Mahoshada

“The first panacea for a misguided nation is inflation of the currency; the second is war. Both bring a temporary prosperity; both bring a permanent ruin. But both are the refuge of political and economic opportunists.” Ernest Hemingway in Notes on the Next War.

At a time when a new Governor of the Central Bank, Mr Ajith Nivard Cabraal, assumes the primary responsibility in the government of protecting the value of the rupee and keeping inflation to a minimum – the year on year increase in the Colombo Consumer Price Index recorded another sharp increase in inflation last month – 17.7 percent. This follows several months when the rate at which the cost of living is increasing has begun to return to the painfully high rates of inflation experienced during the first year of the current government, (i.e., 6.4 percent in March, 9.2 percent in April and 13.2 percent in May 2006).

Does it matter that Mr Nivard Cabraal has no formal training or practical experience in managing monetary policy – one of the more subtle and complicated areas in economics? It ought to be a major concern for both the government and the public, because as Ernest Hemingway correctly pointed out in the quotation cited above, inflation will “bring permanent ruin” if it is not checked.

Today in most countries, the head of the central bank is chiefly responsible for targeting low inflation. Indeed, in some countries their continuation in this position is contingent on achieving low inflation rates. Yet on assuming this critical post, Mr Nivard Cabraal indicates that he sees a much expanded and more political role for the Central Bank, promoting the vision of economic development embodied in Mahinda Chinthana, which he is reputed to have co-authored. Yet this seeming lack of concern for giving top priority to reducing inflation will not only significantly undermine any chances for advancing the process of economic development generally, it will also seriously harm the economic wellbeing of the poor and middle class. The prospects are a continuation of the economic mismanagement seen in recent years.

How can one reconcile the assertions of concern for the poor and middle class being expressed by the government with the reality?

The Poor, Inflation and Inequality
Persistent high rates of inflation do not just happen. And they are most definitely not a result of external economic forces, such as increases in world oil prices. All countries have been faced with rising oil prices, but few countries have experienced the rapid increases in inflation seen in this country. No, it appears that high inflation has become a systemic political and economic problem whose underlying causes are much closer to home.

There is a great deal of research that shows there is a strong positive relationship between income inequality and inflation. Simply put; countries with high levels of income inequality – where a large share of the population is poor – usually experience higher rates of inflation than do countries with more equal income distributions. As this research shows, this is also not an accident. The principle reason this is the case is that high inflation inevitably makes the poor poorer and consequently the rich richer. In the terminology of economics, inflation is a regressive tax; a tax that falls more heavily on the poor than the rich, thereby leading to less equal distribution of income. This happens in several ways.

First, the rich are better able to hold their savings in assets where the value is not negatively affected by rising prices, such as land and housing. The poor, who do not have much in the way of savings in any case, and the middle class, who tend to hold more of their savings in rupees, such as bank accounts, are much more vulnerable to rising prices. Inflation erodes the value of their savings to a much greater extent than for the rich.

Second, the poor and middle class work for wages and salaries that are set in rupee terms. As prices rise, the real value of their incomes – what they can buy with the money they earn – falls. Over time, as inflation erodes the real incomes of the poor and middle class, there are periodic adjustments to take this into account. However, while real incomes may temporarily catch up to past levels, they rarely make up for lost ground and with continuing high inflation, they are soon losing again.

And third, the effects of inflation on the tax system tend to favour the rich. The government relies heavily on taxes on goods and services, particularly the VAT and import duties. These are usually calculated as a percentage of the price of the good, so when that prices increase as a result of inflation, the taxes being paid by consumers quickly increase proportionally. In contrast, income taxes, which fall much more heavily on the rich, do not adjust rapidly to increased inflation levels and as a result, the real burden of income taxes tends to fall as price levels rise. And as the poor and middle class typically spend a high proportion of their incomes, they end up paying a higher share of their incomes to the government in taxes, albeit, taxes that are hidden in the prices of the goods they buy.

The result of inflation is a substantial redistribution of income to the rich from the poor and middle class, who see their real wages and the value of their savings eroded.

‘Elite Bias’ & Political Opportunism
A recent study by Christopher Crowe at the IMF, Inflation, Inequality and Social Conflict, presents empirical analysis that suggests that in countries where there is a relatively high degree of income inequality, governments actually have an incentive to pursue policies that lead to high rates of inflation. (This study can be found at www.imf.org. It should be noted that this working paper does not necessarily reflect the views of the IMF.)

His conclusions are based on two premises: the first described above that inflation benefits the rich at the expense of the poor and middle class; and the second that the rich tend to have greater influence with the government than the poor and middle class, despite their fewer numbers. The latter proposition is termed elite bias and is supported both empirically in a number of other studies and by common sense. Does anyone doubt that individuals with high incomes have greater access to and more influence with senior government leaders, whether they are in the US or Sri Lanka?

Crowe’s study seeks to explain why countries with greater income inequality generally have higher rates of inflation, which reinforces or exacerbates this inequality. His answer lies in the interaction between the presence of elite bias in the political system and high levels of income inequality. In his words, “… higher income inequality creates a more skewed distribution of political power. This in turn leads to policies more beneficial to the elite, including a regressive shift in tax incidence… Democratic and open institutions may be harder to achieve in economically divided societies; however, it is in these societies that they likely deliver the greatest benefits.”

UPFA – Friend of the Rich? UNP – Friend of the Poor?
The conventional political wisdom, such as it is, suggests that it is the UPFA and its main constituent party the SLFP that stands with the poor, while the UNP is the party that represents the interests of the wealthy. If we consider the economic record as it relates to inflation and the rising cost of living in recent years, this would most definitely seem not to be the case.

During the last UNP government, economic policies were introduced that rapidly brought the inflation rate down from 13.4 percent in December 2001 to virtually zero 18 months later. This entailed difficult steps to bring a greater degree of fiscal discipline in managing the government’s finances, including steps to gradually reduce unsustainably high budget deficits. That government also began the arduous process of reducing the country’s very high reliance on taxing goods and building a stronger foundation for taxing incomes.

Since assuming office in 2004, the UPFA have followed a very different course, pursuing policies that have resulted in almost continuous high rates of inflation reaching levels not seen in many years. They have done this through again increasing government budget deficits and increasingly resorting to printing money to finance these deficits – which any monetary economist will tell you inevitably results in higher rates of inflation.

The respective records of these governments strongly support the proposition that it has been the UNP that has pursued economic policies that benefit the poor and middle class, while it has been the UPFA that is following a course that is seriously detrimental to the economic interests of the poor and middle class.

“Lenin is said to have declared that the best way to destroy the capitalist system was to debauch the currency. By a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. . . . Lenin was certainly right.” John Maynard Keynes

And now, as Ernest Hemingway suggested in the citation above, the government is resorting to the second “panacea for a misguided nation” – war.