Could Inflation Stabilization Be Expansionary?

by Michael Bruno and William Easterly

Many former socialist countries have recently experienced both a decline in output and high inflation during the transition to a new economic system. Some governments in these countries have been reluctant to pursue a vigorous inflation stabilization policy because they fear that stabilization could shrink output even further. Their concern derives from the well-documented experience of industrial countries. In the United States, for example, the deep 1982 economic contraction has been linked to inflation stabilization by U.S. Federal Reserve Board Chairman Paul Volcker, who eliminated the double-digit inflation rate that had accelerated during the Carter administration.

Does Stabilization Hurt

Recent evidence suggests a surprising twist: stabilizing from high inflation is not necessarily contractionary, and it may even be expansionary. Stabilization in Argentina, Brazil, and Peru brought rapid output growth once inflation dropped to moderate levels. And development in transition economies, such as Poland, Slovenia, and the Baltic states, seems to fit the pattern of expansionary stabilization as well.

How could stabilization from high inflation be expansionary? It is not so hard

to understand if one considers, how much output usually falls during high inflations. We summarized the average growth rates and inflation rates of twenty-six countries that had episodes of high inflation over the period 1961-92. (An episode of high inflation is defined as a period of two years or more in which inflation exceeds 40 percent annually.) The following table shows that per capita growth is negative during high inflation crises, but after stabilization growth recovers strongly.

Recent theories of inflation have focused on the destruction of the normal functioning of the price and credit system during high inflation periods, confirming what Keynes suggested long ago: "As inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundation of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery."

Countering Conventional Wisdom

But negative growth during inflation may be peculiar to massive price increases. At low rates of inflation the economy may be stimulated in the short run through inflationary demand expansion, so that inflation and growth increase together. Or a favorable external development, such as a fall in oil import prices, could simultaneously slow inflation and accelerate growth. Indeed, there is little evidence that low-to-moderate rates of inflation have any consistent relationship to output growth, positive or negative. In contrast, the negative growth outcomes associated with high inflation are remarkably consistent across time periods and across different samples of data.

Once one accepts that high inflation is associated with output collapse, it is not so surprising that a fall in inflation is associated with rapid output recovery. We analysts of economic data often forget that one way to have rapid growth is first to have rapid decline. This is indeed what we find in looking at the average growth rate of the twenty-six countries, once they have overcome their inflation crisis. After the crises, the average growth rate climbed higher than before the first crisis; output rapidly recovered from its inflation crisis low, and caught up with the pre-crisis trend. These growth recoveries are not just short-lived consumption booms-previous research has suggested that such consumption booms sometimes occur with exchange rate-based stabilization-because the growth recovery lasts over the medium run.

Again, this pattern contrasts with a low inflation scenario, for which there is clear evidence that reducing already low rates of inflation is associated with lower growth in the short-to-medium run. Of course, not every country with high inflation recovers immediately after stabilization begins because country circumstances differ. But, on average, countries that reduce high inflation start to recover once inflation comes down.

Conventional wisdom also holds that inflation stabilization is political suicide. But the conventional wisdom again seems to be false under high inflation: Menem in Argentina and Fujimori in Peru were recently reelected by surprisingly large margins after political campaigns in which they trumpeted their inflation stabilization achievements.

The averages shown in the table above do not include the transition experience of 1990-94 in Central and Eastern Europe and the countries of the former Soviet Union. The transition economies are of course special in many ways. Yet their inflation and growth experience fits the larger pattern. Figure 1 shows the average growth and inflation rates of transition economies over 1992-93. Economies that still had very high inflation continued their output decline; economies that had already brought inflation to lower levels experienced higher growth than before.

Figure 2 shows the same pattern in the year-by-year experience of five transition economies that successfully brought down inflation to more moderate levels: Estonia, Latvia, Lithuania, Poland, and Slovenia. The growth of each economy declined while the inflation rate was rising. When inflation was reduced, the growth declines were reversed. By 1994 all five economies had positive per capita growth.

Growth after high inflation stabilization has a broader historical precedent. It is often forgotten that three of the legendary East Asian success stories-Japan, the Republic of Korea, and Taiwan, China-began their rapid growth in the wake of stabilization of high inflation during severe postwar crises. Indonesia followed the same pattern a few years later. Two of the fastest-growing industrial countries-Greece and Italy-also began rapid growth after stabilizing the high inflation that accompanied postwar crises. These countries not only caught up to their precrisis (or prewar) trend, but kept growing faster.

Was Lenin Right?

The historical examples seem to illustrate a principle set out by Mancur Olson: long-run growth can actually be higher after crises, because crises destroy the power of interest groups that block salutary reforms. The countries in our historical examples put into place institutional reforms that enhanced macroeconomic management-such as central bank independence and limitations on government borrowing-and they committed themselves to compete in the global marketplace.

Although it is clear that growth is recovering in the more recent stabilization examples, it is much too soon to tell whether long-run growth acceleration has taken place. As in the historical precedents, many of the Latin American countries recovering from high inflation utilized the crisis atmosphere to put into place more fundamental reforms, including central bank independence and increased integration into international trade. Time will tell whether they too experience sustained higher long-run growth.

For the transition economies stabilization of high inflation could also provide an opportunity to put in place the foundations of rapid growth for years to come. Keynes attributed to Lenin the view that "there is no subtler, surer means of overturning the existing basis of society than to debauch the currency." The existing basis of society has indeed been overturned in many postcommunist economies. In Russia and other transition economies today, a new basis of society could be laid by stabilizing debauched currencies and beginning growth anew.

Michael Bruno is Vice President (Development Economics) and Chief Economist of the World Bank.

William Easterly is Principle Economist of the PRD Macroeconomic and Growth Division of the World Bank.

The article is related to the author's forthcoming working paper "Inflation Crises and Long-Run Growth," July 1995, 30 p.