Why government policy to control inflation at 5% under whatever circumstances is misguided
THE LAST WORD | Andrew M. Mwenda | A fetish is an inanimate object (like a small stone or wood curving of something like an animal) that is worshipped for its supposed magical powers. That is what controlling inflation in Uganda has become. It is a deeply held policy conviction of the Uganda government that inflation must never exceed 5%. Once it goes beyond that proverbial number, then all hell has broken lose and fears that the economic growth will be harmed run wild. It is a policy orthodoxy that is picked right from the IMF handbook and has become almost like a religious creed whose violation is sacrilegious.
There are many other negative effects of inflation that I do not need to belabour here. However, let us remember that our government accepts some inflation – its policy stance is that it should not exceed the proverbial 5%. Therefore, what inflationary rate is bad inflation: 6%, 10%, 20% or 40%?
Debate on inflation (like debate on corruption) is based on axiomatic faith rather than available evidence. Today, it does not matter how much evidence is adduced to demonstrate some double-digit inflation living side by side with impressive rates of GDP growth – and in fact leading to structural transformation. The high priests of economic policy will continue to recite the gospel according to saint IMF that inflation, all inflation, is bad for economic growth. So regardless of circumstances, macroeconomic stability (control of inflation) will be number one priority.
William Easterly (a professor of economics at New York University and a former economist at the World Bank) and Michael Bruno (a former Chief Economist of the World Bank published a paper in 1995 titled Inflation Crises and Long-Run Growth. After studying inflation across decades in many countries in different parts of the world, they concluded that inflation below 40% was not necessarily injurious to long-run growth and that below 20%, higher inflation seemed to be associated with higher growth.
Michael Spence, a Nobel laureate in economics published a book titled The Next Convergence. In it, he shows that between 1950 and 2000, only 13 countries in the world sustained an average annual rate of GDP growth at 7% and above consistently over a period of 30 years. Why 7%? Economists and statisticians have something called the Rule of 72. This rule states that if anything under measurement grew at an annual average rate of 7% per year, it would double every ten years. So, if you want to know whether your country is being successful at economic management, apply this rule.
Anyway, among the 13 economies that Spence recorded with high rates of GDP growth were Brazil and South Korea. Brazil’s period of high growth was in the 1960s and 1970s when annual average GDP grew above 7% while per capita income grew at an annual average rate of 4.5%. What was the average rate of inflation over those same years? A whole 42%. However, between 1996 and 2016, Brazil tamed inflation at 6% but its per capita income growth over the same period averaged 1.3%.
South Korea perhaps illustrates this point best. During its intense period of transformation from a peasant economy to a modern industrial society (1960 to 1990), South Korea’s GDP grew at an annual average rate of 9.4% while per capita income growth averaged 7%. Remember the Rule of 72? South Korea was doubling per capita income every 10 years. During this same period, inflation averaged 20%.
Meanwhile, between 1992 and 2022, Uganda’s inflation rate has averaged the proverbial 5%, but per GDP growth over the same period has averaged 6.5% and per capita income growth has averaged 3.2% – less than half of South Korea.
Now, I am not suggesting that Uganda government should not care about inflation. As I have already stated above, there are many harmful consequences of inflation. However, these harmful effects have to be placed in context. It is not correct to make control of inflation at 5% a rigid macroeconomic principle that should never be violated under whatever circumstances. Inflation interacts with many other variables to produce growth outcomes.
For instance, the government of Uganda has stated that a significant source of our current inflationary pressures (I would like to know what percentage) is caused by factors beyond our borders – that is to say, it is imported inflation. In the first quarter of this financial year, Uganda government withheld Shs4.0 trillion from spending and the central bank bought treasury bills and bonds worth Shs2.0 trillion in order to control inflation. At a fiscal level, ministries and other government agencies were literally starved of funds to perform basic functions in delivering public goods and services in a religious crusade to control inflation.
But then I wonder, how does tight fiscal and monetary control influence prices of goods that are imported? Besides, has someone calculated the effect of this obsessive desire to control inflation on the economy?
So many businesses that supplied government are not being paid yet an economy is a circular flow of income: one person’s expenditure is another person’s income. Government is a big spender. When it withholds money, its effects reverberate in the entire economy at a gigantic scale. Is it not possible that in seeking to control inflation we could be undermining growth?
Some form of high inflation may be inevitable in a dynamic economy. As South Korean born Cambridge Economist, Ha-Joon Chang, has argued in his book, Bad Samaritans, prices change because the economy changes. It follows therefore that prices rise in an economy where there are many new economic activities creating new demand. In such circumstances, a religious pursuit of lower inflation may protect the wages of existing workers but at the price of undercutting the stimulation of those economic activities from which they can earn a higher wage in future; and even create jobs for so many other people who are unemployed.
Uganda’s tight monetary and fiscal squeeze today is reducing economic activity. Consequently, many firms that supplied government and are not getting paid are laying off workers. Many others cannot hire people to expand because government is constraining demand. This is not good for all workers (employed or looking for jobs) or in expanding economic activity generally. The beneficiary is the financial industry whose earnings depend on financial assets with a fixed return. The policy obsession with controlling inflation at all costs is therefore not a neutral interest-free prescription. It is based on power: those who influence the thinking at the IMF are also the ones that profit from low inflation.