Does inflation cause social damage? No doubt. Are the social ramifications of inflation related to the cause of inflation? Not much. Is inflation control the responsibility of governments? Sure. Do economists know about the cause and treatment of inflation? To some extent. Does our understanding of the cause and treatment of inflation necessarily lead to the control of inflation? Doubtful.
Teymour Rahmani, an economist, prefaced an editorial for the Persian economic daily Donya-e-Eqtesad with these questions and answers. A translation of the text follows:
Subgame Perfect Nash Equilibrium
Economists, including me as well as officials and decision-makers of the country, are in a state called “subgame perfect Nash equilibrium.” This means that we all know that the current inflation situation is definitely far from the social optimum; even a significant number of economists and policymakers know that there are more preferable situations.
However, since the current situation is a form of balance, there is no motivation to change it, so the inflationary situation endures.
We, professional economists, contrary to what is said in media, do not see a lack of knowledge and inaction on the part of officials as the only cause of high inflation. But what has made solving the problem more difficult is that a solution can disrupt the balance and provide the motivation for reaching equilibrium with less social damage. However, our responsibility is to analyze the issue and think of ways of getting out of the existing suboptimal Nash equilibrium.
Inflation bounced back, despite the fact that it declined gradually in the fiscal 2021-22 and began a downtrend in the second half of the fiscal 2022-23 after the shocking discontinuation of foreign currency subsidy for imports.
Liquidity Growth, Imbalances
There is a general agreement about factors that trigger inflation, i.e., “creating the ability to spend beyond the ability to produce”.
Everything that boosts spending beyond the ability to produce must manifest itself in the form of liquidity growth.
We should be careful, as the growth of liquidity is a shortcut or alternative variable for all those forces. After all, an enduring inflation is not possible without the growth of liquidity.
What is happening in Iran is that “spending ability beyond production ability” has intensified in the form of imbalances, a significant part of which is the result of the governments’ financial operations.
At certain periods, the existence of abundant foreign revenues allowed extensive imports and forex rate control which, in turn, and helped control inflation to some extent. The effect of these imbalances remained hidden, but became apparent after forex incomes declined.
Given the rise in imbalances, the average inflation rate in Iran also increased. The graph shows the realized inflation rate and the linear trend of the inflation rate from March 1959 to March 2023.
While it is seeing ups and downs, inflation followed an uptrend over a long period of time and cannot be reversed quickly. Therefore, economists have a more or less unanimous opinion about this part of inflation.
As in the past, the forces of “creating the ability to spend beyond the ability to produce” have shown themselves in the form of liquidity much higher than economic growth, which result in high average inflation. They will persist in the fiscal 2023-24 just like in 2022-23.
Although the government tried to reduce the growth of liquidity in the fiscal 2022-23 and succeeded to some extent, the growth rate of liquidity is still higher than its historical average, so it is necessary to reduce liquidity growth.
At the same time, the government has come to terms with the increase in the interest rate in the fiscal 2022-23 and has set the rate for the interbank market at a higher level. This means that the government has followed the two recommendations made by traditional economics, that is, it has reduced the growth of liquidity and increased the interest rate.
In any case, firstly, the opinions of economists do not differ much about the average inflation; they consider it to be the result of high liquidity growth, and secondly, in 2022-23, there was no strange event in monetary policymaking to spark inflation.
We, economists, have the same usual explanation and the same old advice about the average inflation or inflationary trend: in order to reduce the average inflation and prevent its uptrend, efforts should be made to reduce imbalances and the average growth of liquidity.
Inflation Outpaces Liquidity Growth
But why in the fiscal 2022-23, the inflation rate exceeded the liquidity growth rate? One explanation is that the inflation rate exceeded liquidity growth temporarily, which is not convincing.
Iran has been facing high inflationary expectations since the fiscal 2018-19 when inflation was higher than liquidity growth.
Another explanation is that liquidity has become more fluid. This is not convincing either because it explains inflation, but not the cause of inflation. In other words, the second explanation is more or less the same as the first one.
The third explanation is that in 2022-23, the liquidity growth rate of 30%, for instance, has more inflationary power than the same liquidity growth rate in the 2000s because Iran now lacks forex earnings for making extensive imports and controlling inflation. This can only explain why the inflation-triggering liquidity growth is presently higher.
