Economic Logic and Falling Inflation: Why the Recent Trend Makes Sense?

In the article I wrote earlier, I made an attempt to track the trends in inflation figures choosing 2008 as my starting year. Using data from the State Bank inflation reports, I finally concluded that ‘most of the fluctuations in various inflation indexes can be traced back either to the global trends in commodity prices or domestic shocks such as due to floods, energy shortages or elimination of subsides.’ Furthermore, I also pointed to the increase in the minimum support price of major agricultural commodities (eg. wheat) which consequently increased the prices of other crops as well.

The above analysis had direct policy implications. Firstly, any policy which aggressively attempts to control spurts in inflation – when exogenous shocks are the primary reason – will be counterproductive. Therefore, monetary policy must take a cautionary approach. Secondly, inflation will gradually decline as different shocks finally dissipate in the economy. Both the implications were based on the observation that excess demand is unlikely to be the driving force underlying inflation trends. This observation flows from the fact that growth rates of the past few years have been below the potential. In technical terms used in macroeconomic models, ‘output gap’ have been negative.

There is indeed evidence that the economy has not experienced any major price shock in the previous months thus allowing the inflation to converge to the level consistent with the prevailing output gap. In addition, recent cut in the prices of CNG by Rs. 30 has increased the pace of this downward convergence. However, there are two strong arguments which question the declining trends: one is excessive government borrowing from the banking system which makes decline in overall inflation to look paradoxical; and, the other is how much time (time lag) it may take for the shocks to dissipate in the economy. Both the arguments are interlinked as is everything in economics and they equally strengthen the notion that government must have manipulated the numbers to suit their political needs. However, to me the recent inflation trend appears to follow a pattern which is dictated by economic logic rather than political motives.

Most economic models are tuned to considering the shock processes as exogenous. Endogenous shocks have only recently begun to penetrate in the mainstream models. Therefore, I must accept that I do not have a sound research study to support the following analysis but this in itself is not a valid reason to stop me from doing so. Although most of the shocks are considered to be exogenous but some of them could very well be endogenous at least in some special circumstances.

The first argument of increase in the government borrowing has two parts in it. Government may borrow from the commercial banks or from the State Bank. It is only the latter which significantly contributes towards inflation by resulting in an increase in the money supply as a direct consequence of State Bank printing money. This increase in the money supply is a shock and is mostly treated as exogenous in macroeconomic models. However for Pakistan, in the special case of last few years, money supply shock was endogenous to other exogenous shock processes such as floods, military operation, IDPs, global energy prices which resulted in rising fiscal needs. It will, therefore, be illogical to analyze its effects independent of the exogenous shock processes thus overestimating the consequences and justifying an aggressive monetary policy stance.

The second argument of the ‘time lag’ is less generic and varies from region to region. The time lag itself depends on the degree of inflation persistence and also the dynamics (autocorrelation) of it. Inflation persistence determines the time it takes for any price shock to dissipate. Knowing inflation persistence is vital for conducting monetary policy optimally as it guides the monetary authority (State Bank) on how to adjust the policy instruments in response to shocks (or deviation from the steady state) so as to achieve the desired targets. Lack of inflation persistence implies that the impact of monetary policy response to price shocks will be immediate rather than delayed and gradual.

Recent study by the State Bank showed that aggregate inflation persistence in Pakistan has only been 0.19 for the period of 1959-2011 which has become statistically insignificant for the most recent period of 2001-2011. This means that the impact of the previous shocks has already been felt at the aggregate level and thus the recent fall in the aggregate inflation level to 7.66% is justified. On the other hand, inflation persistence in the core inflation is significant at 0.69 which is why core inflation, which stands at 10.8%, has still not come down significantly and will take more time given no bad news hits the economy in the coming months.

Gold, Fiat Money and the Monetary Management

Having read most of the articles which followed the debate in the US on going back to the Gold standard, I was put off by simplistic arguments being made by both the sides. The primary arguments revolve around the role of Gold in controlling inflation on one hand and how it limits governments’ ability in managing business cycles on the other.  In this article I attempt to discuss both the sides in as much brevity as possible without choosing one over the other.

