A single digit inflation prevails in most countries, but Iran is perhaps the only state that has experienced double-digit inflation for more than five decades.
For Iranians, the dream of seeing price stability and single-digit inflation appears unlikely. Many experts believe that even with the complete removal of sanctions, the average inflation in Iran will remain close to 20%.
Kamran Nadri, an economist, prefaced an editorial for the Persian daily Donya-e-Eqtesad with this note. A translation of the text follows:
Inflation has increased in most countries in recent years. Many countries, especially industrialized ones, which register inflation rates of below 10%, are worried about its negative consequences and have launched a crusade against inflation, even if their production and employment slow down.
The International Monetary Fund and the World Bank have predicted that the economic growth of advanced countries will drop in 2023, as a result of contractionary policies introduced to curb inflation.
Developed countries have adopted policies that may reduce economic growth, although their inflation is much lower than Iran’s. However, Iranian politicians seem to have a different plan and believe that the way to control inflation is by increasing production.
Conundrum, Contradiction
It is a conundrum. On the one hand are developed countries bracing for recession (lower economic growth and higher unemployment rate) in order to tackle inflation that is much lower than Iran’s. On the other hand, there is a country with year-on-year inflation rate of above 60% and nearly five decades of failure to control inflation.
It does not tolerate a decline in production, as it claims that it wants to control inflation by increasing production.
The general public might assume that the stance of Iranian politicians is reasonable, as they believing that “containing inflation is expensive and its price is the decline in production.”
What is the root of this contradiction in the beliefs and behavior of Iranian politicians with that of the global experience to curb inflation? Why controlling inflation in developed countries is often accompanied by a decrease in economic growth in the short run? In other words, why doesn’t anyone in advanced countries say that the way to control inflation passes through production growth?
The answer is policymakers’ understanding of the difference between “economic growth” and “production gap”, and the relationship between inflation and these concepts, as well as the role of “inflationary expectations” and “inflationary inertia” in creating and sustaining inflation.
Economic Growth
Economic growth is synonymous with an increase in production capacity. In economic theories, production capacity over time depends on limitations such as labor force, productivity, quality of human capital and above all, social infrastructures (quality of political, social and economic institutions).
Institutional weakness (including political, social and economic institutions) is the main obstacle in the way of economic growth. Chronic inflation is the outcome of weak governance. Inefficient financial structure and wobbly monetary and banking foundations, or the lack of proper financial, monetary and banking governance are the main cause of inflation.
The cost of inflation is the decrease in investment and production in the economy. Therefore, although inflation has a negative correlation with economic growth, the cause of inflation is not the decline in production growth; rather it is the presence of either phenomenon (high inflation and low economic growth) in the long run.
Improving the quality of financial, monetary and banking institutions can help increase investment and growth of production capacity by reducing the average inflation rate in the long run and better management of inflation in the short run.
However, institutional weakness is not something that can be easily corrected; institutions in some countries do not move toward reform when they are moving in a backward direction.
Production Gap
Production gap is the difference between total demand and potential production capacity.
A positive production gap increases inflation and a negative gap reduces inflation. In fact, unlike economic growth that is created in the long run through institutional reforms and changes in behavioral parameters, the policymaker can only influence production gap in the short run through demand management. Therefore, curbing inflation in the short run is possible mainly by pursuing contractionary policies and creating a negative gap in production.
Inflationary Expectations, Inertia
The problem with inflation is that once it emerges, it tends to persist; it moves forward through the adjustment of production costs and the resulting cost pressure.
Inflationary inertia is reduced only if the policymaker reduces the level of total demand by applying contractionary policies and making the production gap negative. Therefore, the government’s policy to reduce inflation is often associated with recession caused by contractionary policies.
The policymaker could control inflation by creating negative expectations if inflation had no inertia and no tendency to last and was only the outcome of future expectations. Experimental studies based on statistical evidence confirm the existence of inflationary inertia and then show that inflationary expectations cannot be reduced without applying effective contractionary policies. That’s why anti-inflationary policies are usually associated with recession and lower production growth in the short run. Of course, the extent of recession will depend on the central bank’s decision over the degree of the monetary policy’s contraction (and the reaction of producers when it comes to setting prices).
In closing, decision-makers are advised to first shift from the discourse of “reducing inflation by increasing economic growth” to “moving toward economic growth by reducing inflation sustainably”. They should accept that in the short run, the control of inflation will be costly and the cost is the decline in production growth.
Secondly, they need to note that high inflationary expectations and inertia are two important hurdles in the way of inflation management. Overcoming inflationary inertia is easier when inflationary expectations experience a downtrend and policymakers can manage inflation with the help of lower production costs. When inflation expectations are high, the policymakers’ problem is much more difficult. Overcoming high inflation expectations and inflationary inertia at the same time requires more contraction and increases the cost, i.e., reduction of production.
The third and last key point is that contractionary monetary policy can only stabilize inflation at its historical average level. A sustainable reduction of inflation is not possible without undertaking fundamental reforms in financial, monetary and banking governance.
Finally, up until now, it does not seem that Iranian policymakers have the intention of using an active contractionary policy (perhaps because of the dominance of the idea of controlling inflation by increasing the economic growth rate). Just like in the past, their plan revolves around management of foreign currency exchange rates as an anchor of inflationary expectations, and of course, hindsight shows that plan has not been successful.
