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I recently came across a very interesting and thorough research paper from the IMF on the Zimbabwe hyper-inflation episode. What was quite clear from the document was that the high inflation of the period was the result of very high quasi-fiscal losses by the country’s central bank and not of runaway fiscal deficits. Probably the most important factor was interest costs of open market operations while also subsidies (mainly in the form of free forex to public enterprises) and foreign losses (due to a mismatch between foreign assets and liabilities) played a significant role. The annual flows were enormous, close to 60-80% of GDP which explains why annual inflation quickly reached levels of 600% and 1200%.
The rest of the post contains the relevant parts (and figures) of the paper that explain the hyper-inflation process more clearly:
While central bank losses in most countries have not exceeded 10 percent of GDP, Zimbabwe’s flow of realized central bank quasi-fiscal losses are estimated to have amounted to 75 percent of GDP in 2006. Losses have arisen from a range of activities including monetary operations to mop up liquidity; subsidized credit; foreign exchange losses through subsidized exchange rates for selected government purchases and multiple currency practices; and financial sector restructuring. Quasi-fiscal losses of this sort, rather than conventional monetary or fiscal laxity, have been the mainly responsible for the surge in money supply in Zimbabwe during 2005-7. The power to create money to finance losses quickly run into conflict with any recognized monetary policy objective with official inflation reaching 1,594 percent as of January 2007.
The following are noteworthy features of the balance sheet:
- Nonearning assets are substantial; they amounted to 83 percent of total assets as of October 31, 2006.
- RBZ securities, introduced as a sterilization tool at the beginning of 2004, became the largest liability by the end of that year, overtaking currency in circulation, previously the largest liability.
- Starting in 2004 sharp increases in statutory reserves to finance the concessional credit to favored sectors, such as agriculture, led to a steep climb in required reserves, which are not remunerated.
- Foreign liabilities, largely represented by credits from international financial institutions, have for some time been much larger than foreign assets. In this situation any currency depreciation produces losses.
- The smallest liability is capital and reserves which has been kept constant at a very low level. A central bank increases its capital through seigniorage and reduces it by operating expenses and distribution of profits to the government. Figure 1 shows the evolution of seigniorage since 2001 in Zimbabwe. For the RBZ, seigniorage has fallen from over 5 percent of GDP in 2001 to about 0.1 percent of GDP in 2005 because, given very high rates of inflation, real base money has declined drastically in relation to nominal GDP and the RBZ has invested in assets, including QFAs, with large negative real interest rates. Only the failure to apply a recognized accounting framework keeps the RBZ capital and reserve from being negative.
Most of the RBZ’s quasi-fiscal losses were incurred in connection with activities that go far beyond conventional central banking functions. There were four main sources of the losses:
- Subsidies in terms of free foreign exchange to public enterprises; price supports to exporters to partially compensate them for an overvalued exchange rate; and subsidized credit to troubled banks, farmers, and public enterprises.
- Realized exchange losses stemming mainly from the purchase of foreign exchange from exporters and the public at higher prices than sales of foreign exchange to importers (mainly government and public enterprises); and recognition of previously unrealized exchange losses upon repayment of external debt, including to the Fund.
- Interest payments associated with open market operations to mop up liquidity.
- Unrealized exchange losses reflecting official devaluations because foreign liabilities exceeded foreign assets.
To contain money growth, the RBZ sterilized the impact of the direct injection of liquidity into the economy that the QFAs represented. In January 2004 the RBZ started to issue its own bills at effective interest rates of over 900 percent per annum. These RBZ Financial treasury bills were naturally attractive to the market but too costly to the RBZ, so they were soon abandoned and replaced by Open Market Operation (OMO) bills, introduced in May 2004, and Special RBZ bills, introduced in June 2004. The OMO bills had the same interest rates as the existing government treasury bills but the accounting for them was clearly separated from holdings of government treasury bills since the interest cost was charged to the RBZ. The issuance of these bills escalated beginning in September 2004 after the large-scale financial or “liquidity” support to troubled commercial banks. The Special RBZ bills were introduced to absorb excess bank liquidity at the end of the day. They had a maturity of two years and carried an interest rate that was sharply negative in real terms. The long maturities deferred the monetizing consequences of the high nominal interest rates.
