Abstract
No article in Finance and Development has created more interest that Graeme Dorrance’s “Inflation and Growth,” which appeared in Vol. I, No. 1, and has since been widely reprinted. In that article the author dealt with the generally depressing effect of rapid inflation on a country’s economic development. In this article he develops a theme that was only briefly introduced in his earlier article—the effect of a rapid inflation on a country’s international position.
Graeme S. Dorrance
While the fund is vitally interested in encouraging the economic development of all its members, its interests are naturally concentrated in its special sphere of responsibility, as outlined in the first of its Articles of Agreement:
To facilitate the expansion and balanced growth of international trade, and to contribute thereby to the promotion and maintenance of high levels of employment and real income and to the development of the productive resources of all members as primary objectives of economic policy.
Hence, the Fund is directly concerned with everything that influences the expansion and balanced growth of international trade, in the broadest sense, and particularly in the relation between the growth of a country’s trade and its economic progress. Among the negative influences, rapid inflation is disastrously prominent.
In “Inflation and Growth,” it was stated that “serious inflation does not limit its ravages to those on the home economy. It also leads to a worsening of the country’s international position.” This can be seen directly in a country’s international trading position, its international capital transactions, and its exchange rate. More broadly, the worsening of a country’s position in these specific fields can seriously damage its general development.
Rapid Inflation and Trade
The effect of inflation on international trade may be described quite simply. When prices and costs in any country rise rapidly, goods produced in the country soon become more expensive than similar goods produced abroad. Unless the exchange rate changes (the exchange rate problem will be discussed later) this encourages imports and discourages exports.
As prices in a country rise more rapidly than in the rest of the world, not only does the rest of the world buy less of its exports, but people in that country tend to turn from buying these increasingly expensive products of their own industries to the relatively cheaper foreign goods. Far from fostering purchases from home producers, which would encourage home output and the substitution of home produced goods for imports, inflation has the opposite effects: imports are encouraged while the growth of domestic industry is discouraged. The effects are not only quantitative but qualitative. Scarce foreign exchange tends to be dissipated on excessively large imports of consumption goods which might well be foregone in order to encourage the development of new industries. On the other hand, the growth of vibrant export industries tends to be stunted, and production of goods which would be acceptable as import substitutes is discouraged.
While the expansion of imports and contraction of exports have a generally depressing effect on a country’s growth, the impact of inflationary pressures on specific imports and exports may prove to be of more direct harm. The effects of strong inflation on a country’s traditional exports may in many instances be delayed. Producers in well-established activities yielding primary goods greatly in excess of a country’s possible needs (e.g., coffee in Brazil, copper in Chile, rubber in Indonesia, and fish in Iceland) cannot turn to other production quickly, nor can they take advantage of inflationary demand at home. Consequently, the harmful effects of inflationary pressures on the output of traditional exports may be exerted over the long term rather than immediately. This long-term effect of inflation should not be underestimated. While their more stable competitors have advanced, Argentina, Bolivia, Brazil, Chile, and Haiti, with long histories of inflation, have not been able to maintain the volume of their exports at even pre-1913 levels.1
Yet striking as such long-term effects may be, the immediate effects of inflation on exports may be even more harmful in a country that seeks to encourage initiative, experimentation, and enthusiasm for new methods of production. Development of new products is often made easier if there is a prospect that some export sales may be achieved eventually, bringing with them the benefits of fairly large-scale production. If inflation makes the international competitive position of these producers more difficult, they may be discouraged from undertaking new activities, and diversification of the economy will be hampered. Thus, a comparison of two groups of countries, one with relative price stability from 1953 to 1959, and the other with rapid inflation in the same period, showed a marked expansion of traditional exports in the former and relative stagnation in the latter. Perhaps more significantly as an indicator of progress, new or relatively minor exports from the stable countries rose in this period by almost one half, while for the inflating countries these exports remained unchanged on balance.2
The effect of strong inflation on the structure of imports can also retard progress. Declining exports and rising import demands will by themselves lead to balance of payments difficulties. As discussed later, international capital transactions are likely to aggravate these difficulties. In order to cope with these problems, the authorities in an inflating country are frequently forced to restrict imports. These restrictions form an element in general economic policies which are usually directed, in part, toward protecting the living standards of those most hurt by inflation. Social policies that are in themselves desirable—and that may even be indispensable—tend to encourage the import of goods considered to be essential or of high social value. It is upon such goods that the least restriction is imposed and the lowest rates of tax are levied. Because countries are best able to produce certain specific goods that are nutritious or otherwise desirable, these goods come to be regarded as necessities of life in their countries of production (e.g., beans or maize in much of Latin America, or rice in Asia), while they are considered luxuries or semiluxuries in other countries where they are expensive or impossible to produce. The most severe restrictions or highest taxes are placed on imports of nonessentials or products which have not been important imports in the past. This policy, which may be required for social tranquillity, results in exposing the domestic producers of essentials to the full rigor of foreign competition, while protecting the domestic producers of nonessentials and making the import of new products difficult. This can well result in discouragement of domestic production of goods that are either desirable or which the country is best able to produce, and an encouragement of production of goods that are not particularly desirable or which the country is not well-suited to produce. Many a multiple exchange rate system (a device which includes exchange taxes and subsidies on imports or exports and is frequently adopted to minimize the effect of inflation on the balance of payments) might well be interpreted as an ingenious plan to discourage dairy farming and the improvement of children’s welfare, while encouraging the production of alcoholic beverages.
