Since the 1980s, free-market economists have managed to convince the rest of the world that economic stability, which they define as very low (ideally zero) inflation, should be attained at all costs, since inflation is bad for the economy. The target inflation rate they recommended has been something like 1–3 per cent, as suggested by Stanley Fischer, a former economics professor at MIT and the chief economist of the IMF between 1994 and 2001.1
However, there is actually no evidence that, at low levels, inflation is bad for the economy. For example, even studies done by some free-market economists associated with institutions such as the University of Chicago or the IMF suggest that, below 8–10 per cent, inflation has no relationship with a country’s economic growth rate.2 Some other studies would even put the threshold higher – 20 per cent or even 40 per cent.3
The experiences of individual countries also suggest that fairly high inflation is compatible with rapid economic growth. During the 1960s and 70s, Brazil had an average inflation rate of 42 per cent but was one of the fastest-growing economies in the world, with its per capita income growing at 4.5 per cent a year. During the same period, per capita income in South Korea was growing at 7 per cent per year, despite having an annual average rate of inflation of nearly 20 per cent, which was actually higher than that found in many Latin American countries at the time.4
Moreover, there is evidence that excessive anti-inflationary policies can actually be harmful for the economy. Since 1996, when Brazil – having gone through a traumatic phase of rapid inflation, although not quite of hyperinflationary magnitude – started to control inflation by raising real interest rates (nominal interest rates minus the rate of inflation) to some of the highest levels in the world (10–12 per cent per year), its inflation fell to 7.1 per cent per year but its economic growth also suffered, with a per capita income growth rate of only 1.3 per cent per year. South Africa has also had a similar experience since 1994, when it started giving inflation control top priority and jacked up interest rates to the Brazilian levels mentioned above.
Why is this? It is because the policies that are aimed to reduce inflation actually reduce investment and thus economic growth, if taken too far. Free-market economists often try to justify their highly hawkish attitude towards inflation by arguing that economic stability encourages savings and investment, which in turn encourage economic growth. So, in trying to argue that macroeconomic stability, defined in terms of low inflation, was a key factor in the rapid growth of the East Asian economies (a proposition that does not actually apply to South Korea, as seen above), the World Bank argues in its 1993 report: ‘Macroeconomic stability encourages long-term planning and private investment and, through its impact on real interest rates and the real value of financial assets, helped to increase financial savings.’ However, the truth of the matter is that policies that are needed to bring down inflation to a very low – low single-digit – level discourage investment.
Real interest rates of 8, 10 or 12 per cent mean that potential investors would not find non-financial investments attractive, as few such investments bring profit rates higher than 7 per cent.5 In this case, the only profitable investment is in high-risk, high-return financial assets. Even though financial investments can drive growth for a while, such growth cannot be sustained, as those investments have to be ultimately backed up by viable long-term investments in real sector activities, as so vividly shown by the 2008 financial crisis (see Thing 22).
So, free-market economists have deliberately taken advantage of people’s justified fears of hyperinflation in order to push for excessive anti-inflationary policies, which do more harm than good. This is bad enough, but it is worse than that. Anti-inflationary policies have not only harmed investment and growth but they have failed to achieve their supposed aim – that is, enhancing economic stability.
False stability
Since the 1980s, but especially since the 1990s, inflation control has been at the top of policy agendas in many countries. Countries were urged to check government spending, so that budget deficits would not fuel inflation. They were also encouraged to give political independence to the central bank, so that it could raise interest rates to high levels, if necessary against popular protests, which politicians would not be able to resist.
The struggle took time, but the beast called inflation has been tamed in the majority of countries in recent years. According to the IMF data, between 1990 and 2008, average inflation rate fell in 97 out of 162 countries, compared to the rates in the 1970s and 80s. The fight against inflation was particularly successful in the rich countries: inflation fell in all of them. Average inflation for the OECD countries (most of which are rich, although not all rich countries belong to the OECD) fell from 7.9 per cent to 2.6 per cent between the two periods (70s–80s vs. 90s–00s). The world, especially if you live in a rich country, has become more stable – or has it?
The fact is that the world has become more stable only if we regard low inflation as the sole indicator of economic stability, but it has not become more stable in the way most of us experience it.