So then how can we explain the noticeable increase of inflation rate from liquidity growth in 2022-23 and possibly in 2023-24, while our explanation is based on conventional theories.
To understand the issue, it is necessary to refer to the average inflation rate in 2022-23, according to the statistics of the Central Bank of Iran which was 46.5% and that of liquidity growth at 30%. But if we want to compare the 30% liquidity growth with the inflation rate, we have to compare it with the year-on-year inflation rate, which was 63.5% in March 2023, according to CBI.
The year-on-year inflation rate compared with liquidity growth is right, because liquidity growth was 30% in March 2023, which means that the year-on-year growth rate of liquidity was 30%. So the difference between inflation rate and liquidity growth rate is not 16.5%, but it is 30%. There is a significant difference between inflation rate and liquidity growth, which we need to explain.
Inflationary Expectations and Exchange Rate
Any person with a brief knowledge of macroeconomics can immediately confront economists and ask that if the growth of liquidity failed to increase and instead decreased, why did inflation go up? Our theoretically-based answer is that the speed of cash circulation has increased. But the same person can ask why the speed of cash circulation has increased? The answer is that inflationary expectations have increased due to exogenous events, and in practice, events have intensified the outflow of capital and led to the jump in the exchange rate which, in turn has fueled the rise in inflationary expectations and a cycle of jumps in the exchange rate.
As the foreign exchange rate’s impact on inflation is significant, the rise in forex rate has led to a surge in the prices of goods and services. Therefore, in practice, the realized inflation rate has also increased. This explanation does not reject the fact that the increase in forex rate itself is a result of the growth of liquidity and the continuation of inflation, but it emphasizes that the jump in exchange rate is more than what the growth in liquidity explains and part of the jump in the exchange rate has an exogenous origin.
In fact, there is no doubt that in the long run, changes in the exchange rate are a result of liquidity growth or, in other words, shape liquidity growth. But you cannot deny the effect of exogenous factors, especially in the short run, on the exchange rate. The fact that the exchange rate suddenly sees a sharp jump and then decreases again cannot solely be attributed to the growth of liquidity. If the jump in forex rate is only due to the growth of liquidity, why does it occur at a certain point during political events, and if it is caused by the growth of liquidity then it should no longer decrease.
Iran, Other Countries With Hyperinflation
The sharp increase in the prices of assets can also explain why the role of inflationary expectations and currency jump in the high inflation rate compared to liquidity growth was important in the late 2022-23.
In the most recent hyperinflation the world saw, i.e., the case of Venezuela, for which official data has not been published, but is estimated to hover around 5,000% to 10 million percent, the inflation rate far exceeded the growth of liquidity.
In the hyperinflation of Zimbabwe during the years 2007-09, when the inflation rate was hundreds of millions of percent, the growth of liquidity was nothing. So inflation outstripping liquidity growth is not an unprecedented development in the world.
Therefore, the inflation rate can temporarily exceed the growth of liquidity (but only temporarily when the speed of cash circulation is increasing strongly and liquidity is becoming highly fluid). However, these inflations can only continue for a significant period of time, if they involve liquidity growth. In such situations, both the financial needs of the government and companies are intensified and they manifest in the form of higher liquidity growth.
The increase in the exchange rate and inflation become possible when the rise in the exchange rate accompanies liquidity growth. A fraction of the current high inflation is the result of the exogenous shock, but a significant part of inflation is still the result of imbalances leading to the continued growth of liquidity.
Although we are worried about the continuation of inflation and even an increase in inflation rate, there is a clear difference between Iran and many countries with triple-digit inflation and hyperinflation.
Firstly, Iran does not have a significant foreign debt, and secondly, the Iranian government’s debt compared with its assets and the size of the economy is not considerable. This means that policymakers have the opportunity to avoid runaway inflation. However, the intensification of capital outflow can create the same problem that Latin American countries with severe inflations suffered.
The inflation rate could exceed liquidity growth for short periods of time. In such cases, there is usually a currency crisis.
Thirdly, this issue is not incompatible with monetary theory. This issue is important because the solution to prevent runaway inflation is probably different from controlling conventional inflation and even high inflations in Iran’s economy. Foreign exchange policymaking, elimination of exogenous shocks such as political shocks, capital outflows and not allowing forex rate increases as a result of mismanagement are important.
