When saviours are the problem

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR: Central bank policies have often worsened economic crises instead of resolving them. By raising interest rates in response to inflation, they often exacerbate, rather than mitigate business cycles and inflation.

Neither gods nor maestros

US Federal Reserve Bank chair Jerome Powell has admitted: “Whether we can execute a soft landing or not, it may actually depend on factors that we don’t control.” He conceded, “What we can control is demand, we can’t really affect supply with our policies. And supply is a big part of the story here”.

Hence, decisionmakers must consider more appropriate policy tools. Rejecting ‘one size fits all’ formulas, including simply raising interest rates, anti-inflationary measures should be designed as appropriate. Instead of squelching demand by raising interest rates, supply could be enhanced.

Thus, Milton Friedman – whom many central bankers still worship – blamed the 1930s’ Great Depression on the US Fed. Instead of providing liquidity support to businesses struggling with short-term cash-flow problems, it squeezed credit, crushing economic activity.

Similarly, before becoming Fed chair, Ben Bernanke’s research team concluded, “an important part of the effect of oil price shocks [in the 1970s] on the economy results not from the change in oil prices, per se, but from the resulting tightening of monetary policy”.

Adverse impacts of the 1970s’ oil price shocks were worsened by the reactions of monetary policymakers, which caused stagflation. That is, US Fed and other central bank interventions caused economic stagnation without mitigating inflation.

Likewise, the longest US recession after the Great Depression, during the 1980s, was due to interest rate hikes by Fed chair Paul Volcker. A recent New York Times op-ed warned, “The Powell pivot to tighter money in 2021 is the equivalent of Mr. Volcker’s 1981 move” and “the 2020s economy could resemble the 1980s”.

Monetary policy for supply shocks?

Food prices surged in 2011 due to weather-related events ruining harvests in major food producing nations, such as Australia and Russia. Meanwhile, fuel prices soared with political turmoil in the Middle East.

However, Boston Fed head Eric Rosengren argued, “tightening monetary policy solely in response to contractionary supply shocks would likely make the impact of the shocks worse for households and businesses”.

Referring to Boston Fed research, he noted commodity price changes did not affect the long-run inflation rate. Other research has also concluded that commodity price shocks are less likely to be inflationary.

This reduced inflationary impact has been attributed to ‘structural changes’ such as workers’ diminished bargaining power due to labour market deregulation, technological innovation and globalization.

Hence, central banks are no longer expected to respond strongly to food and fuel price increases. Policymakers should not respond aggressively to supply shocks – often symptomatic of broader macroeconomic developments.

Instead, central banks should identify the deeper causes of food and fuel price rises, only responding appropriately to them. Wrong policy responses can compound, rather than mitigate problems.

Appropriate innovations

A former Philippines central bank Governor Amando M. Tetangco, Jr noted it had not responded strongly to higher food and fuel prices in 2004. He stressed, “authorities should ignore changes in the price of things that they cannot control”.

Tetangco warned, “the required policy response is not… straightforward… Thus policy makers will need to make a choice between bringing down inflation and raising output growth”. He emphasized, “a real sector supply side response may be more appropriate in addressing the pressure on prices”.

Thus, instead of restricting credit indiscriminately, financing constraints on desired industries (e.g., renewable energy) should be eased. Enterprises deemed inefficient or undesirable – e.g., polluters or those engaged in speculation – should have less access to the limited financing available.

This requires designing macroeconomic policies to enable dynamic new investments, technologies and economic diversification. Instead of reacting with blunt interest rate policy tools, policymakers should know how fiscal and monetary policy tools interact and impact various economic activities.

Used well, these can unlock supply bottlenecks, promote desired investments and enhance productivity. As no one size fits all, each policy objective will need appropriate, customized, often innovative tools.

Lessons from China

China’s central bank, the People’s Bank of China (PBOC), developed “structural monetary policy” tools and new lending programmes to help victims of COVID-19. These ensured ample interbank liquidity, supported credit growth, and strengthened domestic supply chains.

Outstanding loans to small and micro businesses rose 25% to 20.8 trillion renminbi by March 2022 from a year before. By January, the interest rate for loans to over 48 million small and medium enterprises had dropped to 4.5%, the lowest level since 1978.

The PBOC has also provided banks with loan funds for promising, innovative and creditworthy companies, e.g., involved in renewable energy and digital technologies. It thus achieves three goals: fostering growth, maintaining debt at sustainable levels, and ‘green transformation’.

Defying global trends, China’s ‘factory-gate’ (or producer price) inflation fell to a one-year low in April 2022 as the PBOC eased supply chains and stabilized commodity prices. Although consumer prices have risen with COVID-19 lockdowns, the increases have remained relatively benign so far.

