Inflation targeting constrains development

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR: All too many developing countries have been persuaded or required to prioritize inflation targeting (IT) in their monetary policy. By doing so, they have tied their own hands instead of adopting bolder economic policies for growth, jobs and sustainable development.

Why inflation targeting?

IT refers to monetary policy efforts to keep the inflation rate within a certain low range. Many countries – developed and developing – have adopted this policy priority following New Zealand’s 1989 lead, arbitrarily aiming to keep inflation under 2%.

Initially, developing economies adopted IT after crises to get financial support from the International Monetary Fund (IMF), e.g., after the 1997-98 Asian financial crisis. From the mid-1970s, many had borrowed heavily to accelerate growth. After the US Fed raised interest rates sharply from 1980, many succumbed to debt crises.

The IMF insisted on severe short-term stabilization policies to keep inflation and debt low. The World Bank complemented it with medium-term structural adjustment policies demanding market liberalization and other reforms.

Price stabilization policies to keep inflation low have been an IMF priority since. But instead of accelerating growth, as promised, IT has actually slowed it. Yet, developing countries have jumped on the IT bandwagon – 25 had formally adopted IT by 2020, while most others strive to keep inflation very low.

How bad is inflation?

Most believe that inflation is the greatest threat to the economy and growth. Many presume inflation creates uncertainty, causing resource misallocation. All this is said to retard growth – meaning fewer jobs, less tax revenue and lasting poverty.

Higher prices hurt by reducing purchasing power, especially harming wage-earners. On the contrary, price stability – implying low and steady inflation – is believed to be more conducive to ensuring growth and prosperity.

Another core IT belief is that money only temporarily affects growth, but permanently affects prices. IT advocates believe central bankers should mainly strive for price stability – not employment or growth. They usually presume independent central banks are better at doing so.

Many central bankers and economists dogmatically believe – without evidence – that tightly reining in inflation actually spurs growth. Acknowledging developing countries are more prone to external and supply shocks, the IMF recommended targets of up to 5% – higher than developed countries’ 2%.

Most developing countries aspiring to become emerging market economies have formally adopted IT – e.g., South Africa’s 3–6% or India’s 2–6%. By setting successively lower short-term inflation targets, they believe financial markets are impressed.

But by doing so, they prevent themselves from realizing their full economic potential. Striving to emulate the developed countries’ 2% target constrains both growth and structural transformation. After all, it was quite arbitrarily set for no economic reason, except the NZ finance minister liking the ‘0 to 2 by ’92’ slogan!

Arbitrary targets

While there is little disagreement about likely problems associated with ‘hyper-’ or very high inflation, the threshold beyond which inflation becomes harmful is a moot issue on which there is no consensus.

Inflation targets are arbitrarily set, as acknowledged in an IMF paper. Hence, “any choice of a medium-term inflation target for these [developing] countries is bound to be arbitrary”. Harry Johnson had found early IMF empirical studies of the inflation-growth relationship to be inconclusive.

Later studies did not settle the matter. For example, Michael Bruno and William Easterly at the World Bank concluded that inflation under 40% did not tend to accelerate or worsen, and “countries can manage to live with moderate – around 15–30 percent – inflation for long periods”.

MIT’s Rudiger Dornbusch and Stanley Fischer, later IMF Deputy Managing Director, came to similar conclusions. They found moderate inflation of 15–30% did not harm growth, noting “such inflations can be reduced only at a substantial short-term cost to growth”.

A 2000 IMF paper suggested 11% inflation was optimal for developing countries; 7% inflation would have “an insignificant negative effect” on growth, while 18% inflation remained positive for growth. Yet, it recommended an IT target of 7–11% and “bringing inflation down to single digits and keeping it there”.

The IMF Independent Evaluation Office’s 2007 report on Sub-Saharan Africa found “mission chiefs are evenly divided on whether (or not) the Fund should tolerate higher [than 5%] inflation rates…IMF policy staff acknowledge that the empirical literature on the inflation-growth relationship is inconclusive”.

Hence, very low inflation targets are quite arbitrary without any sound theoretical and empirical bases. But the IMF and its chorus of economists have not hesitated to insist on keeping inflation very low by promoting IT for all, especially to susceptible developing country policymakers.

Constraining development

Very low inflation targets particularly constrain low-income countries (LICs). LIC governments face modest revenue bases and limited domestic savings. Hence, they should borrow more from central banks to finance their development spending.

But such borrowings are prohibited by law in many developing countries – especially those which have formally embraced IT – to prove their anti-inflationary commitment. Thus, a potentially major means for central banks to be more developmental is denied by statute.

By raising interest rates to keep inflation very low, central banks reduce not only consumer spending, but also business investments. Such policies also increase both public and private debt burdens, in turn constraining spending.

