Is inflation good for the economy?


IN any Economics 101 class, students are often made to understand that a modest level of inflation is good for the economy as a whole. A healthy level of inflation contributes to production increase as more money translates to more spending, which directly influences aggregate demand.

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This stems from the ideology of renowned British economist John Maynard Keynes, the father of the Keynesian economics model, which is premised on the “level of investment in the economy must exceed its savings rate in order to promote economic growth.”

Keynes believed that it is aggregate demand that drives production and not supply. To boost aggregate demand in the economy, the government should spend and invest heavily.

Even if the government needs to take on debts, for the sake of the economic health, it is the most direct means to accomplish its goal.

Keynes’ ideology was shaped by the 1929 Great Depression where he realised the only way to get out of a recession is through increased expenditure within the economy.

If the economy is in a recession and everybody cuts back on spending including the government, then it creates a vicious cycle which further deepens the recession.

Reduced demand will lead to lesser production and in turn unemployment. The “Paradox of Thrift” by Keynes categorically states that net savings are bad for the economy. In the bigger scheme of things, where does inflation come into the picture?

To make it less theoretical and fun, let’s talk about the Big Mac index. The Big Mac index first appeared in 1986 in The Economist publication, which measured purchasing power parity (PPP).

Due to the massive expansion of McDonald’s globally, Big Mac, the popular beef hamburger which is a common feature on the menu in most countries, became a benchmark to measure PPP and forex value between various countries.

Pam Woodall who created this illustration with a touch of humour gave rise to “Burgernomics” which remains relevant today. For illustration purposes, let’s compare an ala carte Big Mac in Singapore which cost S$6.40 (RM19.84) versus Malaysia’s RM11.60. The implied PPP is 1.767.

This essentially means that Singapore’s purchasing power is stronger than that of Malaysia by that ratio. Also if we measure against the current forex rate of 1 Singapore Dollar to 3.1 Ringgit, it would imply that Ringgit is undervalued to Singapore Dollar by 75%. As at 21st July 2021, Malaysia was ranked 50 out of 56 on the Big Mac index and against the US Dollar, deemed to be 58% undervalued.

PPP is a metric to compare economic productivity and standards of living between countries. The basis is the “law of one price”. While it works as a useful gauge in theory, economic forces in real life would thwart the accuracy such as different tax regimes and inflationary pressure. There were subsequently many variants to the original Big Mac index such as the “Tall Latte” index which relied on Starbucks’ franchises around the world for comparison.

Economist used the consumer price index (CPI) which measures a basket of goods to ascertain the inflation rate of the economy. Using the Big Mac index price increase year on year would serve well as a handy comparison against the CPI. Personally, I prefer using “Nasi Lemak index” especially in assessing the inflation rate in the local context. “Nasi Lemak” is made up of eggs, anchovies, cucumber, rice, coconut, chilli, oil and chicken. For this reason, it makes a good representation of the daily essential basket of goods, apart from it being our favourite local dish.

For the longest time, the Federal Reserve (Fed) have set an annual inflation target of 2%. Policy makers believe that a slow gradual increase in overall price level keeps businesses profitable and even prevent deflation. Healthy inflation is brought about by healthy economic growth.

Usually it is a result of GDP expansion, wage growth, increase in investment activities and consumer spending. It also contributes to full employment levels. The concern is whether the inflation we are facing today will potentially run off leading to stagflation or even hyperinflation. Due to a common misconception between stagflation and hyperinflation, I must revisit 1970s to distinguish it as many pundits and “gurus” have been using the word “hyperinflation” loosely.

In the late 70s, inflation in the United States was skyrocketing at a rate of 13% in 1979 followed by 13% again in 1980. This was attributed to President Nixon who ended the gold standard in 1973. The USD plummeted on the foreign exchange markets. That made import prices higher, exacerbating “imported inflation”.

Subsequent Fed Chairman tried to control the inflation but did a bad job simply because consumers and companies started buying ahead of time, for fear the price will keep increasing. Then Paul Volcker came into the picture. A steadfast Fed Chairman who was independent minded, he raised interest rate significantly by 8.5% within one year to a high of 20%.

He did so regardless of opposition to overcome the wild inflation in the growing economy. It succeeded to bring inflation down to a moderate level but the side effect was an 18-month-long recession. Many industries like real estate and auto industry were affected, being a casualty of high interest rates.

However, by the time he left office, the economy recovered and ushered 20 years of strong economy for the US. This inadvertently helped President Ronald Reagan win the election and built a strong presidential legacy throughout his tenure. Looking back at this period, it was when the US went through stagflation and the “Volcker Shock”.

So those who are propagating “hyperinflation”, in my humble view, have not studied enough to understand the actual situation. “Hyperinflation” is usually out of control with inflation rate rising at close to 50% per month. It usually only happens during times of war, turmoil and great disaster.

Indeed, I agree the current inflation is unhealthy. Going back to basics, what we are experiencing is not demand driven. In my observation, this is primarily caused by extremely accommodative monetary policy resulting in excess liquidity in the economy, supply shortage (due to prolonged Covid-19 shutdown, slow restart of factory, supply chain issues) and uneven recovery in economies globally.

On 4th August 2021, Janet Yellen, former Fed chairman and current Treasury Secretary have reiterated President Joe Biden’s administration’s view that the inflation surge reflects bottlenecks in the economy and challenges with reopening. She believes it is temporary and will recede to normal levels in the not-too-distant future.

Current Fed Chairman, Jerome Powell on 29th September 2021, maintained his view that inflationary pressure will ease once supply chain bottleneck eases and demand returns to pre-pandemic levels. Hence, the argument between policymakers are about supply crunch versus demand surge and whether it is transitionary or here to stay.

To be honest, it is never easy to get it right. Given the chance, policymakers should be firm to take the foot off the gas and allow the economy to function on its own. Accommodative monetary policies and overly aggressive fiscal spending using the pandemic as sole justification is not sound policy making.

It is merely taking the easy way out by running more deficits to spur artificial growth. I believe that healthy consumer spending is the key to sustainable growth in the economy. Considering the pandemic is moving towards the better, a good place to start is to let the economy return to normalcy on its own accord. It is crucial to rein in economic interventionist hardliners to avoid complex economic challenges in the future such as debts and potential defaults.

Hann, is the author of Once Upon A Time In Bursa. He is a lawyer & former Chief Strategist of a Fortune 500 Corporation.

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