ISSN: 1391 - 0531
Sunday, March 18, 2007
Vol. 41 - No 42
Columns - The Sunday Times Economic Analysis

Understanding the causes and dangers of inflation

By the Economist

Inflation is uppermost in people’s minds. Economists, business people as well as ordinary citizens are quite disturbed by the high rate of inflation. The interests of ordinary citizens lie in the rising cost of living that erodes the buying power of their fixed incomes. The poorer sections of the community are finding the costs of living onerous. The twenty percent rise in prices has been the hot topic of discussion and there are a plethora of explanations. Most official explanations avoid the truth about inflation wrapping it in new fangled theories. None of these are of much help in solving the problem. The fundamental causes and serious consequences of the problem remain largely unexplained. The plain truth is that the country is living beyond its means. Maybe one could say the country is fighting beyond its means. The plain truth is that there is no solution to the problem without reining in the fiscal deficit.

What is inflation? Discussions often demonstrate misunderstanding of the phenomenon of inflation. There is even a lesser understanding of the causes and consequences of inflation. There is a common confusion between the causes of inflation and the effect of inflation. Inflation is often understood as an increase in consumer prices. In fact this is the effect of inflation not inflation itself. A simple yet correct definition of inflation is that it is an increase in money and credit available for spending that is above and beyond the amount of available goods and services. In other words, the rise in prices is a symptom of deeper causes: the result of inflation. In the modern context, all over the world it is a monetary phenomenon caused by the government increasing the money supply. Basically inflation is inevitable when the government increases the money supply faster than the increases in the supply of goods and services.

Inflation is often aptly described as an increase in the amount of currency in circulation beyond the increase in goods and services. High rates of inflation have often been brought about by wars. There are two reasons for this. Military expenditure tends to be large and the expenditure does not lead to an increase in the amount of goods and services available.While the rise in prices is the apparent symptom of inflation, the fundamental problem is more serious than the rise in prices. The rise in prices is indicative of an imbalance in the economy that requires rather drastic remedies and resolution of fundamental problems of the economy. It is an emphatic expression of bad governance. Blaming the inflationary trends on international factors or as being a consequence of economic growth and development is an avoidance of the real problem areas even though they are partial factors in inflation.

The imbalances are a plenty. The fiscal deficit is reaching double digit proportions, the government’s borrowing is increasing money supply and raising interest costs, the trade deficit is running at unprecedented levels and straining the balance of payments and in turn depreciating the currency. The depreciation of the currency is increasing import costs and feeding into the inflationary spiral. While all these detrimental factors are engulfing the economy, scant attention is being paid to mitigating these causes that alone would reduce price rises.

The current inflationary trend is potentially more dangerous than it seems. Apart from the serious social consequences and political repercussions of an inflation, there is the long term damage to the economy as the country’s growth potential could be critically hindered, especially as the inflationary spiral is in a context of a worsening security situation, that is itself having a serious impact on the economy. Besides the international factor of increasing import prices, the depreciation of the currency is compounding the problem and fuels the inflationary trend. There may be temporary respites in rising prices owing to seasonal factors such as good harvests, but these do not resolve the fundamental imbalances.

The economic consequences of inflation are not only the short term difficulties for people. It also has serious long term impacts. Rising prices have impacts on both producers of goods and services and on consumers. In an export-dependant economy inflation could be crippling as costs, the increases in prices would raise production costs and reduce the competitiveness of Sri Lankan exports. A telling example recently was when the country lost its vegetable export market owing to high prices of vegetables. Similarly, other export items could also lose their competitive edge owing to inflation. The “remedy” that is resorted to is the depreciation of the currency to cope with increases in rupee costs. However this remedy has another side to it. It itself becomes a cause for further inflation by increasing import prices.

The burden of controlling inflation has been placed on the monetary authority. It is however well known that when the inflationary pressures generated by fiscal imbalances are excessive, monetary policy instruments tend to be of limited impact. Even more important is the fact that monetary measures that decrease the supply of credit and increase the costs of credit to the private sector hamper economic growth.

Unless the government takes a serious view of the causes of inflation and addresses these, there is no possibility of controlling inflation. Unfortunately even the advisers of the government are not bold enough to give a true account of the reasons for inflation and make it very clear that fiscal discipline is essential. The curtailment of government expenditure is imperative. There is no way of bringing about a curtailment of inflation to around 5 to 7 per cent without a reduction in the fiscal deficit by reducing government expenditure.

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