The RBZ has accumulated substantial domestic interest-bearing liabilities through open market operations to absorb liquidity. The vicious circle of rising losses and rising remunerated liabilities has resulted in inflation and increases in the interest rates of the bills, further accelerating the interest cost for the central bank. By 2005 the net interest cost of sterilization equaled 40 percent of GDP. In 2006 the interest cost grew further but its liquidity impact was partly alleviated as the authorities lengthened the maturity of treasury bills, thus deferring interest payments.
UIP obviously stands for Uncovered Interest Parity. The following is a crude visualization of its explanatory strength. The graph depicts the difference between real 12-month Libor rates for Euro and USD against the change in the US/Euro exchange rate. An increase in the real spread should lead to a Euro appreciation with the two graphs moving in the same direction (data are monthly since January 2007):
It is quite evident that the two series are highly correlated (correlation coefficient of 0.65 with R² equal to 0.42). What is very interesting is the fact that the spread is driven by inflation differentials between the Eurozone and the US (as a result of current disinflationary forces in the Euro area), since nominal rates have converged in the two regions:
Obviously the above graphs are rather crude and a better indicator of future inflation rates would be inflation swap rates. These might help explain recent exchange rate movements (which are not easy to explain in the first graph).
In any case, the relative unwillingness of the ECB to act upon the disinflationary forces in the Eurozone does have its toll on the exchange rate which might negate a large part of the improvement of the RER. How far inflation rates will remain weak is going to play a crucial role on future exchange rate movements.
One recurring statement (usually related with the Euro-Drachma debate) is that the type of currency does not play a role, only the ability to efficiently produce competitive products and the presence of a modern institutional and organizational setting.
This type of reasoning is actually very similar to the ‘New Consensus’ (NC) macroeconomic view. The economy follows a supply-side driven natural growth path, subject to stochastic exogenous shocks which move the economy’s output gap far from zero and create inflationary (or disinflationary pressures). In a New Keynesian model, price and wage rigidities allow the central bank to change the short-term real rate (by changing the short-term nominal rate) which results in a deviation from the natural equilibrium (Wicksellian) rate of interest. This deviation eventually clears the output gap and returns the economy to its predetermined expansion path. The model as a whole contains the neutrality of money property, with inflation determined by monetary policy (that is the rate of interest), and equilibrium values of real variables independent of the money supply. The final characteristic is that the stock of money has no role in the model; it is merely a “residual.”
In essence, the NC world view can be summarized in the words of King (1997):
if one believes that, in the long-run, there is no trade-off between inflation and output then there is no point in using monetary policy to target output. …. [You only have to adhere to] the view that printing money cannot raise long-run productivity growth, in order to believe that inflation rather than output is the only sensible objective of monetary policy in the long-run” (p. 6)
The Keynesian view is quite different and stresses the fact that in reality the economy expansion path is not predetermined by supply-side factors, nor is money neutral. On the contrary:
- Liquidity preference (see Arestis 2003) is an important issue. Financial assets are not close substitutes nor is credit risk negligible. As a result, relative prices and credit spreads play a decisive role since they determine the net worth of economic players (especially banks) and credit availability. Even the mere ‘creation of money’ by the central bank can have expansionary effects if it is targeted on specific, temporarily illiquid assets (with QE1 targeted on MBS being a strong example) since it expands the supply of ‘safe assets’.
- Growth is to a large part endogenous while hysterisis effects are significant. The natural rate of growth is driven by demand growth (Thirlwall 1998) which generates hysterisis effects and path-dependence for the economy (Lavoie 2003). The NAIRU (if it exists at all) is closely related to the capital stock (since the elasticity of factor substitution is less than unitary) which suggests that effective demand and its effect on net investment strongly influences long-term employment (Arestis 2007).
- Economic decisions are governed by genuine uncertainty and not by a known probability distribution, something evident especially in the case of long-term investment projects. Savings equal Investment only ex post and do not ‘drive’ expansion. That would require that while savers increase their preference for liquid assets, investors are more willing to part with liquidity, increase their leverage and hold actual illiquid assets (in the form of fixed investment and higher inventories), which is actually only possible if future profitability is increased and spare capacity is no longer available.
