By JAYATI GHOSH*
Rising interest rates are likely to lead to economic disaster in low- and middle-income countries
Governments and central banks in the US and Europe continue to insist that raising interest rates is the only way to tame skyrocketing prices, even though it is quite clear that this approach is not working. This misplaced reliance on interest rate hikes is likely to lead to economic disaster in low- and middle-income countries.
Spanish-American philosopher George Santayana warned that "those who cannot remember the past are condemned to repeat it in the future." But sometimes even those who can remember what happened have a selective memory and thus draw the wrong conclusions. This is how the global political response to the current bout of inflation is playing out, with governments and central banks across the developed world insisting that the only way to tame rising prices is to raise interest rates and tighten monetary policy.
O volcker shock 1979, when the US Federal Reserve, under then-president Paul Volcker, sharply raised interest rates in response to runaway inflation, set the template for today's monetary tightening. Paul Volcker's interest rate hikes were intended to combat a price-wage spiral by raising unemployment, which reduces workers' bargaining power. Thus, as a result, inflationary expectations are contained.
But high interest rates triggered the biggest downturn in US economic activity since the Great Depression; recovery, as a result, took half a decade. Paul Volcker's policy also reverberated around the world as capital flowed into the United States, resulting in foreign debt crises and major economic recessions that led to a "lost decade" in Latin America and other developing countries. .
But the context in which this oppressive approach was very different from current conditions, because wage increases cannot now be seen as the main driver of inflationary pressures. Indeed, even in the United States, real wages have fallen over the past year. However, that hasn't stopped some system economists from arguing that higher unemployment and the consequent larger falls in real wages are necessary to control inflation.
Current inflation, as well as the restrictive policies that have been adopted, have undermined real wages in the world in general and, in particular, in Brazil, as shown in the graph below:
Even some of the most vocal advocates of monetary tightening and rapid interest rate increases recognize that this strategy is likely to trigger a recession and significantly damage the lives and livelihoods of millions in their own countries and elsewhere. There also seems to be little disagreement that rate hikes haven't slowed inflation so far, likely because rising prices are driven by other factors.
One would expect that the so-called “adults in the room” of global macroeconomic policy would recognize the problem and seek to find more appropriate responses. But national policymakers in advanced economies, as well as multilateral institutions like the International Monetary Fund and the usually more sensible Bank for International Settlements, seem to have no interest in alternative explanations or strategies.
This intellectual inertia is leading economic policy astray. Research has increasingly shown that the current inflationary surge is driven by supply constraints, speculation by large companies in critical sectors such as energy and food, and rising profit margins in other sectors, as well as commodity prices. Dealing with these factors would require sensible policies, such as fixing broken supply chains, limiting prices and profits in key sectors like food and fuel, and controlling speculation in the commodity market.
While governments are well aware of these options, they have not seriously considered them. Instead, elected officials around the world have left it to central banks to control inflation. Central bankers, for their part, relied on the brute tools of interest rate hikes. While this inflicts unnecessary economic pain on millions of people in developed countries, the consequences for the rest of the world are likely to be even worse.
Part of the problem is that the macroeconomic policies of the world's leading advanced economies focus only on what they perceive to be their national interest, regardless of the impact on capital flows and trade patterns in other countries.
The 2008 global financial crisis originated in the US economy, but its impact on developing and emerging economies was far worse as investors fled to the safety of US assets. Later, when developed countries adopted huge liquidity expansions associated with ultra-low interest rates, this caused speculative volatile money flows (hot money), which spread around the world; thus, low- and middle-income countries were exposed to unstable markets over which they had little or no control.
Likewise, today's rapid monetary tightening has revealed just how lethal this integration of financial systems can be. For many developing and emerging economies, financial globalization is akin to a botched house of cards.
An important new article by Dutch economist Servaas Storm shows the extent of the collateral damage that monetary tightening can cause in low- and middle-income countries. Interest rate increases in the US and Europe are likely to result in debt and default crises, significant production losses, higher unemployment and sharp increases in inequality and poverty, leading to economic stagnation and instability. The long-term consequences can be devastating. In its latest annual report on trade and development, UNCTAD estimates that increases in US interest rates could reduce the future income of developing countries (excluding China) by at least $360 billion.
Of course, rich countries cannot be immune to such damage. While policymakers in the US and Europe do not consider the impact of their policies on other countries, the effects are bound to spill over to their own economies as well. But for low- and middle-income countries, the likely results are much higher. To survive, developing and emerging economies must seek greater fiscal autonomy, as well as monetary policy freedom, that allow them to manage capital flows differently. They also need to reshape the business patterns in which their economies operate.
As the current COVID-19 pandemic and climate crisis have shown, pursuing greater multilateral cooperation and an equitable recovery is not just a matter of goodness or morality; doing so is in the enlightened self-interest of rich countries. Tragically, however, almost no one in these countries – least of all their economic policymakers – seems to recognize this.
*Jayati Ghosh is a professor of economics at the University of Massachusetts, Amherst..
Translation: Eleutério FS Prado.
Originally published on the portal Project syndicate.
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