23 Things They Don't Tell You About Capitalism

Why is this? It is because the policies that are aimed to reduce inflation actually reduce investment and thus economic growth, if taken too far. Free-market economists often try to justify their highly hawkish attitude towards inflation by arguing that economic stability encourages savings and investment, which in turn encourage economic growth. So, in trying to argue that macroeconomic stability, defined in terms of low inflation, was a key factor in the rapid growth of the East Asian economies (a proposition that does not actually apply to South Korea, as seen above), the World Bank argues in its 1993 report: ‘Macroeconomic stability encourages long-term planning and private investment and, through its impact on real interest rates and the real value of financial assets, helped to increase financial savings.’ However, the truth of the matter is that policies that are needed to bring down inflation to a very low – low single-digit – level discourage investment.

Real interest rates of 8, 10 or 12 per cent mean that potential investors would not find non-financial investments attractive, as few such investments bring profit rates higher than 7 per cent.[5] In this case, the only profitable investment is in high-risk, high-return financial assets. Even though financial investments can drive growth for a while, such growth cannot be sustained, as those investments have to be ultimately backed up by viable long-term investments in real sector activities, as so vividly shown by the 2008 financial crisis (see Thing 22).

So, free-market economists have deliberately taken advantage of people’s justified fears of hyperinflation in order to push for excessive anti-inflationary policies, which do more harm than good. This is bad enough, but it is worse than that. Anti-inflationary policies have not only harmed investment and growth but they have failed to achieve their supposed aim – that is, enhancing economic stability.

False stability

Since the 1980s, but especially since the 1990s, inflation control has been at the top of policy agendas in many countries. Countries were urged to check government spending, so that budget deficits would not fuel inflation. They were also encouraged to give political independence to the central bank, so that it could raise interest rates to high levels, if necessary against popular protests, which politicians would not be able to resist.

The struggle took time, but the beast called inflation has been tamed in the majority of countries in recent years. According to the IMF data, between 1990 and 2008, average inflation rate fell in 97 out of 162 countries, compared to the rates in the 1970s and 80s. The fight against inflation was particularly successful in the rich countries: inflation fell in all of them. Average inflation for the OECD countries (most of which are rich, although not all rich countries belong to the OECD) fell from 7.9 per cent to 2.6 per cent between the two periods (70s–80s vs. 90s–00s). The world, especially if you live in a rich country, has become more stable – or has it?

The fact is that the world has become more stable only if we regard low inflation as the sole indicator of economic stability, but it has notbecome more stable in the way most of us experience it.

One sense in which the world has become more unstable during the last three decades of free-market dominance and strong anti-inflationary policies is the increased frequency and extent of financial crises. According to a study by Kenneth Rogoff, a former chief economist of the IMF and now a professor at Harvard University, and Carmen Reinhart, a professor at the University of Maryland, virtually no country was in banking crisis between the end of the Second World War and the mid 1970s, when the world was much more unstable than today, when measured by inflation. Between the mid 1970s and the late 1980s, when inflation accelerated in many countries, the proportion of countries with banking crises rose to 5–10 per cent, weighted by their share of world income, seemingly confirming the inflation-centric view of the world. However, the proportion of countries with banking crises shot up to around 20 per cent in the mid 1990s, when we are supposed to have finally tamed the beast called inflation and attained the elusive goal of economic stability. The ratio then briefly fell to zero for a few years in the mid 2000s, but went up again to 35 per cent following the 2008 global financial crisis (and is likely to rise even further at the time of writing, that is, early 2010).[6]