In short, the PBOC has coordinated monetary policy with both fiscal and industrial policies to boost confidence, promote desired investments and achieve stable growth. It maintains financial stability and policy independence by regulating capital flows, thus avoiding sudden outflows, and interest rate hikes in response.

Improving policy coordination

Central bankers monitor aggregate indicators, such as wages growth. However, before reacting to upward wage movements, the context needs to be considered. For example, wages may have stagnated, or the labour share of income may have declined over the long-term.

Moreover, wage increases may be needed for critical sectors facing shortages to attract workers with relevant skills. Wage growth itself may not be the problem. The issue may be weak long-term productivity growth due to deficient investments.

Input-output tables can provide information about sectoral bottlenecks and productivity, while flow-of-funds information reveals what sectors are financially constrained, and which are net savers or debtors.

Such information can helpfully guide design of appropriate, complementary fiscal and monetary policy tools. Undoubtedly, pursuing heterodox policies is challenging in the face of policy fetters imposed by current orthodoxies.

Central bank independence – with dogmatic mandates for inflation targeting and capital account liberalization – precludes better coordination, e.g., between fiscal and monetary authorities. It also undercuts the policy space needed to address both demand- and supply-side inflation.

Monetary authorities are under tremendous pressure to be seen to be responding to rising prices. But experience reminds us they can easily make things worse by acting inappropriately. The answer is not greater central bank independence, but rather, improved economic policy coordination.

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Finance drives world to stagflation

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR. The world is being pressed by financial interests to raise interest rates, ostensibly to check inflation. After the US Federal Reserve started raising interest rates, more central banks have been doing likewise.

Considering inflation’s contemporary causes, such ‘follow the leader’ central bank mimicry cannot check it except by slowing economies. Worse, this has meant taking on huge new risks, seriously damaging world economic prospects in the medium and long-term.

Inflation bogey dangerous

Much earlier, World Bank supported research had shown moderate inflation – in the range of 15–30% – was not harmful to growth, and could “be reduced only at a substantial cost to … growth”.

Nonetheless, “The ratio of fervent beliefs to tangible evidence seems unusually high on this topic”. Unsurprisingly, central banks are still trying to keep inflation below 2% – an arbitrary target “plucked out of the air”, due to a “chance remark” by New Zealand’s finance minister then.

Raising interest rates will derail recovery and worsen supply disruptions and shortages due to the pandemic, war and sanctions. European Central Bank (ECB) Executive Board member Fabio Panetta has noted the euro zone is “de facto stagnating” as economic growth has almost stopped.

As policymakers struggle with inflation, growth and wellbeing are being subjected to huge risks. As Panetta warns, “monetary tightening aimed at containing inflation would end up hampering growth that is already weakening”.

Interest rates rising globally

Among emerging markets and developing economies, South Africa’s central bank raised interest rates for the first time in three years in November 2021.

On 24 March 2022, the Bank of Mexico raised interest rates for the seventh consecutive time. On the same day, Brazil’s central bank raised interest rates to its highest level since 2017.

On 4 May, the Reserve Bank of India raised interest rates – its first rate change in two years and first rate hike in nearly four. On 5 May, Chile’s central bank raised interest rates. Pressed by finance to curb inflation, more central bankers are tightening monetary policy.

Without evidence or reasoning, they insist higher interest rates will check inflation. Their recognized adverse effects for recovery and growth are dismissed as unavoidably necessary short-term costs for some unspecified long-term gains.

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

Interest rate – blunt tool

But central bankers’ dogmatic stances, knee-jerk responses and ‘follow the leader’ behaviour are not helpful. Even when inflation reaches dangerous levels, raising interest rates may still not be the right policy response for several reasons.

First, raising interest rates only addresses the symptoms – not the causes – of inflation. Inflation is often said to be a consequence of an economy ‘overheating’. But overheating can be due to many factors.

Higher interest rates may relieve overheating, by slowing economic activity. But a good doctor should first investigate and diagnose an ailment’s causes before prescribing appropriate treatment – which may or may not require medication.

It is widely accepted 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. If so, long-term solutions require increasing supplies, including by removing bottlenecks.

Higher interest rates reduce aggregate demand. But simply raising interest rates does not even address the specific causes of inflation, let alone rising prices due to supply disruptions of essential goods, such as food and fuel.

Interest rate – indiscriminate

Second, the interest rate affects all sectors, everyone. It does not even distinguish between sectors or industries needing to expand or be encouraged, and those that should be phased out, for being less productive or inefficient.

Also, raising interest rates too often, and to excessively high levels, can squeeze, or even kill productive and efficient businesses along with inefficient or less productive ones.

US bankruptcies had soared in the early 1980s after US Fed chair Volcker’s legendary interest rate spike. “Thousands of businesses that took out bank loans could fail”, warned a leading UK tax advisory firm recently.

