The high inflation-high growth paradox

I was with this group of undergrads who had picked up the idea that it was better for a developing country to pursue a high-inflation-high-growth strategy rather than long-term growth supported by price stability.

“So and so delivered a guest lecture at the uni,” one said mentioning the name of a renowned academic. “He said that price stability is a luxury for a developing country without a proper capital market and a primitive private sector. So, governments have to do everything regarding economic development and inflation is one of the supporting instruments.”

“That argument was very popular after the Second World War even in developed countries,” I said. “But, now everyone has realized its folly and it’s no more in vogue.”

“But, he had a point,” one of the students argued. “Developing countries need basic infrastructure for continuous development and the private sector cannot provide it. So, governments can fill the vacuum by funding them. Hence, inflation is the inevitable cost, but is paid back by immediate high economic growth.”

I felt that the students were more desirous of having their point confirmed than seeking the truth. Hence, I thought of pursuing a different approach. “How did he say that the government should fund these capital expenditure programmes?” I asked. “By having deficits in the budget and borrowing to finance those deficits.” “That’s the issue” I said. “They may borrow from the people. Then, it denies resources to the private sector and its growth is stunted. If they borrow abroad or from the central bank, new money will have to be issued. That money increases the money income of people who now want to consume more. Since goods are not produced immediately, the shortages will raise prices and inflation sets in. If goods are imported to meet the demand, the ensuing foreign exchange shortages lead to the depreciation of the currency. So, we have temporary economic growth coupled with rising prices and falling exchange rates. Now the question is whether this temporary growth can be sustained and continued.”

“But the high growth ensures high living standards. So, all are now better off,” A student pointed out. “Those high living standards will not be permanent unless we have continuously high economic growth. With inflation, that cannot be attained,” I said. “Why not?” they asked. I continued, “Inflation, however much it’s mild, is bad for everybody except for those whose income rises faster than inflation. Then, people would find that they are having a bigger money income, but, day by day, they feel that they’re poorer in terms of the goods and services they could afford to buy. When people are beaten by inflation they look at only the near term and avoid doing things that would benefit them in the long run. This psychology continues to pervade the private sector and its result is that investments needed for long term growth get discouraged.”

“But the lesser growth in the output of the private sector could be compensated by a continuously high investment by the government,” one student said presenting a new point. “Governments like other entities will soon find that they can’t continue to borrow because they reach their borrowing limits. At that stage, they have no alternative but to borrow abroad or get the central bank to issue new money to fund government expenditure programs.

This will worsen the inflationary situation. If money is issued more and more, it would lift the country from a mild inflation to high inflation. Then, inflation becomes self-propelled by higher inflation expectations formed by people. High inflation also puts pressure on the exchange rate to fall. Once inflation degenerates to hyper-inflation, the central bank will have to adopt the strictest monetary policy measures. It involves curtailing credit and raising interest rates. Both act to stifle economic growth and the initial high growth now becomes something in the past.”

“Do you say that governments can’t promote economic development?” one student queried. “I don’t mean that,” I answered. “Governments can still contribute to economic development, not by raising inflation, but by creating a suitable environment for economic growth to take place continuously. That’s by reducing inflation to a very low level so that people would think that inflation would not adversely affect their behaviour. Then, people would take a medium to long term view of the economy and raise investments voluntarily. It contributes to sustainable high growth.”

“Has any country been successful in raising economic growth by ensuring low inflation?” the group asked. “There are plenty of countries,” I replied. “Singapore is the best example. In fact, they openly declared that money cannot produce prosperity. So, they didn’t allow the government to print money and undertake capital expenditure programmes. The result was miraculous. Within a matter of 25 to 30 years, Singapore managed to uplift itself from a poor country to a developed country. Another example is New Zealand in 1990s. Now of course European Union countries and Australia also have joined the bandwagon.” “So, what’s the secret of continuous high economic growth?”

“Low inflation and hard work by people” I replied. “So high-inflation- high growth strategies are simply temporary boosts to economies which can’t sustain themselves. They’re not two pals who can bed together.”