Even in the neoclassical tradition, post-2008 thinking acknowledges that monetary policy can have significant short and long-term effects on growth:
- Long-term rates (which are relevant for investment) are not always closely linked to short-term money market rates, especially in stressed market environments. The central bank therefore needs to use balance sheet policies apart from setting the short-term rate in order to move long-term rate expectations.
- The natural rate of interest is not known with any significant confidence level and is contingent on economic conditions, preferences and expectations (Federal Reserve 2001).
- Disinflation (and even worse deflation) starting from already low inflation levels has strong effects on economic growth, since the output-inflation rate tradeoff is non linear (IMF 1998, Fed 1998), something which is highly relevant in the Greek case.
Furthermore, since the ECB target is of close to 2% annual inflation, strong deflationary expectations (which are now present in Greece) can only be considered a failure of its monetary policy. As long as the ECB does not act to correct this problem, it would be hard to suggest that monetary policy does not play a decisive role in the current Greek predicament.
Lastly, in cases of large real exchange rate devaluations (which is the stated target of the Greek adjustment program) the method of devaluation certainly plays a major role. Internal devaluations are usually followed by debt deflation effects with large output and employment losses and significant increases in non-performing loans and the (private and sovereign) debt burden (which is not deflated as are prices and income). External devaluations on the other mostly hurt the external sector claims while resulting in significant changes of the real exchange rate.
The following chart from the sdw facility of ECB shows that Greek deflation dynamics are ongoing and strengthening:
Ever since mid-2012 both the core inflation (HICP excluding energy and seasonal food) and the services inflation are in negative territory at an accelerating pace. Current core inflation figures stand at -2% while services at -3.5%. After dropping to -5%, durables goods inflation now reads -3.5% showing relative signs of stabilization.
In general, core/services inflation rates of (negative) 2-3.5% can only suggest a very wide output gap which is certainly not an indication of imminent return to positive GDP growth rates. Furthermore, recent GDP figures show that nominal GDP/income continues to fall at close to -6% with the improvements in volume statistics being only the result of higher deflation (GDP deflator is now close to -2.5%). These are the typical elements of a debt deflation cycle with real debt burden increasing compared to a falling nominal income which eventually results in an increase of NPLs and debt-to-GDP readings and also to lower economic activity since consumers start to postpone purchases (especially of durable goods) in anticipation of lower future prices.
I ‘ve focused on the inflation issue in my last posts so I ‘d like to make yet another simple accounting exercise concerning Greek imports.
The Imports to GDP ratio can be broken down to:
Real Imports / Real GDP = (Nominal Imports / Imports Deflator) / (Nominal GDP / GDP Deflator)
or: (Nominal Imports / Nominal GDP) = (Real Imports / Real GDP) * (Imports Deflator / GDP Deflator)
As a result, the change in the ratio can be broken into volume (import penetration) changes and price changes (when imports prices rise faster than the GDP deflator). Focusing on imports of goods, I ‘ve done the corresponding calculation for Greece:
The period numbers are sums and not averages. The 1993 – 1999 period shows large import penetration which is nevertheless counteracted by price effects. The 2000 – 2008 period is dominated by certain years such as 2000 and 2006/2007 when import penetration was quite high. Price effects are much lower in the 2001 – 2008 period (because of the Euro) though still negative. Any unsustainable trends are limited mostly during 2006 – 2007. A further exercise would be to check the correlation with the large credit expansion during that period.
Ι ‘ve focused on inflation in recent posts so I would like to make a few points on export price inflation dynamics in the periphery. Since the idea of reduction in unit labor costs rests on the assumption that lower costs will be reflected on export prices and through price elasticitiy (which is usually below 1) to export growth, it is reasonable to check certain metrics:
- The magnitude of export price inflation in periphery countries compared to Germany and
- How export prices move compared to import prices. A reduction of ULC (other things equal) will allow for higher firm profit margins and lower export prices, even if import prices increase (depending on value added). If on the other hand other firm costs increase (taxes on production/income, access and cost of credit, energy costs), the margin will be lower and export prices will follow import prices closely.
I ‘ve used the Ameco database goods imports and exports deflator series for Germany and the periphery. The latter excludes Ireland which is a rather special case since it is an export hub for large multinational corporations:
It is clear that Greece is an outlier, with export prices increasing over 21% in the 2010-2012 period. while it is also the only country where net export price inflation was positive which is probably a result of other costs on production. The rest of the periphery (with the exception of Portugal) displays a rather normal increase in export prices (the Euro area increase in the 2010-2012 period was 9.4%) with Germany still managing to keep its export inflation at very low levels.
