Economist Urges Government to Reconsider Inflationary Policies

EghtesadOnline: Iranian policymakers seem to think that moderate rates of inflation make the economy perform better.

News ID: ۷۴۶۰۷۱

30 September 2018

However, a growing number of economists today believe that authorities can best promote financial stability and economic growth by making a firm commitment to maintaining price stability.

Hadi Salehi Esfahani of the University of Illinois at Urbana-Champaign is one of them. He expressed his dissent at the prevalent Iranian view in a write-up for the Persian daily Donya-e-Eqtesad on Wednesday. According to Financial Tribune, a free translation of his article follows:

Inflation has been a chronic malaise of the Iranian economy over the past 40 years.

According to the Central Bank of Iran, single-digit inflation rates have been recorded for only four years over the past four decades. Two single-digit rates, 9% and 9.6%, were posted in the fiscal 2016-17 and 2017-18 when the country managed to survive the runaway inflations of 2012-13 and 2013-14.

The other two episodes of below 10% date back to 1981-91. One was in the fiscal 1985-86, thanks to the firm grip of the then government on prices following the significant decline in national revenues and the other occurred in 1990-91, toward the end of Iran-Iraq war, an opening up of the markets and a surge in imports.

Except for these four years, inflation rates in Iran have always oscillated between 10-50%; 20%-odd on average whereas the general level of prices of goods and services in more than 90% of other countries has fallen within single-digit territory for ages–below 5% in three-fourths of them.

Economic policymakers in Iran seem to believe that inflation would become more of a concern only if it surpasses 20% and that moderate rates of 10-20% help economic growth and employment.

In actuality, whenever the growth of Consumer Price Index fell in the neighborhood of 10%, governments turned to expansionary policies that normally led to a rise in prices. Even the decision-makers of 11th government (the first term of President Hassan Rouhani), who claimed to be committed to curbing inflation, allowed the budget deficit to widen and money supply to increase as soon as the rise in the index fell below 10%.

Policymakers are not alone in cherishing moderate inflation. Some Iranian economists also argue that employment and production growth will fall below their potential capacity by keeping inflation rates below 10%.

The cases they cite to prove their claim are countries like South Korea that managed to achieve high economic growth despite their moderate inflation rates over several decades ago.

Coincidentally, whenever the Iranian governments have tried to keep inflation at bay, economic growth began to slow and unemployment started to rise. So don’t fret about moderate inflation rates; cope with it as long as they are below 20%, and whenever they happened to slip below 10%, try to push it up to spur economic growth, believers say.

Although such a notion concerning inflation–let’s call it "the appeal of moderate inflation theory"–might seem credible, it is scientifically incorrect.

The formulation of economic policies on the basis of this wrong assumption has created numerous problems.

> Overlooking Long-Term Implications

Overconcentration on short-term costs of controlling inflation and turning a blind eye on the long-term adverse effects of inflation create one of the biggest problems.

Bringing down inflation when it is high does carry some short-term benefits, no question about that, but the long-term negative effects of keeping inflation high and even at moderate rates are by far worse.

Inflation creates wider fluctuations in relative prices, exclusive of market forces of supply and demand. It reduces the clarity of signals coming from the price system, i.e. information conveyed to consumers and producers, via the price charged for a product or service, which provides a signal to increase or decrease supply or demand.

On top of that, such fluctuations in relative prices, increases the costs of long-term contracts, restricting the mechanisms to create motivation for investment and productivity through long-term “relations of production”.

Moderate inflation has more long-term after-effects on Iran’s economy. To keep the inflation within a moderate range, Iranian policymakers tend to keep the prices of some items, including foreign currency, bread and fuel, unchanged low.

The government assumes that these prices–the so-called key prices–have a significant impact on inflation and that by keeping them at fixed rates, the inflation rate would stay below 20%. In doing so, the difference between nominal value and real value of key prices gets wider and consequently more resources are wasted.

Pegging the key prices to inflation rate might seem to be the solution to this problem like pinning the changes in foreign exchange rates on the difference between domestic and foreign inflation rates. But the policy would create hyperinflation, unless inflation is curbed through tools other than controlling key prices.

Such a policy is not popular with policymakers who believe in the appeal of "moderate inflation theory" because it reduces the effect of relative prices with inflation. The interference created in the markets as a result of fluctuations in relative prices reduces the price elasticity of supply—a measure used in economics to show the responsiveness, or elasticity, of the quantity of a good or service supplied to a change in price, implying to the policymaker that changes in key prices have a bigger inflationary effect than having any impact on production.

Therefore, it is easier for the policymaker to keep key prices unchanged as long as possible and control inflation, at moderate level, through this tool.

A very costly balance would be needed when the distance between key prices and their real values reaches a critical point and then a new vicious circle begins again.

> Advantages of Low Rates

The government and central bank’s commitment to keeping inflation low and improving gross value added by 2-4% can help tackle a series of policymaking problems in Iran.

For one thing, it cuts the difference between domestic and foreign inflation to zero, there is little need for changes in key prices and it becomes easier to keep prices at their real value.

Low rates of inflation also give broader perspective for contracts and set the stage for investment growth and productivity.

The third advantage of low rates of inflation is the decline in fluctuations of relative prices and their compliance with forces of supply and demand.

In addition, such a commitment would keep inflationary expectations at their lowest levels and lessens the likelihood of price hikes. Therefore, the need for intense contractionary policies to control inflation is reduced and the economy would thrive. This is the chief reason behind remaining steadfast to the commitment of keeping inflation at low rates.

If people believe in this commitment, there will be no need for austerity measures. In fact, the economy would see high and steady growth without the need for the government and central bank to do wonders.

It should be noted that keeping inflation at low levels cannot be accomplished overnight; it needs institutional reforms in policymaking besides a better understanding on the part of the elite and the rest of the community on the destructive role of inflation.

By going down this path, Iran can expect a better economy, otherwise a wobbly growth and relatively high inflationary episodes wait in ambush to catch the Iranian people off-guard, just like before.