Has Zimbabwe done enough to control inflation

Never Mind the Markets -

A falling price level in a deflation actually means that even cash increases in value and thus bears interest to a certain extent under the mattress: freshly printed 20-franc notes from the Swiss National Bank. Photo: Martin Rütschi (Keystone)

It was not long ago that inflation was considered a great evil around the world and that it should be prevented. Now everyone would like more of it. Trying to explain.

In the euro zone, the USA, Switzerland and for a long time in Japan, economic politicians and above all the central banks are plagued by one concern: inflation is too low - too low compared to the set inflation target of 2 percent. Inflation stands for the devaluation of money or - viewed from the goods side - for the increase in the price level measured as a percentage of the previous year. The following interactive graphic shows the inflation development since the 1980s for the countries mentioned; the data on the euro zone start with 1992.

How in the world can anyone see a disadvantage when inflation is low? If you look at the graph, it becomes clear that inflation rates were still much higher at the beginning of the 1980s. At that time it was clear: This inflation had to be combated - and we succeeded.

The recent past always has a particularly strong influence on current thinking. For this reason alone, the idea that a little more inflation might be something desirable seems downright absurd to many. A look at history could at least teach us that things have already been seen differently - for example during the Great Depression in the USA, as the following video shows, which practically advocated more inflation as a solution to the current problems at the time:

Nevertheless it does not happen individual point of view It is difficult to see what could be good about it if the goods cost more and the own Purchasing power is falling. From this point of view one would have to assume that the opposite should be true.

The key is that low inflation or even deflation (a falling price level) can still have serious disadvantages in its further consequences. These disadvantages have often been a topic on this blog in specific contexts (for example here, here, here or here) - today it should be a general summary of the most important points:

  • At first glance, low inflation is less the problem itself than the consequence and thus a signal for an underutilized economy with high unemployment. If consumption, export, investment and government demand (as is usually the case in a recession) are not large enough to utilize the productivity capacities of the economy, then companies have far fewer options for setting prices and wages. In the worst case, they even have to lower them. The schematic diagram from this older NMTM article shows the inflation / deflation problem in the business cycle:
  • Low inflation coupled with very weak economic conditions can create a self-reinforcing mechanism that results in deflation and exacerbates the crisis. Deflation means that the general price level is falling. When consumers and businesses anticipate falling prices (which means their money will become more and more valuable), they will wait to buy and invest until prices continue to fall. What is individually rational is dramatic in sum, because the expenses of one are the income and profits of the other.
  • If private and public debt is also very high (as is the case in many countries at present), in the event of deflation, as the value of money increases, so does the real (measured in goods) value of this debt. This continues to slow down consumption and investment and also exacerbates the economic situation.
  • If wages fall less than the price level (the normal case in the case of deflation), this means a real wage increase (employees can afford more goods with the same amount of money). But this increases the real cost to employers and there are layoffs, especially when the economy suffers from a demand deficit.
  • An inflation of a few percentage points (most central banks put it at 2 percent) increases wage flexibility. Workers accept a real wage cut much more easily if it is achieved through insufficient inflation adjustment. In this case, the nominal wage, i.e. the wage bill, remains the same or even increases. As long as this increase is less than inflation, the real wage will fall. This means that employees receive less in terms of goods. As is evident everywhere, this is more likely to be accepted than a falling wage bill with low or no inflation, even if the result is the same after adjusting for purchasing power.
  • In a monetary union like the euro zone, a higher average inflation increases the flexibility of adjustment and vice versa: If the stronger countries like Germany accept a slightly higher inflation, the weaker ones can aim for a lower one in order to achieve greater price competitiveness. In contrast, if the average inflation rate is lower, the weaker only have deflation with the disadvantages mentioned, which are particularly pronounced in these countries.
  • If low inflation turns into deflation, the normal channels of influence of the central banks fail, especially those via the key interest rate. The central banks can reduce this to zero as a minimum. But the falling price level in a deflation actually means that even cash increases in value and thus also bears interest to a certain extent under the mattress. Deflation therefore increases every interest rate without the central bank being able to counteract it with the usual instruments. And again: In a recession, higher interest rates put the brakes on urgently needed investments and make debt servicing more expensive.
  • For the above reasons, a number of economists - even at the International Monetary Fund - are in favor of a slightly higher inflation target for the central banks, which is usually 2 percent. These economists consider 4 to 6 percent more appropriate. One reason for this is the expectation of lower real interest rates (interest rates adjusted for purchasing power, nominal interest rate minus inflation) in the next few years - more on this here. When inflation is low, the real interest rate differs only slightly from the nominal interest rate. This means that the central banks then always operate at the limit of their powerlessness, since their key interest rate (as nominal interest rate) will always be close to the minimum of zero percent. More on this in a current lecture by Paul Krugman for a conference of the European Central Bank.

The above by no means leads to the conclusion: the more inflation, the better.

A central problem for every central bank is to “anchor” inflation expectations, that is, to fix them through their credibility. Because it is the expectations of future inflation among the general population that lead to price adjustments by companies and to corresponding wage demands and offers. In other words, expectations about inflation developments have the greatest influence on how high they actually turn out to be. If the central bank is believed that it can and will stabilize inflation at a fixed level, then inflation will level off there too. More on this topic here.

Because they fear that higher inflation could destroy the credibility of the central banks, some of their representatives are particularly resistant. The proponents of higher inflation are not concerned with ever higher inflation, but with a higher, again to be determined inflation target - around 4 instead of 2 percent - which the central banks should neither significantly exceed nor fall below.

In addition, falling below the inflation target also undermines credibility. If inflation expectations adjust downwards, real interest rates rise, as mentioned above, and with them the costs for debt servicing and investments even before deflation occurs, and the ability of a central bank to react become increasingly weaker.

The example of Zimbabwe is repeatedly used as an argument against higher inflation: In 2008 the central bank of the African state issued 10 million dollar notes. Photo: Tsvangirayi Mukwazhi (AP, Keystone)

As an argument against higher inflation, the story of dramatic hyperinflation, such as that in Germany in the 1920s and the more recent experience in Zimbabwe, with immeasurable price increases is told again and again. This kind of inflation came about in a very different way than a higher inflation target by a central bank. It came about because central banks spent money directly to finance government tasks and reacted to every surge in inflation with even more newly printed money. There was no longer any inflation target or control of the money supply at all. But that is not the point for anyone who thinks slightly higher inflation makes sense.