Net changes are highly negative for the rest of the periphery which means that any reductions in labor and other costs are passed through to prices, despite any increase in import prices (the analysis would be more clear if value added of exports was easily available).
A simple linear trend shows that there is strong positive correlation (coefficient of 1.07) between net export prices and the final export price inflation. The fact that Greece, despite having the largest fall in ULC, is the only country with a positive net increase in export prices suggests that other factors (my guess is access to credit) play a major role in firm costs and do not allow them to not pass through any import price increases. In terms of export price inflation, Greek internal devaluation seems to be quite far from success so far.
What is even more alarming is the fact that during the same period (2010-2012), the private consumption expenditure deflator for Greece increased 8.6% and the domestic demand excluding stocks 3.4%. It seems that exports had price dynamics of their own.
Probably most of the most persistent and wide spread views of the general public is that a large currency devaluation results in more or less equivalent losses in purchasing power. Thus an exit of a periphery country from the Euro (which would probably be accompanied by a large devaluation of between 20-50%) is not considered a viable alternative to the current real income losses due to austerity and recession.
Unfortunately, the reality is quite different. Large devaluations are accompanied with significant changes in the CPI-based Real Exchange Rate (while if the loss of purchasing power was equal to the devaluation, the RER would not move). This is due to the fact that a devaluation only changes the import/export prices of tradable goods, not the general price level.
A very interesting study on the subject suggests a simple accounting model of calculating the effects of a devaluation on the CPI. It starts with a simple index where all goods are considered tradable and changes it to reflect reality:
Table 1 shows that there is substantial comovement between the price of imports and exports and the nominal exchange rate. In Argentina, Brazil, and Mexico this comovement is present at all the horizons we consider. For Korea and Thailand, the comovement is stronger in the ﬁrst few months after the devaluation
Table 1 indicates that the retail price of tradable goods moves by much less than the price of imports and exports (see also Figure 1).Table 1 also shows that the price of nontradable goods and services moves by much less than the rate of devaluation. Although the retail prices of tradable goods move more than prices of nontradable goods and services, the diﬀerences are small relative to overall movements in the nominal exchange rate.
According to Table 3 on average, nontradable goods account for roughly 50 percent of the CPI basket. In our view, this decomposition substantially understates the percentage of the CPI basket that is composed of nontradables because it ignores distribution costs for tradable goods and local goods.
Recall that we compute the CPI using retail prices. These prices are necessarily diﬀerent from producer prices, because they reﬂect distribution costs associated with wholesale and retail services, marketing and advertising, and local transportation services. Burstein, Neves, and Rebelo (2003) show that these costs are large. According to their estimates, the average distribution margin for consumption goods, is roughly 50 percent.
Distribution services are nontradable in nature, since they are intensive in local land and labor. So Burstein, Neves, and Rebelo’s ﬁndings imply that half of the retail price of a tradable good reﬂects nontradable goods and services. Consequently, distribution costs account for approximately 25 percent of the CPI bundle raising the total share of nontradables in the CPI to 75 percent.
Consider the remaining 25 percent of the CPI basket classfiﬁed as tradable goods. Many of these goods are actually local goods that are produced solely for domestic consumption. For example, yogurt is traditionally classifﬁed as a tradable good. However, almost all the yogurt produced in Argentina is sold locally (see Table 8, which provides additional examples). It is difficult to precisely estimate the share of local goods in the CPI. However, the calculations below suggest that local goods could represent as much as 22 percent of tradable goods or 11 percent of consumption. In this case, taking distribution costs and local goods into account reduces the share of pure-traded goods in the CPI basket to 14 percent.
Another, more detailed approach, is the one taken by another paper, which uses Input-Output tables to compute the results of a 50% drachma devaluation (after a switch from the Euro to national currency) on the CPI, under various model assumptions (such as whether workers try to avoid losses in purchasing power by demanding higher wages). The conclusion is that, under the most ‘inflation-prone’ model, the first year inflation will be 9.3%, a rather small cost for the return of sovereignty.