Thus, overall aggregate demand remains depressed, limiting growth unless compensated by greater export demand. But higher interest rates attract capital inflows, causing exchange rates to appreciate, undermining export competitiveness.

Means deny ends

IT policy is problematic for two major reasons. First, it demands debilitatingly low targets. Second, it denies central banks’ potential developmental role by insisting on price stability – read ‘containing inflation’ – as its principal goal.

IMF researchers have acknowledged, “identifying the growth effects of moving from, say, 20 percent inflation to 5 percent has been challenging”.

They concluded, “pushing inflation too low – say, below 5 percent – may entail a loss of output …, suggesting a need for caution in setting very low inflation targets in low-income countries… In particular, inflation targets should be set so as to help avoid risks of an unintended contractionary policy stance.”

Also, San Francisco US Federal Reserve Bank research has concluded, “developing economies that adopted an inflation target did not show any substantial gains in growth in the medium term compared with those that did not adopt a target”.

Thus, developing countries prioritizing IT have, often unwittingly, curtailed their own economic prospects. Falsely promoted as means to enhance growth, jobs and development, IT, in fact, constrains them – the ultimate con!

Rejecting the IT fetish does not mean doing nothing about inflation. Instead, developing countries need to better know the economic challenges they face and the efficacy of their policy tools. National economic priorities should be comprehensively addressed without subordinating all policy goals to the god of IT.

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Inflation targeting voodoo

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR: All over the world, people expect policies by central bankers trained in economics to have a sound scientific base. But in fact, inflation targeting is an article of faith with neither theoretical nor empirical basis.

Policy inspiration

The two per cent (2%) inflation target is now virtually an “economic religion”. US Federal Reserve chairman Jerome Powell noted it had become a “global norm”.

In 1989, New Zealand became the first country to adopt a 2% inflation target. “The figure was plucked out of the air”, acknowledged Don Brash, then Governor of the Reserve Bank of New Zealand (RBNZ), its central bank.

It was prompted by a “chance remark” of NZ Finance Minister Roger Douglas during “a television interview on April 1, 1988, that he was thinking of genuine price stability, ‘around 0, or 0 to 1 percent’.” Meanwhile, Brash seemed to think his role was to keep inflation positive, but under 2%.

In the RBNZ’s annual report to March 1989, Brash was “confident that inflation could be reduced below 2 percent by the year to March 1993”. The finance minister welcomed this, asking “whether it might be feasible to achieve that by the end of calendar year 1992 – he liked the sound of ‘0 to 2 by ’92’”!

Thus, “‘0 to 2 by ’92’ became the mantra, repeated endlessly”. Brash and his colleagues “devoted a huge amount of effort” preaching this new mantra “to everybody who would listen – and some who were reluctant to listen”.

This involved “many hundreds of informal speeches to Rotary Clubs, Chambers of Commerce, farmers’ groups, church groups, women’s groups, and schools”. A new cult –inspired by RBNZ’s inflation targeting – was thus born.

Parliamentary mandate

When the bill setting the RBNZ inflation target between zero and 2% reached the legislature, parliamentarians were about to adjourn for Christmas. Also, “one of the bill’s strongest opponents was laid up in the hospital”.

Nevertheless, the debate over the legislation was robust. Labour unions were worried that an inflexibly narrow target would raise unemployment. The New Zealand Manufacturers’ Federation warned, “This is wrong in principle, undemocratic and inflexible”.

A real estate developer asked Brash to announce his body weight, for him to work out what rope would be needed to hang the RBNZ Governor from a lamppost in NZ’s capital, Wellington. But the bill passed as leaders of the ruling Labour Party brushed aside concerns.

Weak evidence, strong conclusion

Since the RBNZ’s adoption of 2% inflation, “plucked out of the air” as a target, leading economists – some of whom have served as senior officials at the major international financial institutions and central banks – studied long time series for many countries.

However, none could find any strong evidence to justify a single digit inflation threshold beyond which inflation may negatively impact economic growth. Yet, they concurred with a single digit inflation target!

For example, Stanley Fischer concluded, “however weak the evidence, one strong conclusion can be drawn: inflation is not good for longer-term growth”. And Robert Barro asserted, “the magnitude of [negative] effects are not that large, but are more than enough to justify a keen interest in price stability”.

A Reserve Bank of Australia study found “Average inflation is…a fragile explanation of economic growth”. Yet, it concluded, “While the results are not as robust as one would like, the most obvious interpretation of the evidence ... is that the negative correlation between inflation and growth arises from a causal relationship”.

Pierre Fortin – past President of the Canadian Economics Association – emphasized, “Strong claims that there are large macroeconomic benefits to be reaped … are not presently founded on robust quantitative evidence. They are premature”.