Both the primary arguments are strong enough to support either side’s point of view. Let me start with the role of Gold in controlling inflation. Stability in the purchasing power of a unit of currency – which is a store of value – plays a critical role in the efficient working of a market economy. This stability is threatened by the change in the price level (i.e. Inflation) within the economy. Inflation has been established as a monetary phenomenon such that any change in the units of currency in circulation (money supply) results in the change in the purchasing power of a single unit in the opposite direction. It is the inability of the government to change money supply in an economy with Gold as a unit of currency which is argued as a factor contributing towards the desired stability. David Ricardo makes a similar point by saying, "Experience shows that neither a State nor a Bank ever have had the unrestricted power of issuing paper money, without abusing that power.”

The argument that changing price levels is not only a characteristic of Fiat era is incomplete. Inflation episodes during past centuries, when Gold standard was in place, can be traced back to three main reasons: increase in the production of Gold (eg. 1848-1873); periods of government printing notes to fund war expenses etc. (eg. 1782-1814); and, decrease in the reserve ratios or other factor leading to increase in banking credit (eg. 1914-1920). The last two factors have explicit involvement of the government. The first factor, although important, plays a role in a way which does not lead to abrupt changes in the prices due to physical limitations eg. production capacity. Instead the change in price level is rather gradual. Data for the 19^th century also shows that on average, annual increase in gold production have been roughly equal to the annual increase in demand (around 3%) necessary to keep the prices stable.

I now step on the other side of the fence. The most important reason to me for not supporting ‘return to gold’ is the ability of the government to manage business cycles. Although money is neutral in the long run, nominal rigidities in the form of price, wage and information stickiness do allow significant room to central banks such that they can alter the money supply to stabilize the economy in response to shocks. Now one may argue that the volatility of business cycles is actually a causal effect of such government interventions to start with eg. boom (created lets say through cheap credit) must be followed by a bust. This latter argument does hold some ground but still this does not strip the central bank of all its ability to effectively stabilize the economy. So in a perfect world where government is benevolent, ability to alter money supply can decrease the volatility and stabilize the economy.

One may ask, and rightly so, that is the government really benevolent? Not really. There is always a chance that short term objectives will result in policies which will lead to inflation. However, it can be argued that the misadventures during the past centuries were undertaken in the absence of a proper economic theory such that the consequences could not be fully perceived. Similarly, during the 1950s and 60s, policy decisions were led by incomplete economic theory of a permanent trade-off between inflation and output. There is significant support for the argument that the monetary policy of the 80s and onwards (in addition to other factors like improved inventory management) in the US, with greater focus on the stabilization, was indeed successful in reducing the volatility of business cycles while the institutional framework (independence on central banks) allowed limited room for any monetary misadventures.

There may actually be a solution to the respective problems in both the regimes. Under Gold standard, monetary authority can regulate the banking credit to effectively alter the money supply to achieve the desired objectives. While under the Fiat system, it can adopt the price level targeting rule that can help in stabilizing the value of currency.

Ultimately it boils down to an empirical question. Are the benefits from the ability to stabilize greater than the costs associated with possible monetary misadventures? I do not know, as yet!

In honor of the Beloved

when the raising of eyes becomes a sin, and the lowering of eyes rips the heart;

when the mind fails to perceive the Beloved, and the words fail to move the tongue; 
i feel my existence in all this pain, i feel my soul in this human cage!

p.s. In what context I wrote this is somewhat personal. The only thing i can share is that it is for the Prophet (peace and blessing be upon him). You are most welcome to put it in your context!

source of the picture: http://www.360d.com/beloved/beloved/beloved.html

A Prayer

O Allah! Perish me in my attributes and resurrect me, O Resurrector, in the attributes of Your Beloved(صلى الله عليه و سلم)

O Taker of Life! Take the life of my heart and give it life, O Giver of Life, in the love of Muhammad(صلى الله عليه و سلم) and his(صلى الله عليه و سلم) Family.

O Protecting Friend! Protect this slave from his path and guide him, O Guide, in the path of the elect(صلى الله عليه و سلم) who is well-guided(صلى الله عليه و سلم).

O Forgiver! Forgive this evil soul of all its acts and open on it, O Opener, the light(صلى الله عليه و سلم) of the perfect(صلى الله عليه و سلم) lamp(صلى الله عليه و سلم).

O Knower of All! You Know that I am weak so nourish me, O Nourisher, from the knowledge of the well-informed(صلى الله عليه و سلم).

O Possessor of All Strengths! I am the least steadfast so bestow on me the honor, O Bestower of Honors, to spend my life in honoring the most honored(صلى الله عليه و سلم).

