Inflation, the underlying reality

Inflation in Pakistan has now reached punitive proportions and, unless it is timely brought under control, it carries the potential for violent protests ultimately posing an existential threat to Pakistan’s very ethics in as a nation. Much of the problem has been that in tackling this threat (of inflation) our economic managers have made extensive use of modern monetary tools. Although these tools work in developed economies and especially where countries support their own strong exchangeable currencies, for example the United States, United Kingdom, Eurozone and to some extent Japan, Canada and the United States. Continent of Australia, for most developing countries these are either insufficient or simply ineffective.

The reasons being that for these developing countries, since their currencies are not freely exchangeable or convertible, their true economic strength does not manifest itself correctly in the respective values ​​of their national currencies. This invariably leads to forced devaluations even when the going is good, in turn pushing them into a vicious cycle where a push for needed growth (development and job creation) instead sends them down the path of external account challenges. gross leading to debt traps, unbalanced political dictations from lending institutions and resulting inflation of exorbitant proportions for the general public.

An externally pushed economic view calls for the age-old rhetoric of exaggerated independence for the central bank, when in reality demand tends to be meaningless, as central banks in these developed countries cannot really act. as the depositaries of the national currency. without partnering effectively with the other key economic organs (finance, commerce and industry) of the state, because on their own they tend to be visibly limited in the very leverage they can exert in the markets by through currency adjustments or, more importantly, in the value of the currency they may demand when exchanging theirs with the other major currencies in the world. Pakistan is now in this very situation!

To better understand this concept and trace the origin of the use of monetary interventions and currency devaluations as policy instruments, it might be useful to briefly examine the very origin of the concept itself. Against this background, the landmark developments that influenced financial markets in the post-war period occurred 50 years ago, when the international monetary system shifted from a fixed exchange rate regime to one of floating exchange rate. The demise of the Bretton Woods fixed exchange rate system was a landmark event that marked the end of a prolonged period of low inflation, strong economic growth and financial stability.

It was then that President Nixon and his advisers came to an agreement to break convertibility between the dollar and gold at $ 35 an ounce. When Nixon surprised the world by announcing the decision on August 15, 1971, it sparked a series of events that led to the collapse of Bretton Woods. Over the next three months, the US Treasury negotiated the first devaluation of the dollar with its foreign counterparts. Treasury Secretary John Connally and Under Secretary Paul Volcker feared that a growing US trade deficit would grow steadily if the US dollar maintained parity against the Japanese yen and major European currencies.

They were also alarmed by a steady decline in US holdings of gold, which had fallen to just 25 percent of US dollars held by foreign governments and central banks. At the Smithsonian meeting in December, a compromise was reached in which the dollar was devalued by 8%. To maintain Smithsonian parities, the Federal Reserve was forced to tighten monetary policy while central banks in surplus countries were forced to relax their policies.

Both sides, however, were reluctant to do so and a stalemate resulted. The breaking point came in February 1973, when the authorities threw in the towel and closed the foreign exchange markets before the second devaluation of the dollar. This time, officials have realized that it makes no sense to commit to a new set of exchange rate parities unless they can agree on policy measures to reduce inflation and trade imbalances. Thus, when the foreign exchange markets reopened, currencies were free to fluctuate. Looking at what happened, one wonders if leaving Bretton Woods was a good move or not?

The answer to this question is rather relative, since the general Western view today is that despite some valid criticism, it was well founded, as flexible exchange rates were not only good for America, but have also proven consistent with global growth in international trade. and capital flows, the other side might argue differently. For them, from low-inflation countries, they have suddenly grown into high-inflation countries since the 1970s – a brief period of relief, but respites that could never be lasting. This was the main reason why they were never able to move forward or get out of the poverty trap because the value of any productivity gain was systematically eroded by successive devaluations.

Here in Pakistan, successive governments have failed to realize that much of this higher inflation has come from devaluations. In the wake of the current devaluations, as the economic directors of the time tried to make the country’s fiscal policy expansionary, inflation set in and at least for the external account, interest rates are falling. which became almost irrelevant, as a significant portion of the import basket consisted of the bulk anyway – even today, over 50 percent of Pakistani imports tend to be inelastic. Moreover, all artificial measures involving wage and price controls still tended to be counterproductive, because in essence they do not address the root cause of the problem and only make the pain worse.

The other challenge we face today (and after the Bretton Woods collapse) is that, in many ways, for us the international mobility of capital has increased. This means that it has become more difficult to maintain a stable exchange rate, as capital moves from countries with high inflation to those with low inflation. This situation which has arisen is a recurring problem.

Milton Friedman argued that the move to flexible exchange rates was desirable because it allowed low-inflation countries to regain control of their money supply. However, in keeping with Western arrogance, he didn’t bother to take into account that (after the event) developing countries no longer had control over their currencies. This is why, for us, the solution is not to give unbridled autonomy to the central bank or its governor, but to find the means to increase its coordination with the other national levels of economic management, namely the finance, commerce, planning and industry, to take a holistic approach ensuring that the value of the pak rupee is truly defended – Ishaq Dar has been somewhat successful in this, although his approach was more dictatorial in nature, ignoring any advice in the process of commerce and industry.

In addition, it is time that perhaps the intra-central bank structure needs to be honestly reviewed by ensuring more tangible and active participation in its supreme board of directors of knowledgeable and skilled captains of commerce and industry of Pakistan.


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