the West German central bank after the Second World War, was famous for its excessive aversion to loose monetary policy. Even after the birth of the European single currency, the euro, and the consequent de facto abolition of national central banks in the Eurozone countries, Germany’s influence has made the European Central Bank (ECB) stick to tight monetary policy even in the face of persistently high unemployment, until the 2008 world financial crisis forced it to join other central banks around the world in an unprecedented relaxation of monetary policy.

Thus, when talking about the consequences of the German hyperinflation, we are talking about a shockwave lasting nearly a century after the event and affecting not just German, but other European, and world, histories.

How bad is inflation? Germany is not the only country that has experienced hyperinflation. In the financial press Argentina has become a byword for hyperinflation in modern times, but the highest rate of inflation it experienced was only around 20,000 per cent. Worse than the German one was the Hungarian inflation right after the Second World War and that in Zimbabwe in 2008 in the last days of President Robert Mugabe’s dictatorship (now he shares power with the former opposition).

Hyperinflation undermines the very basis of capitalism, by turning market prices into meaningless noises. At the height of the Hungarian inflation in 1946, prices doubled every fifteen hours, while prices doubled every four days in the worst days of the German hyperinflation of 1923. Price signals should not be absolute guides, as I argue throughout this book, but it is impossible to have a decent economy when prices rise at such rates. Moreover, hyperinflation is often the result or the cause of political disasters, such as Adolf Hitler or Robert Mugabe. It is totally understandable why people desperately want to avoid hyperinflation.

However, not all inflation is hyperinflation. Of course, there are people who fear that any inflation, if left alone, would escalate into a hyperinflation. For example, in the early 2000s, Mr Masaru Hayami, the governor of the central bank of Japan, famously refused to ease money supply on the ground that he was worried about the possibility of a hyperinflation – despite the fact that his country was at the time actually in the middle of a deflation (falling prices).

But there is actually no evidence that this is inevitable – or even likely. No one would argue that hyperinflation is desirable, or even acceptable, but it is highly questionable whether all inflation is a bad thing, whatever the rate is.

Since the 1980s, free-market economists have managed to convince the rest of the world that economic stability, which they define as very low (ideally zero) inflation, should be attained at all costs, since inflation is bad for the economy. The target inflation rate they recommended has been something like 1–3 per cent, as suggested by Stanley Fischer, a former economics professor at MIT and the chief economist of the IMF between 1994 and 2001.1 However, there is actually no evidence that, at low levels, inflation is bad for the economy. For example, even studies done by some free-market economists associated with institutions such as the University of Chicago or the IMF suggest that, below 8–10 per cent, inflation has no relationship with a country’s economic growth rate.2 Some other studies would even put the threshold higher – 20 per cent or even 40 per cent.3 country’s economic growth rate. Some other studies would even put the threshold higher – 20 per cent or even 40 per cent.

The experiences of individual countries also suggest that fairly high inflation is compatible with rapid economic growth. During the 1960s and 70s, Brazil had an average inflation rate of 42 per cent but was one of the fastest-growing economies in the world, with its per capita income growing at 4.5 per cent a year. During the same period, per capita income in South Korea was growing at 7 per cent per year, despite having an annual average rate of inflation of nearly 20 per cent, which was actually higher than that found in many Latin American countries at the time.4 Moreover, there is evidence that excessive anti-inflationary policies can actually be harmful for the economy. Since 1996, when Brazil – having gone through a traumatic phase of rapid inflation, although not quite of hyperinflationary magnitude – started to control inflation by raising real interest rates (nominal interest rates minus the rate of inflation) to some of the highest levels in the world (10–12 per cent per year), its inflation fell to 7.1 per cent per year but its economic growth also suffered, with a per capita income growth rate of only 1.3 per cent per year. South Africa has also had a similar experience since 1994, when it started giving inflation control top priority and jacked up interest rates to the Brazilian levels mentioned above.