One sense in which the world has become more unstable during the last three decades of free-market dominance and strong anti-inflationary policies is the increased frequency and extent of financial crises. According to a study by Kenneth Rogoff, a former chief economist of the IMF and now a professor at Harvard University, and Carmen Reinhart, a professor at the University of Maryland, virtually no country was in banking crisis between the end of the Second World War and the mid 1970s, when the world was much more unstable than today, when measured by inflation. Between the mid 1970s and the late 1980s, when inflation accelerated in many countries, the proportion of countries with banking crises rose to 5–10 per cent, weighted by their share of world income, seemingly confirming the inflation-centric view of the world. However, the proportion of countries with banking crises shot up to around 20 per cent in the mid 1990s, when we are supposed to have finally tamed the beast called inflation and attained the elusive goal of economic stability. The ratio then briefly fell to zero for a few years in the mid 2000s, but went up again to 35 per cent following the 2008 global financial crisis (and is likely to rise even further at the time of writing, that is, early 2010).6
Another sense in which the world has become more unstable during the last three decades is that job insecurity has increased for many people during this period. Job security has always been low in developing countries, but the share of insecure jobs in the so-called ‘informal sector’ – the collection of unregistered firms which do not pay taxes or observe laws, including those providing job security – has increased in many developing countries during the period, due to premature trade liberalization that destroyed a lot of secure ‘formal’ jobs in their industries. In the rich countries, job insecurity increased during the 1980s too, due to rising (compared to the 1950s–70s) unemployment, which was in large part a result of restrictive macroeconomic policies that put inflation control above everything else. Since the 1990s, unemployment has fallen, but job insecurity has still risen, compared to the pre-1980s period.
There are many reasons for this. First, the share of short-term jobs has risen in the majority of rich countries, although not hugely as some people think. Second, while those who keep their job may stay in the same job almost (although not quite) as long as their pre-1980s counterparts used to, a higher proportion of employment terminations have become involuntary, at least in some countries (especially the US). Third, especially in the UK and the US, jobs that had been predominantly secure even until the 1980s – managerial, clerical and professional jobs – have become insecure since the 1990s. Fourth, even if the job itself has remained secure, its nature and intensity have become subject to more frequent and bigger changes – very often for the worse. For example, according to a 1999 study for the Joseph Rowntree Foundation, the British social reform charity named after the famous Quaker philanthropist businessman, nearly two-thirds of British workers said they
had experienced an increase in the speed or the intensity of work over the preceding five-year period. Last but not least, in many (although not all) rich countries, the welfare state has been cut back since the 1980s, so people feel more insecure, even if the objective probability of job loss is the same.
The point is that price stability is only one of the indicators of economic stability. In fact, for most people, it is not even the most important indicator. The most destabilizing events in most people’s lives are things like losing a job (or having it radically redefined) or having their houses repossessed in a financial crisis, and not rising prices, unless they are of a hyperinflationary magnitude (hand on heart, can you really tell the difference between a 4 per cent inflation and a 2 per cent one?). This is why taming inflation has not quite brought to most people the sense of stability that the anti-inflationary warriors had said it would.
Now, the coexistence of price stability (that is, low inflation) and the increase in non-price forms of economic instability, such as more frequent banking crises and greater job insecurity, is not a coincidence. All of them are the results of the same free-market policy package.
In the study cited above, Rogoff and Reinhart point out that the share of countries in banking crises is very closely related to the degree of international capital mobility. This increased international mobility is a key goal for free-market economists, who believe that a greater freedom of capital to move across borders would improve the efficiency of the use of capital (see Thing 22). Consequently, they have pushed for capital market opening across the world, although recently they have been softening their position in this regard in relation to developing countries.
Likewise, increased job insecurity is a direct consequence of free-market policies. The insecurity manifested in high unemployment in the rich countries in the 1980s was the result of stringent anti-inflationary macroeconomic policies. Between the 1990s and the outbreak of the 2008 crisis, even though unemployment fell, the chance of involuntary job termination increased, the share of short-term jobs rose, jobs were more frequently redefined and work intensified for many jobs – all as a result of changes in labour market regulations that were intended to increase labour market flexibility and thus economic efficiency.
The free-market policy package, often known as the neo-liberal policy package, emphasizes lower inflation, greater capital mobility and greater job insecurity (euphemistically called greater labour market flexibility), essentially because it is mainly geared towards the interests of the holders of financial assets. Inflation control is emphasized because many financial assets have nominally fixed rates of return, so inflation reduces their real returns. Greater capital mobility is promoted because the main source of the ability for the holders of financial assets to reap higher returns than the holders of other (physical and human) assets is their ability to move around their assets more quickly (see Thing 22). Greater labour market flexibility is demanded because, from the point of view of financial investors, making hiring and firing of the workers easier allows companies to be restructured more quickly, which means that they can be sold and bought more readily with better short-term balance sheets, bringing higher financial returns (see Thing 2).
Even if they have increased financial instability and job insecurity, policies aimed at increasing price stability may be partially justified, had they increased investment and thus growth, as the inflation hawks had predicted. However, the world economy has grown much more slowly during the post-1980s low-inflation era, compared to the high-inflation period of the 1960s and 70s, not least because investment has fallen in most countries (see Thing 13). Even in the rich countries since the 1990s, where inflation has been completely tamed, per capita income growth fell from 3.2 per cent in the 1960s and 70s to 1.4 per cent during 1990–2009.
