After a year-long debate over whether sharply rising prices are merely transitory or persistent, fighting inflation has returned to the top of international priorities.
The world’s major economies have not seen anything like the current rates of inflation for decades. The seven per cent rate the US recorded in December marked a 40-year high, and the rate in the EU is the highest in Europe since the Euro was introduced 20 years ago.
Fighting inflation, maintaining price stability, and protecting the poor and low-income segments are among the foremost priorities for the developing nations. But they are more severely impacted by global inflation in two ways.
The first is imported inflation in the form of the soaring prices of goods and materials from abroad. The second, and more dangerous in my opinion, comes from the anti-inflationary measures the developed nations are using because of their adverse effects on monetary flows to developing nations, financing costs due to higher interest rates, pressures on local currencies, and the growing risk of defaulting on debts that accumulated before and during the pandemic in what is known as the fourth wave of external debt.
The prognosis on inflation brings to mind the question Queen Elizabeth II of the UK famously asked Luis Garicano, director of economic research at the London School of Economics (LSE), during a visit to that prestigious institute in November 2008 following the outbreak of the global financial crisis.
If the problems were this big, why did no one notice them, she asked.
Experts stepped forward with interesting answers, both long and short. The gist was that economic policies have shortcomings, and these are due to problems with making economic forecasts under conditions of high uncertainty and insufficient coordination between economic decision-makers.
Years later, we find ourselves in a similar situation with respect to inflation, one that threatens grave repercussions for societies, economies, and markets around the world. Even though forecasting inflation trends is easier than predicting financial crises, the forecasting has failed again.
Harvard University economist Jason Furman notes that none of the members of the Federal Open Market Committee (FOMC), which is involved with setting US Federal Reserve rates, expected inflation to exceed 2.5 per cent in 2021, a prediction that has proven wide of the mark. When 36 economic experts were asked for their prognosis on inflation in the US in May last year, they generally agreed that it had less than a 0.5 per cent chance of exceeding four per cent. The prices of US treasury bonds reflected similarly low predictions among players in the financial markets.
As usual when major mistakes happen, there is a lot of finger-pointing. Some have faulted the prediction models, saying that they were unable to accommodate the sharp fluctuations in the economy or the different behaviour and reactions of investors, producers, and consumers. Others have blamed the monetary authorities for being too slow to take decisions regarding inflation.
In my opinion, the mistake that major central banks have made is the result of a combination of factors. One is the inability of standard forecasting models to factor in all anticipated and unanticipated developments, especially in times of uncertainty.
For example, it appears that they did not fully appreciate the extent of the disruption in supply chains and the impact of Covid-19 variants on the markets for goods, services, and labour on the supply side and how suddenly and rapidly the demand side could surge due to the cumulative purchasing power that had been pent up since the beginning of the pandemic and that was boosted by monetary easing packages.
Another factor is that political pressures make it hard to take harsh anti-inflationary measures that could impede growth, increase unemployment, and disrupt recovery efforts. It appears that decision-makers did not possess strong enough evidence to justify preemptive measures. In addition, the governments of many of the G7 group of countries lack the powers of persuasion and the exceptional leadership abilities needed in times of crisis.
WHAT SHOULD BE DONE? To benefit from the lessons of the past, we need to let principled pragmatism guide us and keep the goals of progress and development foremost in our minds.
These goals can only be realised by sustaining high rates of economic growth and monetary and financial stability. Those in charge of economic management should not deviate from these aims, regardless of the obstacles. They must also have the courage to acknowledge mistakes, if they occur, and to rectify them without delay.
At present, they need to take urgent action at a time when they do not have the luxury to indulge in the art of procrastination, which has incurred high costs borne by the general public. Accordingly, they should take the following measures:
- Develop practical and realistic economic-forecasting models. This means that these models should be able to accommodate new and unprecedented variables and defy the conventional assumption of normal times that the future is a linear extension of the past.
- Central banks and other official agencies should publicise the results of the models and guidelines, stating how the results have been taken into account in the decisions they have made.
- Summon the necessary humility to encourage experts to propose practical alternatives to the current policies. Recent economic developments should have deflated the arrogance of some officials, who have tended to speak about the future as though they alone had the power to pierce the veil.
- In the developed economies, the main burden of handling inflation falls on the central banks. Their monetary policy mechanisms are more effective because the vast majority of the population is integrated into the formal economy. Everyone has a bank account and is linked to the financial sector through assets and liabilities in the form of stocks, bonds, mortgages, loans, credit cards, and so on.
These means of influencing the economy are considerably fewer in the developing nations, and inflation in these countries cannot be reduced to a simple question of monetary policy. The problem has structural dimensions, including distortion in the markets and their rules of operation. As a result, much closer coordination between monetary and financial policies is required in terms of both taxation and public spending, in addition to measures to protect markets and consumers from high inflation.
- Strengthen social-security systems and safety nets for the poor and low-income sectors of society in order to protect them from the repercussions of inflation. The urgency of this cannot be overstated.
- Continue to reduce and restructure the public debt by relying more on local resources and extending loan maturities.
- Rely primarily on investment instead of borrowing as a means to finance sustainable development projects that are economically and socially feasible and merit priority.
- Review the efficiency of public spending, especially in infrastructure projects. According to international studies of governance and public spending, some developing economies incur more than a 50 per cent loss on their total investments in such projects compared to 20 per cent in the developed nations.
- Introduce proper climate-change policy management to avert sudden and unprecedented price hikes in conventional energy (as has occurred recently) due to the overly hasty reduction in critical investments in energy resources and wild speculation in the prices of renewable energy and raw materials.
Such ad hoc energy-related policies and behaviour have increased inflation without attaining any concrete climate-change goal. Indeed, they have generated a new cause of rising prices in the shape of “green inflation.”
- Increase public awareness of developments in the financial markets and their impact on the investments and savings of the general public.
With inflation, many financial bubbles burst and many Ponzi schemes and other confidence games promising large and quick profits proliferate. Recently we have seen high volatility and sharp declines in the stock and bond markets, with cryptocurrencies such as Bitcoin sustaining the greatest losses. The regulations introduced by the Singapore Monetary Authority, reputed for its prudent standards of financial supervision, are worth mentioning, since these have prohibited the advertising or public promotion of these high-risk assets in order to protect non-specialists.
Other countries are also considering mechanisms to safeguard the general public. Britain, for example, has banned some companies for violating advertising rules in their publicity campaigns for high-risk cryptocurrencies.
*An Arabic version of this article appeared on Wednesday in Asharq Al-Awsat.
*A version of this article appears in print in the 27 January, 2022 edition of Al-Ahram Weekly.