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February 17, 2015



The genie of inflation

The country has faced a high rate of inflation in the last ten years or so, which has affected the poor, lower and middle income classes whose hard-earned – and honest – income did not and could not keep up with rise in prices, leading to erosion in their already low living standards.
Some among them, who had the opportunity to supplement their relatively meagre incomes through illegal means or could arrange to send some members of their families for employment abroad, may have succeeded in reducing their economic hardships. But the vast majority of them has continued to suffer from sharply rising prices in silence and are at a loss to understand why no government was able to control the high rate of inflation.
The answer is very simple. The governments have been creators and not curers of inflation in Pakistan. Still worse, every government has followed a standard operating procedure in explaining price developments. Leaving aside the attempt to create an illusion of low inflation through manipulation of official price statistics, every government has attributed inflation to anything and everything other than their own unsound economic policies.
Mostly, a government would explain high inflation in terms of natural factors such as weather, floods or other disasters, attribute it to rising world prices, and hold the previous government responsible for it, or blame smugglers, hoarders and black marketers. No government will accept the truth that, in the words of Shakespeare, “the fault, dear Brutus, is not in our stars, but in ourselves”.
While blaming others – and mentioning factors beyond their control – for rising prices, governments are always ready to take credit if the rate of inflation falls even if their policies may have nothing to do with it. The most recent example of this is the PML-N government which continued to pursue expansionary fiscal and monetary policies fuelling inflation but when inflation declined recently due to a

fall in world commodity prices it took credit for it. The reduction in petroleum product prices was triumphantly announced by the prime minister and he, along with the chief minister of Punjab, stated that it reflected their deep concern for the welfare of the people and their sound economic policies. One wonders how long governments will continue to fool all the people for all the time.
There is of course a small component of inflation that may be called ‘imported inflation’. It has three parts – trend in world prices, movement in the nominal exchange rate and the level of import tariffs. The world commodity prices need to be taken as a given. But changes in the nominal exchange rate are basically determined by the government and the exchange rate can be stabilised on a durable basis if prudent fiscal and monetary policies are pursued to keep the inflation rate at par with the trading partner countries. The import tariffs are also determined by the government and they directly impact the landed cost of imports. Thus, out of the three factors determining imported inflation, two reflect the outcome of domestic economic policies.
Natural disasters, supply bottlenecks and shortages of supply of some strategic commodities may also have a temporary effect on prices. Their recurrence may indicate lack of sound planning and development strategy. But their one-time impact should wither with a return to normalcy in the supply chain and cannot be a factor for sustained high rate of inflation extended over a decade or so. Some structural factors may also play a temporary role in determining the rate of inflation at a given time due to adjustments in relative prices but are not responsible for the sustained high rate of inflation witnessed in the country in the last decade.
The real cause of the sustained high rate of inflation is fiscal mismanagement by successive governments. The country’s leaders and bureaucrats spend public money lavishly and wastefully and siphon off a part of it through kickbacks and corruption and tuck it away in Swiss banks or real estate in Paris, London, Dubai or New York. The rest constitutes wasteful government consumption at home. High current public expenditure relative to public investment is a major factor for inflation.
Superimposed on the wasteful public sector current expenditure is a taxation system that is inflationary in its impact. The government collects direct taxes from the poor rather than the rich who fail to pay their due share of income taxes and heavily relies on indirect taxes. Whatever income tax is collected comes from the salaried class and in the form of withholding taxes on small savers and on economic and banking transactions. Their incidence on prices is similar to that of indirect taxes.
The main source of revenue of the government is indirect taxes consisting of sales tax and excise and customs duties that are all passed on into prices. Add to that increases in utility prices to offset the inefficiencies in their production and theft in their distribution. These are all government made factors affecting prices.
The PML-N government has indulged more aggressively in this regressive form of taxation to avoid collecting direct taxes from the business community, landlords and operators in the underground economy. Even smuggling, hoarding and black marketing are the product of bad economic governance and political patronage of such activities.
The problem does not stop there. Government expenditure is way above tax revenue and the gap is being filled by excessive money creation. One does not need to be an economist to understand that if too much money is created to chase too few goods on a sustained basis, it translates into higher prices.
Every government since the 1980s adopted the easy route of money creation in place of taxation as a means to finance fiscal deficit. That has generated a high rate of demand-pull inflation for a long time and entrenched inflationary expectations in economic decision-making by consumers, distributers, produces and importers.
Learning from the past history of the country, legislative reforms were undertaken during 1993-97 to make the State Bank of Pakistan (SBP) autonomous so that it could control excessive money creation. But recent governments placed compliant and timid governors and deputy governors at the helm of affairs of the SBP. They then obliged the government by allowing monetary expansion beyond the safe limits regardless of the statutory provisions of the revised SBP Act. This is evident from the fact that money supply increased at 3-4 times the rate of increase in supply of goods and services in the last decade or so and has been the dominant factor for inflation in Pakistan.
The finance minister and the SBP governor should realise that the genie of inflation cannot be put back in its bottle on a durable basis without the pursuit of prudent fiscal and monetary policies. They should listen to Gottfried Haberler, a great economist, who had stated long ago that “there is no record in the economic history of the whole world, anywhere or at any time, of a serious and prolonged inflation which has not been accompanied and made possible, if not caused, by a large increase in the quantity of money.”
They should also read a book on central banking written by Steven Solomon, a financial journalist, wherein he stated that “a separate, independent central bank that functioned as a ‘supreme court’ over money was still democratic capitalist society’s most pragmatic political means of depoliticising the partisan struggle for the control of money, and for providing the long-term monetary soundness necessary to maximising economic wealth production”.
The writer is a former governor of the State Bank of Pakistan.
Email: [email protected]