All in all, inflation, at low to moderate levels, is not as dangerous as free-market economists make it out to be. Attempts to bring inflation down to very low levels have reduced investment and growth, contrary to the claim that the greater economic stability that lower inflation brings will encourage investment and thus growth. More importantly, lower inflation has not even brought genuine economic stability to most of us. Liberalizations of capital and labour markets that form integral parts of the free-market policy package, of which inflation control is a key element, have increased financial instability and job insecurity, making the world more unstable for most of us. To add insult to injury, the alleged growth-enhancing impact of inflation control has not materialized.
Our obsession with inflation should end. Inflation has become the bogeyman that has been used to justify policies that have mainly benefited the holders of financial assets, at the cost of long-term stability, economic growth and human happiness.
Thing 7
Free-market policies rarely
make poor countries rich
What they tell you
After their independence from colonial rule, developing countries tried to develop their economies through state intervention, sometimes even explicitly adopting socialism. They tried to develop industries such as steel and automobiles, which were beyond their capabilities, artificially by using measures such as trade protectionism, a ban on foreign direct investment, industrial subsidies, and even state ownership of banks and industrial enterprises. At an emotional level this was understandable, given that their former colonial masters were all capitalist countries pursuing free-market policies. However, this strategy produced at best stagnation and at worst disaster. Growth was anaemic (if not negative) and the protected industries failed to ‘grow up’. Thankfully, most of these countries have come to their senses since the 1980s and come to adopt free-market policies. When you think about it, this was the right thing to do from the beginning. All of today’s rich countries, with the exception of Japan (and possibly Korea, although there is debate on that), have become rich through free-market policies, especially through free trade with the rest of the world. And developing countries that have more fully embraced such policies have done better in the recent period.
What they don’t tell you
Contrary to what is commonly believed, the performance of developing countries in the period of state-led development was superior to what they have achieved during the subsequent period of market-oriented reform. There were some spectacular failures of state intervention, but most of these countries grew much faster, with more equitable income distribution and far fewer financial crises, during the ‘bad old days’ than they have done in the period of market-oriented reforms. Moreover, it is also not true that almost all rich countries have become rich through free-market policies. The truth is more or less the opposite. With only a few exceptions, all of today’s rich countries, including Britain and the US – the supposed homes of free trade and free market – have become rich through the combinations of protectionism, subsidies and other policies that today they advise the developing countries not to adopt. Free-market policies have made few countries rich so far and will make few rich in the future.
Two basket cases
Here are the profiles of two developing countries. You are an economic analyst trying to assess their development prospects. What would you say?
Country A: Until a decade ago, the country was highly protectionist, with an average industrial tariff rate well above 30 per cent. Despite the recent tariff reduction, important visible and invisible trade restrictions remain. The country has heavy restrictions on cross-border flows of capital, a state-owned and highly regulated banking sector, and numerous restrictions on foreign ownership of financial assets. Foreign firms producing in the country complain that they are discriminated against through differential taxes and regulations by local governments. The country has no elections and is riddled with corruption. It has opaque and complicated property rights. In particular, its protection of intellectual property rights is weak, making it the pirate capital of the world. The country has a large number of state-owned enterprises, many of which make larg
e losses but are propped up by subsidies and government-granted monopoly rights.
Country B: The country’s trade policy has literally been the most protectionist in the world for the last few decades, with an average industrial tariff rate at 40–55 per cent. The majority of the population cannot vote, and vote-buying and electoral fraud are widespread. Corruption is rampant, with political parties selling government jobs to their financial backers. The country has never recruited a single civil servant through an open, competitive process. Its public finances are precarious, with records of government loan defaults that worry foreign investors. Despite this, it discriminates heavily against foreign investors. Especially in the banking sector, foreigners are prohibited from becoming directors while foreign shareholders cannot even exercise their voting rights unless they are resident in the country. It does not have a competition law, permitting cartels and other forms of monopoly to grow unchecked. Its protection of intellectual property rights is patchy, particularly marred by its refusal to protect foreigners’ copyrights.
Both these countries are up to their necks in things that are supposed to hamper economic development – heavy protectionism, discrimination against foreign investors, weak protection of property rights, monopolies, lack of democracy, corruption, lack of meritocracy, and so on. You would think that they are both headed for developmental disasters. But think again.
Country A is China today – some readers may have guessed that. However, few readers would have guessed that Country B is the USA – that is, around 1880, when it was somewhat poorer than today’s China.
23 Things They Don't Tell You about Capitalism Page 7