Economic inflation

Name(s):

Overheating of economy

Vulnerability of countries to inflation

Nature

Inflation is an unacceptable decrease in the purchasing power of money, as measured by an accepted general price index. Not all increases in the general price index can be usefully labelled as inflationary, particularly when the increase over a period of months or years is relatively small. The term is usually reserved for larger increases, especially when they continue unchecked. Precise definitions are however lacking, although a general price increase of less than 1% per quarter is often considered as 'creeping' inflation. An increase of 50% per month is termed 'hyperinflation'. Although there is agreement on the general meaning of inflation, disagreement remains on how it is to be measured: which price level should be used to measure the purchasing power of money; what allowance should be made for innovations; whether both official and black market prices should be considered when the latter exist; whether prices should be gross or net of subsidies and sales taxes; and how price rises following disasters should be considered. Inflation is also a condition of generalized excess demand for stocks of goods and flows of real income, in which 'too much money chases too few goods'. It is also a rise of the money stock or money income in a society, either total or per capita. Other concepts of inflation also exist.

Background

Historians have found traces of inflation at least as far back as the Roman Empire. From the time of Nero, the silver denarius and the gold aureus were tampered with, debasing its value and helping to wreck the economy. Later when other kings and emperors again sponsored metallic money, usually gold and silver, a common device was to clip the edges of coins so that a larger number could be minted from the same amount of metal. This worked until the populace caught on the and effect of more coins in circulation reduced the value of each in the marketplace. Paper money was introduced from China by Marco Polo to Europe and generally it was redeemable for coin. However during the 1920s, this was perceived as a hindrance to economic progress and governments received discretionary powers of control. Governments needing funds for reparations and rehabilitation simply printed the money required. Once started the inflationary spiral was accelerated by the general loss of confidence and the preoccupation with speculation rather than production. In Germany in 1923, the price level in terms of pre-war marks had risen thirteen hundred thousand million marks. The postage on an ordinary letter cost 100,000,000,000 marks. This hyperinflation is exceptional. Since World War II, the western industrial world has witnessed an unbroken rise in prices and money incomes, as yet without major, 1929-type, panics and without erosion of accepted business procedure. In some countries like Argentina and Israel, however, inflation in the mid-eighties reached the 400% level, bringing back the spectre of hyperinflation. The possibility of having a stable world-economic environment of low rate, creeping inflation, with islands of hyperinflation within it is unlikely, even though a recent ILO survey (comparing prices for December 1984 with those of December 1983) shows inflation to be on the decline worldwide.

Incidence

For industrialized countries as a group inflation dropped from a peak of 9.4% in 1980 to 4.8% in 1983 and declined further to 2.9% in 1987. In the developed countries represented within the OECD, whenever the general price level is rising by 5% or more, prices go up even in industries where productivity gains are well above average. Under these conditions, everyone is likely to become much more conscious of inflation. There is a general feeling of insecurity, and everyone tries to obtain priority for their income claims. An increase in inflationary expectations was clearly apparent in the acceleration in the collective bargaining cycle, the swelling demands for wage and other kinds of indexation, and the persistence of historically high interest rates. In the seventies and eighties 'double-digit' inflation appeared. Inflation feeds on itself, and unless and until people become convinced that over the longer run prices are going to be significantly more stable than they have been in the recent past, there is a clear danger that the whole process will gradually accelerate.

Contractual arrangements between borrowers and lenders, which can be modified to mitigate the adverse economic effects, pass the burden of price increases to others and make inflation increasingly difficult to control. It takes a long time before interest rates, contractual arrangements, pension schemes, etc, catch up with a given rate of inflation. The lags may be as long as 5, 10 or even 20 years, and thus there will always be distortions and inequities, the more so if the rate of inflation is accelerating. In particular, money rates of interest generally lag behind price rises thus stimulating excessive indebtedness and inefficient allocation of resources. Further, with high rates of inflation there must be much uncertainty as to what exactly the price rise is likely to be over a number of years, and this uncertainty will distort and inhibit long-run lending and investment decisions. It would therefore be quite wrong to conclude that, because the economic costs of inflation in the past have not been readily apparent, they could not quickly become considerable if the gradual but inexorable rise in inflationary expectations were to continue.

The social and political consequences of continuing inflation must also give great cause for concern. They are not easy to pin down because the impact of inflation on individuals and groups is extremely haphazard. Also, under inflationary conditions, income gains and the accumulation of wealth often appear to result not so much from work or sacrifice as from ingenuity and the exercise of economic and political power and influence. Resentment against inflation is incoherent and diffuses through the community. It therefore tends to strengthen other forces making, for disenchantment with government and existing political parties.

[Developing countries] The process of development in the majority of countries is accompanied by continuous inflationary pressure, translated, more often than not, into open and protracted inflation. In part this is because the growth process is driven by the aspiration of the masses to improve their standard of consumption, thus prompting governments to assume entrepreneurial functions and to encourage private entrepreneurs to embark on development schemes that offer a promise of future increases in consumption. The consumption habits of richer economies are adopted by developing countries without corresponding improved production techniques, thus resulting in smaller saving potential.

Further, the adverse consequences for the developing countries of inflation in the developed areas cannot be ignored. The impact of inflation and high interest rates on the net foreign exchange earnings of the developing countries, and on the value of aid and the cost of borrowing in real terms, is difficult to assess. But it is quite clear that successive periods of over-expansion followed by contraction, in the developed countries, greatly complicate the task of economic planning in developing countries. And it is evident that the volume and quality of development assistance has suffered from the fact that donors have so often been preoccupied by problems of domestic inflation, and the consequent balance of payments and budgetary difficulties.

Inflation rose to 1.3% on an annualized basis in the 15-nation European Union in 1999. Inflation was lowest in France and Austria (0.8%) and highest in Ireland (2.8%).

Counter-claim

1. The desire to continue to enjoy the benefits of economic growth, coupled with the difficulty of reconciling this with reasonable price stability, raises in an acute form the question of how much inflation really matters. Post-war experience shows that some economies may learn to live with moderate inflation and that in fact rising price levels provide a stimulus to the more productive segments of the economy, spurring profits, rewarding those factors most mobile and innovative, and penalizing the lethargic non-adaptive elements. Inflation is particularly necessary in the developing countries since there is no feasible alternative for financing the investment necessary for economic growth. Inflation provoking a redistribution of income in favour of profits and economic growth is often a necessary complement in developing countries. Increases in aggregate demand must result in increased prices because of structural bottlenecks in foreign trade, transportation, materials and food.

2. Governments have clung to the monetarist promise that low inflation is the precondition for job creation. With inflation in the industrialized world at a 25-year low in 1993 and unemployment at a post-war high, it increasingly appears as though low inflation is in fact the cause and result of high unemployment. The UK's unemployment rose by over 1 million in the two years (1990/91) during which inflation was more than halved (9.1 to 4.2%) Disinflation, such as experienced in the USA in 1985, led to a drop in economic growth. The restructuring of businesses to allow for low inflation promotes fluctuations in prices which are independent of government economic policy and continue after pressure to reduce inflation is removed. Because return on tangible assets is depressed, investors sell such assets to buy high-yield securities and induce a wave of debt crises.

Narrower

Hyperinflation

Export of inflation

Repressed inflation

Prohibitive labour costs

Reduces

Obsolete deliberative systems

Aggravates

Unemployment ^{[in 5 loops]}

Excessive costs ^{[in 7 loops]}

Food insecurity ^{[in 3 loops]}

Unbalanced growth