The biggest problem of the post-1990 era, inflation, so far has been almost impossible to deal with. Time and again, year after year, cabinets have been announcing ever lower inflation predictions, assuring the public and the markets that their projections were realistic and credible. But, as each year drew to its end, governments admitted to yet another failure, and recognised that inflation was still there, in the economy, and was eating away at people’s purchasing power. Which, however, never stopped them from venturing into saying that next year the struggle would begin again and that inflation would eventually be kept in check.
Poor luck. Nothing would change the next year: a government with its hands and feet tied, a central bank shrugging its shoulders saying the real economy is not responding, and an inflation rate just as stubborn as last year’s. What went wrong?
Most often in the Romanian economy, management goes wrong. Unfortunately, not in merely one official institution, but in virtually all of them. We will talk about three: the Government, the Central Bank, and Parliament.
A rash manager
Through a Finance Ministry that is increasingly avid for resources, but with a virtually closed foreign market, the Government confirmed a now classical habit: if you can’t assure foreigners you’re liquid, the only thing left is to borrow from your wife. In our case, on the domestic market. The shortage was so dire that government bonds were sold out at double, even triple the inflation the same government had forecast. In its momentous drive, the Finance Ministry ignored (at least) two essential elements.
The first is the theory of rational expectations, which maintains that the public and the markets formulate their expectations of future prices using all information available to them and relating this information to the expectations of the government’s policy. Therefore, if the government borrows at such costs, it must be disregarding its own inflation target, in other words, it has no credibility when it vows to keep inflation in check. Interest rates above 100% must be financed with current revenues but since they don’t grow as fast, repayment becomes impossible. Most often, the debt is rolled over, and each time around the interest is a little higher, because payables grow, too. And the theory of rational expectations again comes into play. We now have an obvious spiral which at the top has an ever increasing state debt, an inflation that is increasingly hard to control and a government with increasingly less credibility. Aside from 1998, when the official forecast was 45% and the real inflation was only 40%, inflation was off target in every other year. But 1998 was not by far a good year. A 40% inflation rate is still huge, not only in Europe, but especially in the regional scope (to say nothing of the fact that the struggle against inflation has been a zero-sum game, because what was “gained” with inflation was lost with the current account deficit, at that time the highest in the last nine years).
The second element is somewhat more subtle, although its effects are just as evil. Budget deficits are not that evil in theory – the problem is to keep them from perpetuating to ever higher levels. In theory, a budget deficit, however large (within reasonable limits, though) should not trouble anyone as long as the interest rate at which the state borrows to finance it does not exceed the growth rate of Gross Domestic Product. If the interest rate tends to grow faster than GDP, the state should take note, because the deficit will tend to grow with each year. And with Romania’s case, when GDP has been declining for three years, it can hardly be imagined where the money will come from for payment on interest in the future. Of course, solutions exist: the state can either start printing money and fill in the deficit (again ruining in citizens’ eyes its reputation as a fighter against inflation), or, in the future, it may have to extract as much revenue as possible from taxes (which generally means higher taxes). Since printing more money is out of the question – because the central bank is independent and (at least theoretically) it cannot be forced to finance the deficit – there is the hypothesis of the contracting fiscal policy – a lever that is difficult to use in a receding economy, and an extremely unpopular one, too. But on the other hand, perhaps because of the political rotation in power, another coalition may have to struggle for maintaining such an imbalance?
Eyes wide shut
The policy of shoulder shrugging has sheltered the central bank from the blame of failing to maintain a reasonable (and controllable) inflation rate. “The economy is not responding” – was a catch phrase in the NBR over the last four years, but the reality is that the real economy did respond. High inflation made the people switch to dollar savings, and the “lei hunger,” NBR’s policy to protect the national currency, led to considerably higher interest rates, with two medium-term consequences: credits in lei were stifled, and inflation surged because of the sterilisation policy. The high interest the NBR offered to attract liquidity had to be paid and was paid, but caused regular inflation spikes.
Suffocation of the credit is perhaps a harsh expression. But the reality is that growing rates in the economy have a much more perverted effect than merely freezing the credit. The problem is known as adverse selection – adapted to the present situation, it says that with high interest rates, profitable investment projects, which may obtain lower interest rates, are kicked out of the market, where only the risky ventures remain. Borrowing at high rates, these high-risk projects, if unprofitable, tend to carry an additional risk for the bank, which becomes more vulnerable and spreads its vulnerability into the whole banking system. And the results were all around us in the last two years…
On the other hand, it’s not all NBR’s fault. Had the banking law clearly stated a goal to be pursued – price stability – and granted the central bank complete independence, the advantages today would be immense, both for the populace and for the credibility of the state’s economic institutions.
Vox populi
The legislative can persist in debating the central bank independence law, but it would have gained nothing had the NBR followed its own anti-inflation policy over the years. In fact, if the NBR were to achieve better credibility compared to the Government and Parliament, the three institutions would have grown separated by a rift. But the imbalance would have been beneficial: if at least one of the three institutions were to enjoy the complete credibility of the public, the benefits would have been shared by the other two as well. Assuming that the National Bank – an institution only autonomous, not independent – were to publish its own inflation targets and the populace were to believe it, and assuming that those targets were met, regardless of the political turmoil this accomplishment would have aroused, this credibility could have served as a much better foundation for a medium-term strategy, because inflation, the number one public enemy, would have been a variable with much less fluctuation than now.