Another way to gain more perspective on the subject is to look into the recent high inflation history of Greece during the 80’s, early 90’s. The Ameco database provides a very useful statistical series with the contributions of various factors to the final demand deflator. The factors are import prices (corrected for the exchange rate), the exchange rate, nominal ULC, gross-operating surplus (firm profit margins) and net indirect taxes. The series can be used as a close proxy for the CPI and allows one to breakdown inflation into the contributions of the domestic sector and the exchange rate:
During the 80’s the mean contributions of the exchange rate and the domestic sector were 3.3% and 15.4% while in the 90’s 1% and 8.9%. Neither the inflation of the 80’s, nor the disinflation of the 90’s was a result of the external sector (constant depreciation in the first period, ‘strong drachma policy’ in the second) but of large (monetary) claims of the domestic sector on production. Inflation dropped because the domestic sector contribution went from 15% in 1990-1991 to 5% in 1997 and 2.5% in 2000 (the same values for the exchange rate were 2%, and -0.5%). One can attribute the persistent high inflation to mismanagement and loose monetary policy rather than to currency depreciation.
The Ameco database includes a very helpful series of ‘Contribution to the change of the final demand deflator’ by category of final demand. This breakdown can be used to examine inflation dynamics in Greece since 1990 and especially during the Euro era. I ‘ve chosen not to include 2009 in averaging since it contains outliers due to the recession:
A few clear conclusions are the following:
- Inflation dynamics during the ’90s were not the result of the external sector but rather of high claims of the domestic sector (workers and corporations) on output. The disinflation of that period was an attempt to lower these claims by anchoring inflationary expectations closer to the Euro average. Overall, this attempt was successful as is evident in the following graph:
- During the boom years of 2000 – 2008, the foreign sector, ULC and Groos Operating Surplus contributed almost equally (with a small residual for net indirect taxes) to inflation dynamics. ULC only contributed 1/3 which means that the relationship between the ULC and the CPI based REER is rather weak, especially if one takes into account the large credit expansion of the corresponding period and the high increases in asset prices (which makes consumption more a function of wealth and access to easy credit than of current discretionary income). Moreover, the Nominal EER contribution was actually negative which made foreign goods less expensive and led to a loss of competitiveness.
- After 2009, the fall in ULC is quite substantial (a total contribution of -5,75%) with the nominal EER also helping in the fall of inflation. On the other hand, import prices contributed strongly to domestic inflation (especially during 2011) while firms seem to be able to extract an increasing claim out of nominal output with a large ‘regime change’ after 2010 (the contribution was essentially zero during 2009 – 2010). It is not clear if this phenomenon should be attributed to low competition or an attempt by firms to survive since their lack of access to bank credit makes sales the only available source of funds.
Overall, the attempt to lower the CPI-based REER (and also ease the burden on labor by lowering the general price level) requires that firms decrease their nominal claims. It is not quite clear if that requires an increase of competition in product markets or renewed access to bank credit (in my view this is an excellent topic of further research).
One more interesting element is the price change (computed through price deflators) of Greek goods imports and exports:
It is clear that export prices follow import prices very closely (correlation coefficient equal to 0.907 with R² of 0.82). The fact that fuel is a large part of both exports and imports probably plays a major role. In any case, the reasonable conclusion is that exports have a large import content (something which could be verified through an Input-Output table analysis) making their pricing largely a function of import prices. That lowers the importance of ULC quite a lot, since they do not seem to explain a large part of export price changes.
The latest IMF WEO 2013 among other things includes an interesting chapter on recent developments on the link between inflation and unemployment. Compared to past recessions, deflationary pressures have been mild during the Great Recession:
These developments are attributed to the already low inflation (which creates a need for outright wage cuts in order to achieve lower inflation rates or even deflation) and anchoring of inflationary expectations due to monetary policy. Structurally high natural rates of unemployment do not seem to be present. One can then question whether the ‘divine coincidence’ still holds, where (based on the augmented Phillips curve) an inflation targeting central bank can maintain a zero output gap by achieving an inflation rate close to inflationary expectations. Since the Phillips curve appears to have become flatter, a low value for ε (in the APC π – π* = -ε [u -u*]) means that low inflation can coexist with large and persistent (as long as inflationary expectations are anchored) spells of unemployment. As a result, the current macroeconomic environment calls for a rethinking of central bank mandates closer to the Fed doctrine (which targets both unemployment and price stability).