O Owner of All! Subdue this treacherous self with Your Majesty and shape it, O Shaper of Beauty, with Your Names so it could reach the Evident(صلى الله عليه و سلم) Truth(صلى الله عليه و سلم).

O All-Merciful! O All-Beneficent! O Absolute Ruler! O Pure One!

Bring my state in order, O Maker of Order!

O Responder to Prayer! O Hearer of All! O Righteous Teacher! O Perfectly Wise!

source of the picture: http://nj-behindtheveil.blogspot.co.uk/2011/09/in-name-of-allah.html

Fight against corruption

EVERY year up to $1.8 trillion in illicit funds derived from corruption, tax evasion and organised crime circle the globe, according to a Transparency International report 2010. The figure is much larger than the funds allocated for the Millennium Development Goals.

In another study by Ernst & Young, half of those surveyed estimated that corruption raised project cost by at least 10 per cent.

Apart from the direct monetary losses due to misappropriation of scarce resources, corruption not only distorts markets and creates unfair competition but also weakens institutions by nurturing and sustaining the corrupt government officials and politicians through bribery.

In a similar Ernst & Young survey, almost a fifth of more than 1000 executives claimed to have lost business due to a competitor paying bribes.

However, corruption, which takes advantage of shortcomings in transparency, internal governance and lack of oversight, is not limited to government-led businesses and institutions. Corruption within private enterprises is increasingly becoming an important subject in policy circles, especially after the 2008 recession. It constitutes: executives giving generous payouts to themselves; majority shareholders trying to influence corporate strategy at the cost of long-term profitability; and, staff abusing power entrusted to them for personal gains.

Corruption decreases FDI while FDI decreases corruption: Past studies have spent significant energies in understanding effect of corruption on FDI and mechanism with which such an effect materialises. However, only few have made an attempt to explore the possible effect of FDI on corruption and have found the relationship to be negative and statistically significant. The two main studies in this regard are Pinto and Zhu (2011) and Larrain and Tavares (2004). Larrain and Tavares (2004) use FDI inflows as a measure of openness to access the effect of openness to FDI on corruption after accounting for trade intensity. They find the relation to be significant and negative.

Mechanism of this effect: Due to limited research, the mechanism of how FDI may lower corruption also remains less understood. One way to understand this is to look at the restrictions placed on FDI inflows. With the help of a theoretical model, Krueger (1974) shows how trade restrictions are used ‘as originators of rent’. She emphasises on the role of competition for import licences as an inducement to corruption.

Moreover Ades and DiTella (1999) emphasise high level of corruption in countries where local firms have limited exposure to foreign competition. Deriving inference from trade openness, one may argue that foregoing protectionist policies towards FDI inflows will lower the avenues of corruption exploited by the agents for their individual gains.

Second, FDI itself brings positive spill-over effects through improvement in technology, better management practices and transparency in corporate governance. The increasing role being played by the multinationals in the transfer of technology has been talked about for a long time now.

Findlay (1978) was one of the first few to show this in his ‘explicit analytical model of technological diffusion’. Findlay highlighted the role of major corporations with higher level of efficiency in enabling the less developed countries to better adopt the new technologies. This higher level of efficiency of major corporations further results in the transferring of advanced management skills to domestic firms. In a case study on Russia, Braguinsky and Mityakov (2012) show that domestic firms which interact with foreign corporations in Moscow are twice as transparent as other domestic firms.

Word of Caution: Pinto and Zhu (2011) also discuss the negative consequences of FDI if domestic characteristics are not fully understood. They find FDI to be associated with high levels of corruption in less developed economies and in autocracies. This is mainly due to non-competitive markets, high custom duties (lowering the degree of openness) etc in the less developed economies.

TI report has argued that in the absence of competitive markets, FDI may very well lead to increase in corruption as foreign firms bribe the officials to gain unfair foothold in the host economy. On the bright side, this gives less developed countries a promising starting point: strengthen their competition commissions, gradually lower the custom duties, and move away from protectionist policies.

Policy Implications: As it is not in the benefit for those in power to increase transparency and accountability, increasing demand to fight corruption has often led to a stand-off between governments and people. Under such conditions, FDI as an additional tool can play an important role in a gradual advancement of a country away from corruption. By this I do not mean to say that fighting corruption should be replaced with encouraging FDI rather this mechanism must be used to augment the fight against corruption.

First Published in Dawn (3rd September 2012)

http://dawn.com/2012/09/03/fight-against-corruption/