Inflation is growth's enemy. So is reducing it, at least in the short run. Why, then, do countries get themselves into inflationary habits by abandoning the salutary effects of stable prices? Why do they remain addicted? And what does it take to break the habit? Orthodox medicine--or heterodox? (Orthodox measures concentrate on the budget and either money or the exchange rate. Heterodox measures add to the orthodox an incomes policy and a fixed exchange rate.)
We look here at the answers offered by a diverse body of recent Bank research (see a partial list on page 4). The studies examined episodes of moderate (low double-digit), high (high double-digit), and extreme (triple- and quadruple-digit) inflation.
Dornbusch (1992), summarizing his analysis of 23 countries, writes that in early 1991 Argentina, Brazil, Peru, Poland, and Yugoslavia were in the midst of extreme instability or at best in the early stages of stabilization. Another group of countries--including the Soviet Union, Romania, and Bulgaria--was on the verge of slipping into high or even extreme inflation. A third group had already run the course and stabilized, as Bolivia and Israel did, or had avoided the extreme experience and opted for stabilization early and decidedly, as Mexico did.
Dornbusch draws four main lessons from these experiences.
Inflation is similar everywhere. It is a mistake to believe that the problems of a particular country are their unique situation set ordinary economics aside.
Complacency is dangerous. Extreme inflation is not around the corner whenever there is a budget deficit. But inflation can easily become a habit--and from there an unstable process. Complacency has a disastrous price: society falls apart as the middle class disappears, and society is divided into those who know how to get ahead with inflation and those who fall behind.
Democracy makes hard moves harder. Political change toward a more participatory democracy has not favored price stability. Political change may carry with it the expectation of an improvement in opportunities and living standards--as with the growth of Solidarity in Poland.
Because democratic institutions do not make hard choices easy, democratic countries have almost invariably implemented special procedures to adopt and implement the hard measures needed for stabilization. The abhorrence of inflation's destructiveness may nevertheless allow stern measures that had been considered politically impossible but that are needed to rebuild confidence and stability.
Fiscal austerity is inevitable. Successful policies to combat inflation all contain the basic orthodox measure: fiscal restraint. But the desire to stabilize prices and bring budgets closer to balance does not imply that zero inflation must be achieved at any cost. Some countries use policies that accept a moderate rate of inflation because there is a steeply rising cost of disinflation. Inflation control thus has limits, discussed in the next section.
Dornbusch and Fischer (1991), summarizing their analysis of eight bouts of inflation, write that there are basically two answers. One is that inflation is integral to a country's public finance. The other is that inflation is allowed to persist because it is too hard or too costly to stop.
Too easy to print. At least since the 1920s it has been understood that printing money is one way, albeit not the preferred one, of financing budget deficits.
Thought to be relevant only to extreme inflation economies, inflationary money printing accounts for a significant portion of government revenue even in economies with moderate rates of inflation. So it is plausible to consider inflation as a conscious instrument of public finance.
Dornbusch and Fischer accept that inflation rates will be higher in countries where alternative sources of revenue are costly. But the costs of inflation, and the gradual shift away from money holding that is common under moderate and high inflation, make them skeptical of the public finance argument for moderate inflation.
Too costly to stop. A different motive for inflation comes from the observation, or at least the belief, that inflation is costly to stop.
Because lagged inflation appears mechanically as a determinant of current wage and price inflation, disinflation is costly because inflation can be lowered only through protracted unemployment.
In economies where inflation is substantial--say 20 percent a year--some implicit or explicit form of indexing wages to inflation is unavoidable. In many countries wage increases follow a regular pattern of once or twice a year adjustments, often mechanically based on past inflation. And the higher past price inflation is, the more work that unemployment has to do in bringing down wage inflation.
Dornbusch and Fischer write that for inflation to fall, there has to be a major break in the process whereby each sector, including the monetary authorities, accommodates the inflation rate of every other sector. One possibility is a change in the structure of indexation among wages, prices, and the exchange rate. Another is a new set of rules for setting the exchange rate and public sector prices.
Using the exchange rate to initiate a disinflation is very common, but a risk is overvaluation, which greatly complicates the unwinding of inflationary forces. Alternatively, a change in the wage rules might move from compensating for past erosion of the purchasing power of wages to setting wages forward on the basis of expected inflation. But if all else fails, high unemployment will have to be used to slow inflation by reducing wage and demand pressures.
Most of the countries Dornbusch and Fischer studied reached moderate or high inflation as a result of external, and particularly commodity price, shocks. Countries that remained in the moderate inflation range after arriving there--Chile and Colombia, and for a shorter time Mexico--did so only by taking decisive action to prevent inflation from rising at certain specific points. Brazil, which was not willing to slow its growth to stay in the moderate inflation range, found itself with high and sometimes extreme inflation.
Three of the countries that successfully disinflated to low inflation--Ireland, Korea, and Spain--did so at a significant output cost. Each used nonmarket (heterodox) measures, the equivalent of an incomes policy, to assist the disinflation. In Korea, wage growth was restrained through restraint over public sector wages and moral suasion of the private sector.
Each of these disinflations was accompanied by a very strong orthodox fiscal contraction. Chile and Mexico also undertook fiscal contractions to reduce high inflation to the moderate range, and Colombia to keep inflation moderate.
Indexation and disindexation appear to have been important in the Latin American inflations and disinflations. But whether disinflation is easier in the absence of indexation, or whether the absence of indexation indicates a government's commitment not to live with inflation, is difficult to say, write Dornbusch and Fischer.
Revenues from the inflation tax (seigniorage) accounted for a significant share of government revenues in most of the moderate inflation countries. These revenues, especially high at the start of most of the inflationary episodes, slowed the fiscal effort that had to be made to reduce inflation. But there is little evidence in the literature that revenue considerations were important in the inflationary thinking of any government. This may reflect a general lack of understanding of the inflationary process, or it may mean that seigniorage is rarely an explicit reason for a government to pursue inflationary policies. Dornbusch and Fischer believe the second interpretation.
Kiguel and Liviatan (1988 and 1992) sum it up thus: Countries typically find themselves in moderate or high inflations as a result of external shocks. When the next inflationary shocks hit, it takes explicit counterinflationary policies to prevent inflation from rising. Moderate inflation is not a state that economies stay in without a government commitment to prevent further increases in inflation.
Governments have successfully reduced moderate inflations to low through a combination of tight fiscal policy, incomes policy, and generally some exchange rate commitment. But there is little support for the view that an exchange rate commitment, or an incomes policy, alone allows a country to move at low cost from moderate to low inflation.
What, then, of the choice between orthodox and heterodox measures? Orthodox stabilization policies are very successful in stopping extreme inflation. The success is usually much more limited, especially in the short run, in countries suffering chronic high inflation, where inflation is downwardly rigid and persis- tent. In these countries the heterodox approach is more effective in bringing down inflation initially, although the costs of disinflation are not avoided altogether. These costs typically arise at a later stage, when the government tries to sustain the initial success as controls are phased out.
While incomes policies can do much in the high-inflation countries in fiscal adjustment programs, the heterodox approach is not recommended for stopping inflation in countries that traditionally have experienced low inflation. These countries should rely as much as possible on orthodox measures.
In short: For moderate or extreme inflation, use orthodox measures. For high inflation, use heterodox measures.
This article draws on the sources listed here.