The Inflation v/s Growth Debate

Titbits

As slipping growth accentuated recently, the Ministry of Finance (MOF) and the Bank of Mauritius (BOM) have found themselves increasingly at odds and the MOF looked to the Central Bank to reduce interest rates to provide a fillip to growth. The view that the MOF is for growth and that the Central Bank is obsessed with price stability is a simplification. Similarly, reference to policies of central banks across the planet and their “forward guidance” strategy to try to justify one’s pro-growth position is illogical and absurd.

The situation is very different in these economies. Many of these fiscally constrained economies are in a liquidity trap with interest rates at or near zero, high unemployment, unsustainable debt and low inflation and low growth. Political debate has moved on from the need for fiscal stimulus to the recognition that fiscal deficits have grown substantially and need to be reduced. Policy makers are again facing a dilemma. Should governments be spending more if there are concerns about the effectiveness of fiscal stimulus?

Indeed, five years after the global crisis erupted, the world is seized by a debate between fiscal austerity and fiscal stimulus that shows no sign of disappearing any time soon. Billions of euros and dollars have been spent on so-called recovery packages, and central banks are engaging in a robust agenda that would have been unrecognizable just a few years ago — cutting interest rates and pumping more money into the economy to overcome the economic crisis, quantitative easing, macro prudential monitoring and asset market support. Transmitting the fundamental tension pitting austerity/fiscal adjustment against growth as reflected in the G20’s current policy to the local context is indeed ridiculous. Our specific condition has been missed by analysts and the crisis has consequently been misdiagnosed. Is it any surprise that remedies proposed are less than appropriate? Mauritius is not Greece 2010; our public finances are not unsustainable. The Mauritian debt picture is nowhere close to being unsustainable. Its external indebtedness ratios are low and foreign reserves are reasonable enough to cover short-term obligations. Critically, the rupee has been floating and has avoided significant over-valuation. The deterioration in the current account has coincided with the period of slowing growth; the somewhat weak infrastructure has depressed private investment but it has been compensated by large capital inflows mainly in the real estate sector. Thus we need not be subject to stern austerity because we do not have a fiscally unsustainable situation like Greece. Even mild austerity will have deleterious effects on growth, on the fragile private sector balance sheets and on financial stability which is increasingly threatened by rising non-performing assets in some banks.

In sum, Mauritius’s economic situation is quite different in its combination of slowing growth, low budget deficit, medium inflation, a weak external situation and mildly appreciating currency. It needs to carefully craft its own unique policy mix.

The Right Policy Mix

There has been a call for “fresh thinking” on macroeconomic policy that goes beyond the pointless debate on inflation v/s growth. Mauritius needs to either loosen its fiscal policy or reorder its expenditures to revive growth supported by a more accommodative monetary policy based on the premises that the excess liquidity in the system is controlled, and that inflationary pressures are contained. The MOF has failed miserably in its ability to reorder its existing expenditures in favour of more targeted expenditures that help build diversified productive capacity for the future. At the very least we would have expected a neutral fiscal policy stance or as recommended by the IMF, a positive discretionary fiscal impulse of 0.5% of GDP focused on specific growth-supporting interventions. Instead, as we see in Tables I and II, that the fiscal policy stance was rather too conservative as from 2011.

Table I

As % of GDP	2010	2011	2012	2013 (E)
Consolidated Budget Deficit (inclusive of special Funds)	-3.0	-2.1	-2.2	-2.5

Source: IMF
(The estimates (E) for 2013 are based on the actual expenditure on the acquisition of non-financial assets as at June 2013 which is a mere 30% of the total earmarked capital expenditure.)

Table II: Central Government Finances

As % of GDP	2010	2011	2012	2013 (E)
Structural Primary Balance	0.4	0.9	0.8	0.8

Source: IMF

For the past six years, the MOF has had a poor track record on capital spending. The implementation rate for capital projects remains abysmal. Despite high allocation year in year out, execution has been poor; it has been unable to remove the structural hurdles to investment, especially in physical infrastructure, and address the underlying causes of implementation delays such that today the country faces an enormous infrastructure deficit and key constraints in the water, electricity and transport sectors. In each of these sectors assistance is now being sought, after six years of dilly-dallying, from development partners to plan, assess and implement projects. Table III on expenditures from the National Resilience Fund (NRF), one of the Special Funds outside the budget, is just one such example that shows the incapacity of the MOF to overcome the implementation capacity constraints.