Why is this? It is because the policies that are aimed to reduce inflation actually reduce investment and thus economic growth, if taken too far. Freemarket economists often try to justify their highly hawkish attitude towards inflation by arguing that economic stability encourages savings and investment, which in turn encourage economic growth. So, in trying to argue that macroeconomic stability, defined in terms of low inflation, was a key factor in the rapid growth of the East Asian economies (a proposition that does not actually apply to South Korea, as seen above), the World Bank argues in its 1993 report: ‘Macroeconomic stability encourages long-term planning and private investment and, through its impact on real interest rates and the real value of financial assets, helped to increase financial savings.’ However, the truth of the matter is that policies that are needed to bring down inflation to a very low – low single-digit – level discourage investment.

Real interest rates of 8, 10 or 12 per cent mean that potential investors would not find non-financial investments attractive, as few such investments bring profit rates higher than 7 per cent.5 In this case, the only profitable investment is in high-risk, high-return financial assets. Even though financial investments can drive growth for a while, such growth cannot be sustained, as those investments have to be ultimately backed up by viable long-term investments in real sector activities, as so vividly shown by the 2008 financial crisis (see Thing 22).

So, free-market economists have deliberately taken advantage of people’s justified fears of hyperinflation in order to push for excessive anti-inflationary policies, which do more harm than good. This is bad enough, but it is worse than that. Anti-inflationary policies have not only harmed investment and growth but they have failed to achieve their supposed aim – that is, enhancing economic stability.

False stability Since the 1980s, but especially since the 1990s, inflation control has been at the top of policy agendas in many countries. Countries were urged to check government spending, so that budget deficits would not fuel inflation. They were also encouraged to give political independence to the central bank, so that it could raise interest rates to high levels, if necessary against popular protests, which politicians would not be able to resist.

The struggle took time, but the beast called inflation has been tamed in the majority of countries in recent years. According to the IMF data, between 1990 and 2008, average inflation rate fell in 97 out of 162 countries, compared to the rates in the 1970s and 80s. The fight against inflation was particularly successful in the rich countries: inflation fell in all of them. Average inflation for the OECD countries (most of which are rich, although not all rich countries belong to the OECD) fell from 7.9 per cent to 2.6 per cent between the two periods (70s–80s vs. 90s–00s). The world, especially if you live in a rich country, has become more stable – or has it? The fact is that the world has become more stable only if we regard low inflation as the sole indicator of economic stability, but it has not become more stable in the way most of us experience it.

One sense in which the world has become more unstable during the last three decades of free-market dominance and strong anti-inflationary policies is the increased frequency and extent of financial crises. According to a study by Kenneth Rogoff, a former chief economist of the IMF and now a professor at Harvard University, and Carmen Reinhart, a professor at the University of Maryland, virtually no country was in banking crisis between the end of the Second World War and the mid 1970s, when the world was much more unstable than today, when measured by inflation. Between the mid 1970s and the late 1980s, when inflation accelerated in many countries, the proportion of countries with banking crises rose to 5–10 per cent, weighted by their share of world income, seemingly confirming the inflation-centric view of the world. However, the proportion of countries with banking crises shot up to around 20 per cent in the mid 1990s, when we are supposed to have finally tamed the beast called inflation and attained the elusive goal of economic stability. The ratio then briefly fell to zero for a few years in the mid 2000s, but went up again to 35 per cent following the 2008 global financial crisis (and is likely to rise even further at the time of writing, that is, early 2010).6 Another sense in which the world has become more unstable during the last three decades is that job insecurity has increased for many people during this period. Job security has always been low in developing countries, but the share of insecure jobs in the so-called ‘informal sector’ – the collection of unregistered firms which do not pay taxes or observe laws, including those providing job security – has increased in many developing countries during the period, due to premature trade liberalization that destroyed a lot of secure ‘formal’ jobs in their industries. In the rich countries, job insecurity increased during the 1980s too, due to rising (compared to the 1950s–70s) unemployment, which was in large part a result of restrictive macroeconomic policies that put inflation control above everything else. Since the 1990s, unemployment has fallen, but job insecurity has still risen, compared to the pre-1980s period.

There are many reasons for this. First, the share of short-term jobs has risen in the majority of rich countries, although not hugely as some people think.

Second, while those who keep their job may stay in the same job almost (although not quite) as long as their pre-1980s counterparts used to, a higher proportion of employment terminations have become involuntary, at least in some countries (especially the US). Third, especially in the UK and the US, jobs that had been predominantly secure even until the 1980s – managerial, clerical and professional jobs – have become insecure since the 1990s.

