Mythologising inflation

A few economists continue to hold that inflation was caused by the surge in the global price of oil and commodities.

A few Pakistani economists continue to hold that inflation in the country, which peaked at a 26 per cent per annum a couple of years ago, was caused by the surge in the global price of oil and commodities. It is important to know the facts for if we misdiagnose the causes of recent inflation we will not know how to tame it. A bright economist working at Lums, Dr Ali Cheema, showed in his article “Stabilisation Policy: Less Mythologizing, More Reality”, that as far back as 2004, inflation was already on an increasing trend well before the global price hike.This rising inflation was a reflection of increasingly pro-cyclical fiscal deficits and an expansionary monetary policy. Dr Cheema also showed that the external current account deficit had reached unsustainable levels well before the global price shock. Bad policies, not bad luck, were the principal determinants of accelerating inflation.

Overheating pressures were first talked about as early as 2005, when inflation had crossed into double-digits and was accelerating. An excellent paper, “An Overheating Economy?” in the 2005 Annual Review of Social Policy and Development Center, cautioned policy-makers that the economy was showing signs of stress that they would be “ill-advised to ignore”. Unencumbered by the humourless IMF, the budget for 2005-06 had become dangerously pro-cyclical, adding to demand pressures when it should have been acting counter-cyclically to dampen them. When adjusted for the phase of the business-cycle, the calculated “fiscal impulse” showed that the fiscal position was hugely expansionary. The growth rate of real imports, led by consumer goods imports, was 44 per cent versus a growth of only 8 per cent in real exports. The difference between the two had shaved off almost five percentage points from growth. The bizarre consumption-driven growth strategy being followed at the time showed real private consumption rising by 17 per cent in fiscal year 2005, double the rate of the previous year. Private investment rose by only 4.8 per cent. The much-hyped high level of foreign exchange reserves were actually falling when measured in terms of the “cover” these reserves provide relative to the value of imports.

The State Bank had moved into a tightening phase, but it was a case of too little too late given the inertia built into the forward momentum of the economy. With General Musharraf busy saving his “second-skin”, it was clear that economic issues had taken a back seat. Against this background of a rapidly unravelling economy, the global oil and commodities price shock only served to exacerbate inflation. It did not cause it.

The new government appeared stupefied and let matters drift. They dithered while pontificating on Plans A, B and C, looking around for someone who would give them unconditional money or ‘financing without adjustment’. The rest, as they say, is history. Inflation soared and the exchange rate collapsed amid a loss of confidence and massive capital flight.

Inflation did come down to close to single digits briefly because of “base-effects” but also because of adjustment taking hold. The federal budget for fiscal year 2011 offered the hope of another year of stabilisation until the provinces came out with their tax-free deficit budgets in a mad race to spend the money they got from the much-touted NFC award in another example of the perils of ‘financing without adjustment’. They upset the entire macroeconomic framework and rendered all its targets irrelevant. Now Pakistan has to cope with the aftermath of epic floods and inflation has made a vigorous comeback. But inflation is still not all about the price of onions and potatoes. It is the coherence and credibility of macroeconomic and structural polices that matter. Getting that right is the only way we can defeat this most cruel tax.

Published in The Express Tribune, October 14^th, 2010.