Table III

National Resilience Fund (NRF)	2011	2012
Amount earmarked (Rs million)	4,378	7,765
Amount spent (Rs million)	660	777

Source: 2013 Budget documents

Thus, with an appropriate fiscal policy response, the economy would have been more resilient. By appropriate fiscal response, we mean it to include: (1) specific growth supporting measures that recreate the economic foundations for global competitiveness and develop valuable sectors that are truly competitive in the global market place – those structural reforms that would generate productivity improvements to restore the economy’s competitiveness and reduce the current account imbalance; (2) a more reformist agenda aligned to a better targeting of social spending, reduction of those subsidies that do not necessarily benefit the needy and efficiency gains for public enterprises, and (3) investments in public infrastructure, services and human capital to remove bottlenecks, meet the increasing needs of the emerging sectors and of a modern economy.

Inflation Risks

Casting aspersions on the dogged professionalism of the BOM in an increasingly politicised environment seem to be a feeble attempt to transfer the blame for one’s failed policy making over the past several years. Controlling inflation and ensuring financial stability are the core accountabilities of a central bank, ones on which it should reasonably expect to be judged. The BOM has earned its credibility in its relatively lonely crusade of achieving its price goals by nipping inflation in the bud and anchoring inflationary expectations.

Thus it is undeniable that the current monetary policy stance has delivered low and stable inflation and it is understandable that it will continue with such policies as long as inflationary pressures persist. Most of the forecasts show that inflationary pressures are expected to prevail in 2013. The MOF itself has assumed in its medium term macroeconomic projections that inflation would shoot up to 6%. In its 2013 Article IV documents, the IMF is also expecting a pick up in inflation in 2013 as a result of the recent wage increases and possible spill over to the private sector and adjustments in administered prices. Moreover, the inflation expectations survey conducted in May 2013 has forecast the y-o-y inflation for 2013 to be within a range of 5.3-5.8%.

* * *

Weak Monetary Transmission Mechanism

The need for close coordination between monetary policy and fiscal policy has been brought out more than ever by the crisis. As we have seen, fiscal policy failed to deliver on its expected role to revive growth, how about monetary policy? It seems that it equally failed to support growth. And we are not surprised when the Governor of the BOM acknowledges that the 100 basis point cut in the repo rate in September 2010 or the 250 basis points reduction between September 2008 and March 2009 were ineffective.

Based on the study carried out by Tsangarides (2010), “Monetary Policy Transmission in Mauritius Using a VAR Analysis,” IMF WP/10/36, the IMF has noted that monetary policy is ineffective because of the absence of policy interest rate pass-through to other interest rates, and it has a statistically insignificant impact on output. The lack of pass-through is attributed largely to the excess liquidity in the banking system and the bottlenecks and structural problems in our financial markets. The asymmetries of monetary policy in conditions of excess liquidity and business pessimism due to weak external demand render the effects of expansive policies less certain. Investment may remain stagnant in response to easier monetary conditions, i.e., lower interest rates. Monetary policy in these situations is like pushing on a string.

Effect of PRB Awards on Inflation

According to the econometric analysis carried out by MOF, the PRB effect on inflation turned out to be insignificant. There are indeed reasons to believe that impact of PRB could have been dampened by, for example, household debt and the impact of the lower prices of globally traded goods which declined for the third consecutive quarter since their historical peak in August 2012.

But we have to be careful about our assumptions on permanent, transitory income or net present value of expected future labour income. The PRB does more than just re-establishing the loss in purchasing power of public officers. And it is erroneous to assume that most civil servants believe that their increase in income is transitory.

In a new book, ‘Never Let a Serious Crisis Go to Waste: How Neoliberalism Survived the Financial Meltdown’, economic historian Philip Mirowski points to the fact that much of economists’ authority stems from their claims to insight into which policies will make people better off. Those claims arise from core theorems of mathematical economics, which in turn depend on some wildly implausible assumptions, such as the idea that people are perfectly rational and make decisions with full awareness of all possible futures. However if economists used more realistic assumptions, the theorems wouldn’t work and claims to any insight about the right policies would immediately fall apart. A word of caution: try to take a few tiny steps from mathematical fantasy to reality, and you will quickly have no theory at all and no reason to think that your policies are far superior to alternatives. It all goes up in a puff of smoke.

---

* Published in print edition on 30 August 2013

Tags:G20, Monetary Transmission Mechanism, Philip Mirowski, PRB Awards, R. Chand