Opinion

Financial and economic equations moving to awkward positions


Published : 11 Oct 2022 08:37 PM

In the paradigm of economics, recession-inflation in the modern context is gaining careful scrutiny all over the world. 

Socio-economists tend to describe this dynamic as a situation where the rate of inflation is high or increasing, resulting not only in the slowing down of economic growth but also in unemployment remaining high. Iain Macleod, who was British Conservative Party Chancellor of the Exchequer in 1970, in his own way created a new word- stagflation – to describe such a situation. The Economist and the Newsweek gave it publicity and it slowly became a dominant word within the macroeconomic paradigm. Most economists agreed with him that stagflation is very costly and difficult to eradicate once it starts- both in social terms as well as in the context of budget deficits. 

Economic and financial historians recall even today about the United Kingdom experiencing an outbreak of inflation in the 1960s and 1970s. As inflation rose then, British policy makers failed to recognise the primary role of monetary policy in controlling inflation. Instead, they attempted to use non-monetary policies and devices to respond to the economic crisis. Policy makers also made "inaccurate estimates of the degree of excess demand in the economy that also contributed significantly to the outbreak of inflation in the United Kingdom in the 1960s and 1970s."

Since then, a wide range of diverse evidence has been compiled by economists supporting the second explanation against the supply shock view that the 1970s stagflation was due to OPEC’s quadrupling of oil prices in October 1973. Although the weakening economy was putting some downward pressure on inflation, overall inflation rose in accordance with the Expected Augmented Phillips Curve (EAPC). The stagflation became more severe in the early 1970s but had been suppressed by the price controls and wage freeze imposed by President Nixon starting in August 1971 and through 1972. Later the October 1973 OPEC oil price hike affected wage- price controls once again. 

Stagflation was not limited to the United Kingdom, however. Economists have shown that stagflation was prevalent among several major market economies from 1973 to 1982. After inflation rates began to fall in 1982, economists' again moved their focus from the causes of stagflation to the "determinants of productivity growth and the effects of real wages on the demand for labor". There is also some consensus that the government can cause stagflation if it creates policies that harm industry while growing the money supply too quickly.

Economists Anis Chowdhury and JK Sundaram have been following the evolving scenario very carefully since the beginning of March, 2022 after socio-economic instability crept into the scene because of Ukraine. In March, Reuters drew attention with their statement-  “With surging oil prices, concerns about the hawkishness of the Federal Reserve and fears of Russian aggression in Eastern Europe, the mood on Wall Street feels like a return to the 1970s”. The World Bank also warned that “surging energy and food prices had heightened the risk of a prolonged period of global stagflation reminiscent of the 1970s.”

We have in this context noticed that as costlier energy has pushed up production expenses, businesses have also raised prices and cut jobs. With higher food, fuel and other prices, rising costs, coupled with income losses, reduced aggregate demand is further slowing the economy. In this context one can recall Ben Bernanke, former US Fed Chair’s observation “an important part of the effect of oil price shocks on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy”.

Today, once again, measures are being taken through interest rate hikes- but this is reducing needed investments. Outside the US economy, these sharp and rapid interest rate hikes have led to debt crises in Poland, parts of Asia, Latin America and sub-Saharan Africa. Now countries seeking International Monetary Fund (IMF) financial support have to agree to severe fiscal austerity, liberalization, deregulation and privatization policy conditionalities. Some sociologists feel that strict enforcement of such factors has led to per capita income falling and poverty rising- particularly in Latin America and Africa.

On 24 March 2022, the Bank of Mexico raised interest rates for the seventh successive time. On the same day, Brazil’s central bank raised its interest rates to the highest level since 2017. On 4 May, the Reserve Bank of India also raised interest rates. It may be noted that this was the first change in two years and the first rate increase in nearly four years. On 5 May, Chile’s central bank also increased interest rates. Pressed by finance to curb inflation, more central bankers were seen showing interest in tightening monetary policy. Critics have observed that some of these measures to check inflation through higher interest rates were undertaken without sufficient reasoning.