Fourth, even if the job itself has remained secure, its nature and intensity have become subject to more frequent and bigger changes – very often for the worse. For example, according to a 1999 study for the Joseph Rowntree Foundation, the British social reform charity named after the famous Quaker philanthropist businessman, nearly two-thirds of British workers said they had experienced an increase in the speed or the intensity of work over the preceding five-year period. Last but not least, in many (although not all) rich countries, the welfare state has been cut back since the 1980s, so people feel more insecure, even if the objective probability of job loss is the same.

The point is that price stability is only one of the indicators of economic stability. In fact, for most people, it is not even the most important indicator. The most destabilizing events in most people’s lives are things like losing a job (or having it radically redefined) or having their houses repossessed in a financial crisis, and not rising prices, unless they are of a hyperinflationary magnitude (hand on heart, can you really tell the difference between a 4 per cent inflation and a 2 per cent one?). This is why taming inflation has not quite brought to most people the sense of stability that the anti-inflationary warriors had said it would.

Now, the coexistence of price stability (that is, low inflation) and the increase in non-price forms of economic instability, such as more frequent banking crises and greater job insecurity, is not a coincidence. All of them are the results of the same free-market policy package.

In the study cited above, Rogoff and Reinhart point out that the share of countries in banking crises is very closely related to the degree of international capital mobility. This increased international mobility is a key goal for free-market economists, who believe that a greater freedom of capital to move across borders would improve the efficiency of the use of capital (see Thing 22). Consequently, they have pushed for capital market opening across the world, although recently they have been softening their position in this regard in relation to developing countries.

Likewise, increased job insecurity is a direct consequence of free-market policies. The insecurity manifested in high unemployment in the rich countries in the 1980s was the result of stringent anti-inflationary macroeconomic policies. Between the 1990s and the outbreak of the 2008 crisis, even though unemployment fell, the chance of involuntary job termination increased, the share of short-term jobs rose, jobs were more frequently redefined and work intensified for many jobs – all as a result of changes in labour market regulations that were intended to increase labour market flexibility and thus economic efficiency.

The free-market policy package, often known as the neo-liberal policy package, emphasizes lower inflation, greater capital mobility and greater job insecurity (euphemistically called greater labour market flexibility), essentially because it is mainly geared towards the interests of the holders of financial assets. Inflation control is emphasized because many financial assets have nominally fixed rates of return, so inflation reduces their real returns. Greater capital mobility is promoted because the main source of the ability for the holders of financial assets to reap higher returns than the holders of other (physical and human) assets is their ability to move around their assets more quickly (see Thing 22). Greater labour market flexibility is demanded because, from the point of view of financial investors, making hiring and firing of the workers easier allows companies to be restructured more quickly, which means that they can be sold and bought more readily with better short-term balance sheets, bringing higher financial returns (see Thing 2).

Even if they have increased financial instability and job insecurity, policies aimed at increasing price stability may be partially justified, had they increased investment and thus growth, as the inflation hawks had predicted. However, the world economy has grown much more slowly during the post- 1980s low-inflation era, compared to the high-inflation period of the 1960s and 70s, not least because investment has fallen in most countries (see Thing 13). Even in the rich countries since the 1990s, where inflation has been completely tamed, per capita income growth fell from 3.2 per cent in the 1960s and 70s to 1.4 per cent during 1990–2009.

All in all, inflation, at low to moderate levels, is not as dangerous as free-market economists make it out to be. Attempts to bring inflation down to very low levels have reduced investment and growth, contrary to the claim that the greater economic stability that lower inflation brings will encourage investment and thus growth. More importantly, lower inflation has not even brought genuine economic stability to most of us. Liberalizations of capital and labour markets that form integral parts of the free-market policy package, of which inflation control is a key element, have increased financial instability and job insecurity, making the world more unstable for most of us. To add insult to injury, the alleged growth-enhancing impact of inflation control has not materialized.

Our obsession with inflation should end. Inflation has become the bogeyman that has been used to justify policies that have mainly benefited the holders of financial assets, at the cost of long-term stability, economic growth and human happiness.

Reference book: Things they don't tell you about capitalism

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