Bailout, deficits, and inflation
WHEN speaking at the "Macro-economic Management in the Global Challenges" conference, Finance Minister Abdul Muhit expressed concerns about collecting more tax revenues to offset some of the adverse effects of global recession that is slowly tiptoeing into the Bangladesh economymostly through loss of exports and expatriate remittances. However, expectation of higher tax revenues during a recession to help the economy is counter-intuitive.
Muhit's decision against cash incentives in exporters bailout package and financial assistance to returning migrant workers as stipulated in my March 19 piece "Bailing out businesses" may be a stark coincidence but they're very sensible. As in my article, he also voiced the same alarm about future inflation when he affirmed that the government would act prudently to subdue inflationary pressures.
Other experts and generalists proposed other measures which boil down to providing either subsidy for resuscitating businesses or stimulus spending for infrastructure buildingthe former saves jobs while the later creates jobs. Whether it's low cost fertilisers and seeds for farmers, food rationing for the poor and "not so poor," bailout funds for export sector businesses, and now for digital Bangladeshall these have one generic namesubsidy.
The oddity about subsidy is that the recipients become dependent on it as their entitlement. Businesses tend to corrupt elected officials to prolong the tenure of subsidy through manipulating their accounting books of profits and losses. Additionally, fund recipients, as in the US, open up opportunities for self-aggrandizement and diversion of funds to non-productive activities. The exchequer ends up with burgeoning budget deficits with the consequences of higher money growth and inflation.
Government budget deficits result from a shortfall of tax revenues over spending. To finance this revenue shortfall, the treasury sells bonds in the private market. These deficits induce credit demandif not offset by reducing spending elsewhere or an increase in credit supplythat naturally exerts upward pressure on interest rates. In order to keep the interest rate on "target" consistent with monetary policy goals, the central bank may then buy bonds from private seller -- a process called debt monetisingresulting in increased bank reserves and hence larger money stock and subsequently higher rate of inflation.
Deficits can also cause inflation through lessening public's money demand. This happens if rising interest rates drive down the public's money holdings, causing money supply exceeding money demand, ceteris presibus. However, this effect is minor, unless interest rates increase massively.
A second channel works through wealth effects on money demand. Since the two are positively related, any sign of a declining wealth due to increased deficit spending will induce a decrease in money demand causing an imbalance in the money marketan excess money stock, a higher aggregate demand, thus higher inflation.
Deficits themselves can also induce a wealth decline if the funds raised in the financial market are used inefficiently. For example, a significant wealth effect would result if deficit spending diverts a significant amount of productive resources away from private investmentthe crowding out effect.
Another important channel by which deficits can cause inflation is through currency devaluation/depreciation. It results from persistent debt monetisation.
Depreciation and devaluation are sometimes incorrectly used interchangeably. Devaluation is an official intervention in which the value of a domestic currency relative to other currencies, under a fixed exchange rate regime, is decreased.
In contrast, depreciation is market drivenan unofficial decrease in the exchange rate in a floating exchange rate system, induced by excessive money growth.
Whilst depreciation or devaluation make exports cheaper to foreigners, they increase the domestic price of imports and tend to put upward pressure on the general price level.
Increased export prices and falling import prices boost aggregate demand and hence inflation. This is unlikely to happen if the economy is in a recession. However, higher price of imported industrial and agricultural inputs would likely cause cost push inflation.
Then there is the likely spectre of a global recovery being accompanied by global inflation as all the industrialised countries are also on bailout and stimulus spending spree now. Hence international inflation would very likely impinge upward pressure on the Bangladesh economy through higher priced imported inputs.
Over the July-December 2008 period, domestic banks, domestic non-banks, and foreign sources financed 47.12, 19.24, and 33.66 per cent of the total deficits compared to 61.71, 10.14, and 28.15 per cent respectively over the same period in 2007.
Average money growth and inflation rate over the same period was 19.6 and 6.5 per cent respectively, which are already too high. Interested quarters should keep an eye on the growth of deficits and money growth to track the courses of inflation.
Obviously 14.59 per cent of the deficits over the July-December 2008 period were financed by non-bank public (private savings and possibly money-printing). Such private savings are unlikely to be fetched under a full-blown recession and supply of savings will also become unattractive if the interest rates on savings rate fall. Hence debt monetisation is the likely alternative to finance all forms of subsidy.
The fons et origo of the recessionary thrust in Bangladesh is totally external. No domestic fiscal incontinence can ride the country out of this fiasco in the short-run. However, I see a glimmer of hope for a significant recession rescue package from foreign sources if Barack Obama succeeds in persuading the leaders of the G-20 countries for aggressive stimulus spending when they all meet in London next week.
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