But despite facing higher inflationary expectations, tightening international monetary conditions, and Ukraine uncertainties, the European Central Bank (ECB) and Bank of Japan have not joined the bandwagon- refusing to raise policy interest rates so far.

The chief economist of the IMF and the Bank of International Settlements has warned that inflation is a major concern. Such a view however needs to be seen against central bankers’ anti-inflationary efforts mainly being involved with raising interest rates. This approach however tends to slow economies, accelerate recessions and often trigger debt crises without quelling rising prices due to supply shocks. Anis Chowdhury and JK Sundaram have noted that economic recoveries from the 2008-09 global financial crises (GFC) remained tepid for a decade after initially bold fiscal responses were quickly abandoned. Meanwhile, the indirect influence of other unconventional monetary policies and the Covid-19 pandemic has raised debt to unprecedented levels. In addition, GFC trade protectionist responses, US and Japanese ‘reshoring’ of foreign investment in China, the pandemic, the Ukraine instability and sanctions against Russia and its allies have reversed earlier trade liberalization.

Higher interest rates in the rich North have also promoted capital flight, causing developing country currencies to depreciate, especially against the US Dollar. We have seen an example of this in Bangladesh. We are also seeing how in Bangladesh, as in many other developing countries, the slowing world economy is reducing demand for many of their exports. In Bangladesh the foreign orders for our garments products have been affected. The same is true in the context of migrant worker remittances.

The IMF also acknowledges that globalization, ‘off shoring’ and labour-saving technical change has weakened unionization and workers’ bargaining power. However, the wage-price spiral has also been replaced by a profit-price swirl with larger corporations’ market power increasing. Greater corporate discretion and reduced employees’ strength have thus increased profit shares, even during the pandemic. Corporations are taking advantage of the situation, passing on costs to customers. The net profits of the top 100 US corporations have tended to have increased by a median of 49 per cent. This is happening while more consumers are struggling to meet their basic needs. Interest rate hikes have also hurt wage-earners, as reduction in national income has been exacerbated by real wage stagnation, even contraction.

It is this scenario which prompts one to suggest that there needs to be greater effort towards protecting the vulnerable. This might accelerate the transition to a more sustainable consumption and production, including transition to cleaner renewable energy.

Some economists, with regard to the steps being undertaken have drawn attention to certain important factors which should not be overlooked.

They feel that raising interest rates only addresses the symptoms – not the causes – of inflation. Inflation they think can be a consequence of an economy ‘overheating’ and this can be due to many factors. Higher interest rates may relieve overheating, by slowing economic activity. However, it is also accepted by many strategic economists that the current inflationary surge is due to supply chain disruptions – exacerbated by war and sanctions – especially of essential goods such as food and fuel.

In this regard, they think that long-term solutions require increasing supplies, including the removal of bottlenecks. They have observed that higher interest rates could also reduce aggregate demand. Costs of living also rise if businesses pass higher interest costs on to consumers by raising prices. Consequently, simply raising interest rates would not properly address the specific causes of inflation- let alone rising prices due to supply disruptions of essential goods, such as food 

and fuel.

It has also been observed that the interest rate affects almost all sectors. It does not differentiate between sectors or industries needing to expand or be encouraged, and those that should be phased out, for being less productive or inefficient. Instead, raising interest rates too often, might seriously cast a long shadow not only on less productive and inefficient business institutions but also on productive and efficient businesses.

There is also another significant aspect. Interest rates do not distinguish between households and businesses. Higher interest rates may discourage household expenditure, but it might also reduce all kinds of spending – for both consumption and investment. This could lead to overall demand shrinking – discouraging investment in new technology, plant, equipment and skills. Consequently, higher interest rates might unfavorably affect long-term productive capacities and technological progress of economies.

We need to remember that our financial efforts to have a stable path forward must not also forget another dimension. Higher interest rates raise debt-servicing expenses, especially mortgage payments for indebted households.

Muhammad Zamir, a former Ambassador, is an analyst specialized in foreign affairs, right to information and good governance