Third, interest rates do not distinguish among households and businesses. Higher interest rates may discourage household expenditure, but also dampen all kinds of spending – for both consumption and investment.

Hence, overall demand may shrink – discouraging investment in new technology, plant, equipment and skills. Thus, higher interest rates adversely affect long-term productive capacities and technological progress of economies.

Debt, recessions and financial crises

Fourth, higher interest rates raise debt servicing costs for governments, businesses and households. With the exceptionally low interest rates previously available after the 2008-09 global financial crisis (GFC), debt burdens rose in most countries.

These undoubtedly encouraged risky, speculative behaviour as well as unproductive share buybacks, increased dividends, and mergers & acquisitions. Interest rate hikes have triggered many recessions and financial crises. Thus, raising interest rates now will likely trigger a new, albeit different era of stagflation.

The pandemic has pushed public debt to historic new highs. Forty-four per cent of low-income and least developed countries were at high risk of, or already in external debt distress in 2020.

Before the COVID-19 crisis, half the small island developing states surveyed already had solvency problems, i.e., were at high risk of, or already in debt distress. Thus, raising interest rates can trigger a global debt crisis.

Fifth, paradoxically, higher interest rates raise debt-servicing expenses, especially mortgage payments, for indebted households. Costs of living also rise if businesses pass higher interest costs on to consumers by raising prices.

Hence, the main beneficiaries of low inflation and higher interest rates are the holders of financial assets who fear the relative diminution of their value.

Developing countries vulnerable

Developing countries are particularly vulnerable. Higher interest rates in developed countries – particularly the US – trigger capital outflows from developing countries – causing exchange rate depreciations and inflationary pressures.

Higher interest rates and weaker exchange rates will aggravate already high debt service burdens – as happened in Latin America in the early 1980s after US Fed chair Volcker greatly increased US interest rates.

To discourage sudden capital outflows and prevent large currency depreciations, developing countries raise interest rates sharply. This may lead to economic collapse – as in Indonesia during the 1997-98 Asian financial crisis.

Although pandemic response measures – such as debt moratoria – provided some relief, business failures rose nearly 60% in 2020 from 2019. Middle- and low-income countries saw more business failures.

The World Bank’s Pulse Enterprise Survey – of 24 middle- and low-income countries – found 40% of businesses surveyed in January 2021 expected to be in arrears within six months.

This included more than 70% of firms in Nepal and the Philippines, and over 60% in Turkey and South Africa. Business failures of such scale can trigger banking crises as non-performing loans suddenly soar.

Instead of checking contemporary inflation, raising interest rates is likely to greatly damage recovery and medium-term growth prospects. Hence, it is imperative for developing countries to innovatively develop appropriate means to better address the economic dilemmas they face.

Related IPS commentaries

Deepening Stagflation: Out of the Frying Pan into the Fire. 5 April 2022. https://www.ipsnews.net/2022/04/deepening-stagflation-frying-pan-fire/

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Inflation Targeting Voodoo. 1 March 2022. https://www.ipsnews.net/2022/03/inflation-targeting-voodoo/

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Out of Africa: Rich continent, poor people

Jomo Kwame Sundaram

KUALA LUMPUR. Capital flight from the global South is immense, with widespread adverse effects. A new book proposes measures to curb, even reverse capital flight from Africa. It also offers pragmatic lessons for many developing countries.

On the trail of capital flight from Africa extends pioneering work begun much earlier. The editors – Leonce Ndikumana and James Boyce – estimate Sub-Saharan Africa (SSA) has lost more than US$2 trillion to capital flight in the last half century!

SSA currently loses US$65 billion annually – more than yearly official development assistance (ODA) inflows. The book’s studies carefully investigate natural resource exploitation – of South African minerals, Ivorian cocoa, and Angolan oil and diamonds.

Such forensic country analyses are crucial to more effectively check capital flight. Outflows since the 1980s from the three countries have been massive: US$103 billion from Angola, US$55 billion from Cote d’Ivoire, and US$329 billion from South Africa in 2018 dollars.

Capital flight has been much more than cumulative external debt. Annual outflows were between 3.3% and 5.3% of national income. Nigeria, South Africa and Angola account for the most capital outflows from SSA, with Cote d’Ivoire seventh.

Resource booms

As governments get more revenue from natural resources, the fiscal ‘social contract’ is eroded. When people pay taxes, they expect state spending to benefit the public. But with more revenue from resources – via state monopolies, royalties and taxes – governments become less accountable to their own citizens.

Gaining and maintaining access to foreign credit has similar effects. Developing country governments then focus on ingratiating themselves with friendly foreign donor governments to get ODA, and on enhancing their credit ratings.