Cheerleaders claim inflation-targeting has delivered low inflation. But others have alternative explanations for the Great Moderation. The “one-size-fits-all” mantra has also effectively shut the door to alternative strategies for robust, sustainable and inclusive growth.

Harm’s way

Inflation targeting can be harmful, especially as monetary authorities have little control over external sources of inflation. Current inflationary pressures are largely due to rising international food and fuel prices.

Targeting also harms the economy when inflation is caused by supply shocks, such as production and distribution disruptions, e.g., due to pandemic related lockdowns or other restrictions.

Raising interest rates or monetary tightening to achieve targets when inflation is largely due to external or supply shocks will exacerbate the debt burdens of households, businesses and governments, thus reducing economic growth and employment prospects.

Central bankers trying to “cool” labour markets in their anti-inflation crusade hurt labour by raising unemployment and worsening working conditions. It is likely to be socially less costly to ‘accommodate’, i.e., accept supply or external shock inflation than mechanically achieving an arbitrary inflation target.

Inflation targeting has also privileged price stabilization at the expense of other central bank responsibilities, including maximizing employment, growth and progress.

Of course, central bankers should be monitoring prices of key goods and services (e.g., food, fuel, housing, healthcare) which weigh heavily on consumer spending. Policymakers must design alternative policy tools to address such essential price rises rather than relying solely on raising interest rates.

Targeting a specific inflation rate is against the International Monetary Fund (IMF)’s Articles of Agreement. Article IV states, “each member shall: (i) endeavor to direct its economic and financial policies toward the objective of fostering orderly economic growth with reasonable price stability, with due regard to its circumstances”.

Thus, IMF members are obliged to foster economic growth, and maintain “reasonable” price stability – not chasing a fixed inflation target, presuming that growth would follow. There is no ‘one-size-fits-all’ policy or universal target. And policy design depends on country specific circumstances.

Counter revolution

Inflation targeting should never have become monetary policy. It should have been rejected long ago if policymaking was informed by theory and experience. But central banks have been targeting inflation, supposedly to enhance growth and employment!

Some assert money is “neutral”, insisting central bankers cannot affect real economy variables, e.g., output, employment, investment. Thus, they have “discounted the role of money in … monetary policy more than is justified”.

But money is far from neutral, impacting the real economy quite significantly. This was evident after the 2008-2009 global financial crisis and during the COVID-19 pandemic. Policymakers should instead be primarily concerned about the real economy – output, employment, sustainable development.

Unsurprisingly, inflation targeting has not accelerated growth, especially in developing countries. Even in developed countries, it seems to have exacerbated “secular stagnation”, i.e., anaemic growth.

Thus, instead of increasing growth, employment and structural transformation, the inflation obsession has slowed economic growth. Universal rejection of the inflation targeting hoax will thus advance human progress.

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Financialization at heart of economic malaise

Anis Chowdhury and Jomo Kwame Sundaram

SYDNEY and KUALA LUMPUR: COVID-19 has exposed major long-term economic vulnerabilities. This malaise – including declining productivity growth – can be traced to the greater influence of finance in the real economy.

The deep-seated causes of the current resurgence of inflation, inequalities and contractionary tendencies have not been addressed. Meanwhile, reform proposals after the 2008-2009 global financial crisis (GFC) have been largely forgotten.

Declining productivity

Productivity growth has been declining in major economies since the early 1970s. As the World Bank noted, well “before the … pandemic, the global economy featured a broad-based decline in productivity growth”.

World labour productivity growth slowed from its 2007 peak of 2.8% to a post-GFC nadir of 1.4% in 2016, remaining under 2.0% in 2017-2018.This slowdown has hurt over two-thirds of advanced, emerging market and developing economies.

Except for a brief productivity spike in some countries around the turn of the century, labour productivity growth in developed Organization for Economic Cooperation and Development (OECD) countries was declining, with trends low, but stable after the GFC.

Why the slowdown?

For Robert Gordon, this was mainly due to declining total factor productivity growth (TFP) – or slower technical innovation, organizational improvements and labour skill growth – in recent decades, particularly in industrial nations.

For the World Bank, reduced investment and TFP growth deceleration have been roughly equally responsible for the productivity slowdown. Slowing working age population growth and limited education progress have also contributed.

The United Nations noted, “as firms around the globe have become more reluctant to invest, productivity growth has continued to decelerate”. It blamed the slowdown on reduced investments in machinery, technology, etc.

Slower transitions to more diverse and complex production have also delayed progress. Some supply shocks due to ‘natural causes’ – of which 70% were climate change related – have also hurt productivity growth.

Growing inequality has weakened demand, slowing economic and productivity growth. As workers’ spending declined with labour’s income share, demand has been sustained by more public and private borrowing.