Discouraging the import of new products, particularly if administrative controls are the means of discouragement, may well impede development. The import of materials or new types of equipment may be essential for the growth of new industries and the diversification of the economy. On occasion, strict import quotas based on historic trade patterns have prevented the import of necessary spare parts and forced the closing, at least temporarily, of vital new industries.
Rapid Inflation and Capital Movements
Strong inflation does not limit its havoc to transactions in goods and services: it also distorts the international movements of capital. First it discourages the flow of capital, and hence of resources, to developing countries. Perhaps even more tragically, it fosters flight of capital from the latter countries.
One of the differences between stable and inflationary economics is that investors can make reasonable estimates of future money costs and money receipts in the stable countries, while this is impossible once inflation is well under way. Further, this uncertainty bears most heavily on foreign investors. All the chances in the lottery are stacked against them. International investment is in any event likely to be more hazardous than domestic investment. With inflation, the hazards involved in movements of international capital are increased by the unpredictability of exchange rates. Not only are the net returns on investment in the developing country’s currency unknown, but the returns in terms of the investor’s currency are even more speculative. So it is not surprising that foreign investors tend to shy away from countries with extreme inflation, and that such countries tend to cut themselves off from access to resources from abroad.
While a strong inflation by itself is thus likely to frighten capital away from a developing country, the policies frequently adopted by governments to ease the burdens of rising prices may have an effect that is even greater in discouraging national progress. As suggested above, strong inflation usually leads to the adoption of payments restrictions. Among the first candidates for restriction are payments on foreign capital. Even if assurances are given that foreign investors will be favorably treated, experience has taught these investors to be wary of restrictive systems, which usually contain considerable scope for administrative arbitrariness. Thus the almost inevitable exchange restrictions brought by strong inflation do more than discourage capital from fostering development. They so frighten capital away, and even encourage repatriation, that measures designed to conserve foreign exchange may in fact dry up a country’s resources and actually dissipate its reserves.
It is hard to rank the effects of inflation on a country’s balance of payments on any scale of severity. However, the effect of a strong inflation on capital flight must stand high on any such list. This capital flight has not only economic but also severe social effects. The inevitability of exchange rate depreciation in the uncertain world of a rapidly inflating country means that there is one sure prospect: if people can get their money out of the country, they will be able to benefit in the future. Thus, to quote an extreme example, if a Brazilian receiving at all times only the current minimum wage had started at the beginning of 1959 to save 1 per cent of his wages, and if he had been able to lend these savings at an interest rate of 1 per cent a month, he would have accumulated approximately 15,000 cruzeiros by the end of 1964; if he had instead used these savings to buy a dollar bill each time he had accumulated enough cruzeiros to do so, he would have had a bundle of dollar bills worth approximately 45,000 cruzeiros at the end of 1964. It is little wonder that the incentive to capital flight becomes all-pervasive in an unstable economy, and that savings which might be used to develop the country fly abroad.
It may be maintained that the harmful effects of inflation on capital inflows may be mitigated, and the flight of capital prevented, by exchange controls. Such arguments ignore the experience of virtually all exchange controllers that such controls cannot be effective when pressures on them are great, and often they may even have a tendency to induce capital flight.
Rapid Inflation and the Exchange Rate
Exchange rate movements are often front page news in a country where inflation is rampant. It may be taken that once inflation is under way the exchange rate must break. Rising prices leading to an increased demand for imports and an unwillingness to export cannot persist without complete collapse of the economy, unless the exchange rate moves to offset the rise in domestic prices. In fact, the rush to import, the collapse of exports, the slowdown in capital inflows, and the flight from the home currency all produce such pressures on the exchange rate that eventually it is likely to deteriorate even faster than prices are rising. This rapid worsening of the rate makes import prices rise more rapidly still and magnifies, in terms of national currency, the profits to be made from capital flight, thereby aggravating the pressure on the exchange.
If exchange depreciation were allowed to progress fast enough it might serve to reduce imports adequately, encourage export production, and eventually encourage the belief that future capital flight would not be profitable. On occasion, a freely moving exchange rate may indeed redress the harmful effects of inflation on the balance of payments. However, if this happens, the prices of imports will rise more rapidly than other prices, a situation which could be unfavorable to those imports that are frequently essential to maintain the standard of living or the continued operation of domestic industry. Further, the foreign exchange value of a country’s currency is often taken as a symbol of its real worth, despite the overvaluation that has developed owing to rapid inflation. Governments therefore try to hold the rate in an attempt to soften the sufferings caused by inflation and to help retain that confidence in the currency which is essential if monetary stability is sought, even as a distant ambition. Recent history is replete with examples of such attempts to stem the tide of exchange depreciation. Before these attempts fail, as in a rapid inflation they are bound to, the worst effects of the eventual depreciation are observed. With strong beliefs developing that the exchange rate cannot be held indefinitely, importers rush to buy goods before prices rise, and exporters hold up their sales in the hope of better days; with depreciation confidently expected, capital is sent out of the country in the belief that it can be brought back soon at a large profit. Attempts to peg the rate lead to the worst of both worlds. The harmful effects of a depreciation are not even delayed, while the handicaps of a fixed rate out of line with reality are experienced. In brief, a strong inflation necessarily involves a depreciation of the exchange rate, with the adverse effects of such a movement on the economy. Yet, even though a worsening of the rate may impose burdens on a country, to attempt to hold the rate when inflation is rampant may have even more serious consequences.
1
The evidence on this point is contained in J. Herbert Furth, “On United Nations Economics,” World Politics, January 1960, pp. 264-71.
2
The data for this comparison are contained in G. Lovasy, “Inflation and Exports in Primary Producing Countries,” IMF Staff Papers, Vol. IX, March 1962, pp. 37-69.