Hence, such regimes have less political need to provide ‘public goods’, including services, let alone accelerate social progress. Thus, erosion of the fiscal ‘social contract’ undermines not only public wellbeing, but also state legitimacy.

To secure power, ruling cliques often rely on ‘clientelism’ – patronage or patron-client relations – typically on regional, ethnic, tribal, religious or sectarian lines. Their regimes inevitably provoke dissent – including oppositional ethno-populism and civil unrest, even armed insurgencies.

Unsurprisingly, such regimes believe their choices are limited. Another option is repression – which typically rises as the status quo is threatened. The resulting sense of insecurity spreads from the public to the elite, worsening capital flight.

Exploiting valuable natural resources not only generates export earnings, but also attracts foreign investments. One result is ‘Dutch disease’ as the national currency rises in value – reducing other exports and jobs, inevitably hurting development prospects.

Thus, vast private fortunes have been made and illicitly transferred abroad. Ruling elites and their allies rarely only rely on either state or market to become richer. The book shows how both state and market strengthen private and personal power and influence.

Plundering Africa

The book’s case studies show how resource extraction has been central to capital flight. In all three countries, the efficacy of fiscal policy tools – especially to foster investments for development – has been undermined.

Outflows have increased with economic liberalization, as unrecorded financial outflows – via the current account – grow with freer trade. Thus, trade-related financial transactions enable corruption and capitalflight.

In Côte d’Ivoire – the world’s top cocoa producer – rents initially came from supply chains connecting farmers to consumers. Corrupt partnerships – connecting domestic elites to foreign businesses – have been crucial to such arrangements.

Thus, natural resource primary commodity exports have enabled illicit capital flows. Ivorian cocoa exports have been consistently under-reported – with trade statistics of major importers showing massive under-invoicing by exporters.

Post-colonial political settlements have given a few privileged access to resource rents. With capital flight thus enabled, successive Ivorian regimes have been less obliged to spend more on development or public wellbeing.

Due to the cocoa boom, the post-colonial ‘Ivorian miracle’ ended when prices fell. The bust triggered a political crisis, culminating in civil war. But the crunch also meant the country could no longer service its foreign debt.

In Angola too, natural resources worsened its protracted civil wars. After these ruinous conflicts, oil rents enriched the triumphant nepotistic regime. This enabled the control to gain control of more, even as most Angolans continued to live in destitution.

Angola’s massive oil exports mainly benefited the small elite of cronies around the president. They failed to develop the economy or improve most lives. All this has been enabled by ‘helpful’ professionals who have enriched themselves doing so.

While benefiting its elite and foreign transnationals, Angola’s ‘oil curse’ has blocked balanced and sustainable development of its economy. Despite rapidly depleting its oil reserves, Angola and most Angolans have benefited little.

South Africa – SSA’s second largest economy after Nigeria – seems less reliant on natural resources. Post-apartheid economic liberalization has enabled capital flight as private corporate interests – especially the influential minerals-energy complex – quickly took advantage of the new dispensation.

By under-invoicing their exports, mineral interests have been engaged in massive capital flight and tax evasion. Meanwhile, business cronies have enriched themselves in new ways, e.g., in the state’s electric power sector. Such abuses were exposed by the Gupta family scandal, leading to then President Jacob Zuma’s downfall.

Stemming capital flight

‘State capture’ by politically influential nationals have undermined government regulatory capacities with help from transnational enablers. Ostensible ‘good governance’ reforms have enabled capital flight and tax evasion – by undermining ‘developmental governance’, including prudential regulation.

Institutional environments, mechanisms and enablers facilitate capital flight, tax evasion and wealth accumulation offshore. With often complex, varied and changing facilitation, capital flight has shifted massive wealth abroad for elites.

Transnational financial networks have eased capital outflows – at the expense of productive investments, good jobs and social wellbeing. Capital flight has worsened financing, including budgetary gaps – aggravating related social deprivations.

Wealth creation enhances the economic pie, but distribution depends on who appropriates it. Improved understanding of such varied and ever-changing relations of appropriation is crucial to effectively curb this haemorrhage.

Greater awareness should inspire and inform better measures to check capital flight from the global South. Instead of the Washington Consensus ‘good governance’ mantra, a developmental governance agenda is needed.

Hence, curbing capital flight is crucial for financing sustainable development. Checking capital flight and related abuses – such as trade mis-invoicing, money laundering, tax evasion and public asset acquisition by elites – requires well-coordinated efforts at both national and international levels.

All researchers, policymakers and regulators will gain from the book’s forensic analyses of financial, fiscal and other such abuses. International financial institutions now have little excuse for continuing to enable the capital flight and tax evasion still bleeding the global South.

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