The cost of fighting inflation--less than previously thought
The battle against inflation is not so costly in lost jobs and output as many economists have thought.
To a world struggling with the problem of persistent inflation, this should be encouraging news. It comes from a new study of the experience of 33 nations by Martin J. Bailey, a University of Maryland economist.
For most politicians, the task of taming inflation is fearsome. It requires the application of restrictive monetary and fiscal policies. This slows down the economy, resulting in reduced production and higher unemployment. In the United States, for instance, the tight monetary policy of the Federal Reserve System prompted the current recession.
Back in 1978, the annual report of President Carter's Council of Economic Advisers, chaired by Charles L. Schultze, held that the costs of tackling inflation were enormous. To get rid of a mere 0.5 percent of inflation would take a loss of $100 billion in output. It might take six years of such losses amounting to 7 percent of real gross output to trim the rate of inflation by just 3 percent.
This gloomy outlook was based on some research by economist George Perry at the Brookings Institution, which Mr. Schultze had headed before moving back into government with the return of a Democratic administration.
Professor Bailey thought this analysis was far too pessimistic and has spent some two years conducting an econometric analysis of the inflation-fighting experience of most of the industrial countries plus some developing countries, such as Argentina, Chile, Brazil, India, Pakistan, the Philippines, and South Korea.
His basic conclusion is that the war against inflation is five to seven times less damaging than estimated by the 1978 report.
On average, he finds, a 5 percent reduction in the growth of a nation's money supply will over some three years slash the inflation rate by about the same 5 percent. The peak loss of output will amount on average to about 2 percent in industrial production or of gross domestic product, that is, the output of goods and services within a nation. Lesser losses will extend over about two years.
However, his study shows, there is considerable variation in the amount of the loss between nations and separate business cycles. The range for the same 5 percent slowdown in the money supply growth ran from 0 to 5 percent in the peak loss of industrial output and 1 to 3 percent for gross domestic product.
Of course, such losses are not insignificant. But as Mr. Bailey put it: ''Licking inflation isn't so expensive as previously put forward.''
This certainly is proving to be the case in the United States. Inflation has come down from a peak of 13.3 percent in 1979 to an annual rate of 3.2 percent over the last six months, or down 10.1 percent. That, by the Perry scale, should have meant lost potential output of more than $2 trillion. It has been nowhere near that. However, the economy has been growing slowly for a few years, with a short recession in 1980 and the current recession. Lost output has undoubtedly been some hundreds of billions of dollars.
Mr. Bailey's study examined mostly data from the 1970s, but did include some earlier statistics. He also knocked out of the study any experience where inflation exceeded 100 percent.
In an interview, Bailey listed several other conclusions he has drawn from his study, presented at a conference here last week of the National Bureau of Economic Research:
* An anti-inflationary program will succeed only if it includes a reduction in the growth of a nation's money supply. In some countries, that cut in the growth of money will require a tighter fiscal policy with less government debt being financed by the nation's central bank.
* A drop in the growth of the money supply produces consistently a proportionate decline in the rate of inflation. ''It never misses by more than 1 percent,'' says Bailey.
* There is no significant difference between the impact of anti-inflation programs in industrial and developing nations.
* There is, however, a sizable distinction between countries with high and variable rates of inflation and those without. The former have far less trouble bringing inflation down. Professor Bailey surmised that their people are used to inflation jumping about and resist change less firmly. For example, inflation peaked in Argentina about 1975 at about 450 percent when the economy was in a recession. In a year it was brought down to around 200 percent, and yet output increased.
* The study threw no light on the much-debated policy question of whether a quick, sharp cutback is superior to a gradual one of equal cumulative size.
* The rate of inflation can be brought down by a dramatic and believable anti-inflation program. In Uruguay, the election of a new president and appointment of a strong finance minister in the 1960s brought down the rate of inflation from something like 125 percent to around 25 percent even before a somewhat firmer monetary and fiscal policy could take effect, Mr. Bailey recalled. This illustrates the possible psychological impact of a firm stance on inflation.
Thus, he argued, some ''fanfare'' is useful in tackling inflation. But where central bankers have talked tough and acted weak, the fanfare does little good. It has to be believable.