This is quite evident in the case of Euro periphery countries such as Greece, where disinflation is accompanied with very large increases in unemployment. Since I ‘ve already touched upon the fact that the Phillips curve does not take into account firm profit margin changes, I will focus on the relationship between wage inflation and unemployment:
Starting in 2010 there’s a definite structural break in the rate of growth of ‘Nominal Compensation per Employee’ with wage increases turning negative and following the change in unemployment rate closely. During the 2006 – 2012 a simple linear trend is:
gw = 2.97 – 1.25Δu with an R²=0.86 while for 2010 – 2012 the trend becomes:
gw = 0.44 – 0.87Δu with an R²=0.90
It is clear that expectations of wage increases are close to zero (the 0.44 intercept) while the curve has become much flatter with the ‘unemployment multiplier’ falling below 1. That means that it will take more than 100bp changel in the unemployment rate to achieve a 1% fall in wages. Internal devaluation can only work through productivity from now on, especially since unemployment rates are moving closer to 30%.
Looking into the final demand deflator contributions one can observe the fact that most of the inflationary pressures since 2010 have been either transitory (import price and indirect tax effects) or the result of an effort by firms to maintain their profits margins (which given the fact that Greece is most probably going through a credit crunch are the only source of funding):
Labor and wages are the ones to have incurred most of the recession cost (with nominal ULC contributing a fall of -3.3% during 2012) while any remaining inflationary pressures seem to be the result of import prices and profit margins. The above suggest that a better targeted (and relaxed) monetary policy can be highly effective without fuelling any inflationary pressures since the Phillips curve is much flatter while a relaxation of credit constraints would allow firms to use bank credit again for working capital and investments instead of relying only on their own profits. That would allow them to adopt a pricing policy closer to domestic demand conditions and lower the CPI-based REER without hurting unemployment further.
Since i ‘ve recently had a couple of university professors analyze the expectations augmented Phillips curve, I ‘d like to do a short analysis of the relationship, especially in the context of inflation targeting by central banks. First, it is important to point out that the original Phillips equation reflected a relationship between wage growth and unemployment. The modern Phillips curve assumes constant real wages in order to substitute wage inflation for the inflation rate and come up with:
π = π* – ε(u – u*) where π* is the expected inflation rate and u* is the natural rate of unemployment.
This assumption shows its weakness if one uses another route to come up with a breakdown of inflationary sources. Using the equation of exchange:
PQ = PY (Q: real output, Y: real income)
and noting that income is distributed between wages and profits we can come up with:
PQ = (W + U)
Multiplying and dividing by W:
PQ = (W + U/W) * W
W + U/W is actually the aggregate mark-up of profits to wages, which can be set to m:
PQ = mW
Dividing both parts by L (employment):
P*(Q/L) = m*(W/L)
and renaming Q/L to average labor productivity (APL) and W/L to the money wage and taking natural logs we end up with:
π = m + w – APL
In other words, inflation is created by the excess increase of wages and markups to the growth of productivity. Given that the original Phillips curve focused on wage inflation, we can substitute w with the expectations augmented equation to reach:
π = m + (π* – ε(u – u*)) – APL
and moving inflation expectations to the left:
π – π* = m – APL – ε(u – u*)
Modern central banks follow inflation targeting with a view of minimizing the output gap. Taking that policy as given and assuming it is successful at anchoring actual inflation to the expected it is clear that:
m – APL = ε(u – u*)
As a result, only if the markup growth rate is equal to the increase of labor productivity will the outcome be unemployment close to the natural rate while workers will enjoy constant real wages. If firms manage to increase their markups more than productivity they will be able to earn a larger share of income while leading the economy to an unemployment gap. The increased unemployment will lower labor bargaining power and its ability to achieve wage increases. Consequently, pure inflation targeting will not necessarily lead to an optimal outcome but can allow ‘capitalists’ (used with the classical definition of owners of the means of production) to secure higher shares of income while lowering the labor force negotiating power and increasing the unemployment gap. Coupled with a financial sector willing to provide easy credit, this policy can have long-term redistributional effects.
* The original discussion appeared on heteconomist.