The real record — inflation (continued)

For those coming in late, even though inflation has risen under the current government (Chart 1), real GDP per capita has grown by around 4½ per cent a year under successive governments over the past decade.

Over the last couple of weeks, I have had a bit of correspondence about inflation. This post answers some of the questions.

The first question posed is — why is inflation a problem if income has risen fast enough to compensate for it?  Recall, real GDP per capita — that is, income after inflation is accounted for — has been growing by 4½ per cent a year.  So, the question, what difference does it make if inflation is 5% or 10%?

A simple answer is, inflation is a problem because people think it’s a problem.  That might sound like a flippant answer, but it’s not.  Inflation matters because it affects people’s decisions about the future.  If inflation was steady at some rate, say 7%, and people knew that it was going to be steady at 7%, that would not be a problem.  Whether it’s a firm deciding on a new investment, or workers negotiating payrise, or families deciding how much to save for children’s education — if people knew that inflation would be 7% (or any other rate), they would make their decisions accordingly.  The problem is, the higher the inflation is, the harder it is to keep it steady.  That’s why economists counsel low and steady inflation.  And while there are many issues where the economists’ prescriptions can seem at odds with popular perception, or even common sense, when it comes to inflation, economic theory and the common sense are on the same side.

There is another reason why high and unsteady inflation matters, even if real GDP growth remains steady.  While economic growth can come about for many reasons, some (many) of which not having anything to do with government policies or actions, persistently high and unsteady inflation is almost always because of failures in economic policy making.  Persistently high and unsteady inflation also puts the economy at risk of economic crisis, with all the human costs such crises entail.  That’s why, when comparing economic records of various governments, inflation is perhaps a more appropriate metric than economic growth.

Note the qualifiers “persistently high and unsteady” and “almost always” — it’s possible that sometimes a spike in inflation is beyond the control of any government.  This leads to the second question I have been asked: how much of the recent inflation is because of global food prices?

As Chart 2 shows, global food prices rose sharply in 2007-08, declined a bit in 2009, and then rose again in 2010.  The 2007-08 global food price rises came as a surprise to most policymakers around the world, including Bangladesh.  The causes of that rise were primarily global, as was the decline in 2009.  That year’s fall in global food prices was a result of the Global Financial Crisis.  As that crisis ended, it was predictable that food price would gradually return to pre-crisis levels.  And that’s what happened.  Can the Bangladeshi policymakers be excused for not being prepared?

The 2010 rise in global food prices should have been anticipated by the government.  And global oil prices showed the same pattern, which should have also been anticipated when the government set the plans for the rental power plants.  Evidently, this is clearly not something the government did.  Let me quote MA Taslim, a Dhaka University professor and one of the best commentators on Bangladesh economy:

Economic management is widely believed to be the weakest link of the government. However, the ineptness with which the electricity issue has been handled is simply mind-boggling. The government seemed to have embarked on the rental plant road without a clear idea about its finances, logistics and consequences. For example, the government now claims that the blowout in subsidy is due to unforeseen increases in the prices of petroleum products and not due to policy lapses.

It seems absurd that the government could have planned (in 2009 say) on the basis of current prices, which were clearly very low in the aftermath of the most severe worldwide recession since the Great Depression (see the chart below). Even a cursory glance at the graph of the monthly crude oil price would have revealed that except for an abnormal period of about 18 months in 2008 and 2009, there was a clear upward trend since the beginning of the millennium. Interestingly if one drew a trend line with the price data of 2002 to 2007 and then extended it up to 2012 to get the forecast value he would have arrived at a number that is very close to the actual price. Hence, the future price increases should have been anticipated and hedged against.

The government’s electricity record is something I’ll leave for another time.  For now, let’s accept that electricity is important, and put aside the question of whether subsidies are appropriate.  The relevant issue for us is, how the fiscal blowout caused by the mistaken fuel price assumption and the subsidies were paid for.  In late 2011, when the full fiscal cost of the rental power plants was becoming apparent, the government resorted to borrowing, including from the Bangladesh Bank (Chart 3) — that is, printing money.  This directly pushed inflation up, and put Bangladesh at risk of a crisis.

When a central bank ends up printing money to pay for ill-conceived government programmes, it means trouble.  When Mr Atiur Rahman was appointed the Bangladesh Bank governor, this blog was about the only place where this risk was raised.  It’s a call I would like to have gotten wrong.

Under Mr Rahman’s stewardship, and with full ‘encouragement’ of the industry and finance ministers, Bangladesh Bank pursued expansionary monetary policy in the first half of this government’s term (Chart 4).

Credit to private sector grew sharply in 2010-11.  The thinking was that Bangladesh needed more private sector investment if economic growth was to rise  to 8% (from 6% pace we have had for a decade now).  Right diagnosis.  Wrong prescription.  Private investment has been held back by infrastructure bottleneck and poor governance.  Unless these issues are tackled, pumping credit and money into the economy would only push up prices — of goods as well as assets (the stock market bubble under this government is subject of another post).

That is, not only did the Bangladesh Bank’s acquiescence to the government’s faulty fiscal projections cause inflation, the Bank’s own policies also contributed to inflation.

And there is another way the Bank’s policy inactions contributed to inflation.  As I’ve said many times before, the taka-rupee exchange rate is a key determinant of rice prices in Bangladesh.   Bangladesh Bank, and the government, should have anticipated that as taka depreciated against the rupee, rice prices would rebound in 2010.  The policymakers proved to be oblivious.

As it happens, inflation has subsided in the past year and a half, even as the economy has continued to grow at a robust pace.  This answers another question I have been asked — does high inflation necessarily accompany fast growth.  No, it doesn’t.

So, why has inflation subsided?  Because, under the conditionalities of the $1 billion IMF loan, government has reigned in expenditure, and the Bangladesh Bank has curbed credit and money supply growth.  The IMF prescriptions have tamed inflation, at least to some extent.

One hears a lot about the spirit of independence these days.  It seems to me that at least as far inflation under this government is concerned, our ‘pro-independence’ policymakers proved to be pretty incompetent, and the IMF-dependent policies actually worked.

So much for independence then.