The International Monetary Fund (IMF)’s April 2017 World Economic Outlook confirmed this trend. Productivity growth declines have lowered real incomes, reducing consumer spending, demand and growth.

A joint report of the Bank of International Settlements (BIS), OECD and IMF also blamed unconventional monetary policies – very low, even negative real interest rates, and corporate bond purchases. Thus, corporate financial fragilities have weakened investment and productivity growth, especially since the GFC.

Deeper malaise

More sustainable and inclusive growth policies can help increase productivity. But blind faith in ‘market solutions’ since the 1980s has worsened resource misallocations, sectoral imbalances and job-skill mismatches.

One-sided demand stimuli – through more deficit spending or monetary expansion, without complementary supply-side measures – have only made limited impact. Also, supply-side measures to enhance growth need appropriate regulatory reforms – not wholesale deregulation.

Deregulation has often strengthened product market oligopolies while labour’s bargaining strength has generally declined. Growing corporate power has reduced labour income shares as executive salaries have risen since the 1980s.

Paranoia viz deficits and debt has cut public spending. Public investment remained flat during the early 2000s, rising slightly after the GFC, before declining until the pandemic. Worse, public spending cuts have not been offset by more private investment.

Slower capital stock increases cut potential growth in advanced economies from the 1980s. Debt and deficit paranoia has cut public services, social protection, public education and healthcare – hurting the vulnerable most.

Negative externalities

Markets have also failed the environment, undermining sustainability. Inadequate investments in renewable energy and sustainable agriculture have resulted in food and energy shortages – now exacerbating inflationary pressures.

Financialization, tax cuts and deregulation have also encouraged speculative activities, share buybacks and other portfolio purchases. Unconventional monetary policies have also enabled unviable ‘zombie’ firms to survive.

Thus, there has been rising protectionism and harmful beggar-thy- neighbour policies – such as competing corporate income tax rate cuts while weakening environmental protection and labour rights.

Meanwhile, much needed productive investments, especially in infrastructure, technology and innovation, remain underfunded. National problems have been worsened by failure to improve multilateral economic governance.

Financialization

Declining productivity growth was due to finance’s creeping dominance over the real economy from the 1970s. With banking more internationalized and concentrated, traditional financial intermediation by commercial banks has been undermined by market allocation and ‘universal banking’, combining both commercial and investment banking services.

Financialization has thus subverted economic motives, markets and institutions, adversely affecting progress, balanced development and long-term productivity growth in various ways:

· Corporate decision-making and firm behaviour are increasingly influenced by short-term financial market indicators, e.g., share market prices, rather than medium- and long-term prospects;

· Non-financial corporations increasingly profit from financial, rather than productive activities;

· ‘Non-traditional’ financial activities (e.g., stock market investments) of commercial banks have increased their exposure to systemic, including external risks;

· The distinction between short-term speculation and patient long-term investment has become blurred;

· Executive and even managerial remuneration has been increasingly linked to short-term profitability, as measured by share prices, not longer-term considerations.

Such features have adversely affected real investments and innovation, due to finance pursuing short-term returns. Thus, financialization has negatively affected investment, technology adoption and skill upgrading, with adverse consequences for productivity and decent jobs.

Misallocation

The financial system has also undermined the real economy by syphoning talent from it, with attractive inducements. Thus, talent has gone to finance at the expense of the real economy, especially harming technological progress.

James Tobin challenged “throwing more and more of our resources, including the cream of our youth, into financial activities remote from the production of goods and services, into activities that generate high private rewards disproportionate to the social productivity.”

Then American Finance Association president Luigi Zingales showed financial growth in the last four decades has basically been rent seeking, i.e., securing profits without adding any value.

Finance has captured rents “through a variety of mechanisms including anticompetitive practices, the marketing of excessively complex and risky products, government subsidies such as financial bailouts, and even fraudulent activities… By overcharging for products and services, financial firms grab a bigger slice of the economic pie at the expense of their customers and taxpayers”.

Banking abuses have been innovative, ranging from collusion, abusive practices, market manipulation, rigging interest, exchange and other rates, passing risk to unsuspecting customers, aiding and abetting tax evasion and money laundering.

Real economy drag

Finance has thus retarded development of the real economy in various ways. First, financial development has not been conducive to intermediating between savings and real investments. Markets allocate funds by criteria other than promoting investment in the real economy.

Second, financial markets and speculation do not generate or otherwise add real value. Third, financialization and regulatory failure have generated more frequent and damaging financial crises.

Seeking to maximize returns, fund managers and their ilk mainly invest in response to short-term financial trends. Presumed to be best left to markets, actual capital formation – increasing economic output – and productivity growth have slowed, to the detriment of most.

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