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Wednesday, September 03, 2003

Rogoff on Global Disinflation

The Jackson Hole papers have now been posted . Among them is a highly relevant and interesting one by Ken Rogoff about global disinflation and globalisation. As Rogoff indicates the last decade has seen an enormous reduction in the level and volatility of inflation almost across the board. The million dollar question is why. Clearly improvement in cenral bank policies and fiscal strategies may form part of the picture, but they alone certainly can't do sufficient heavy lifting to provide an adequate explanation. Rogoff's solution: globalisation and deregulation have reduced the effect of monopoly pricing, leading to reduced inflationary pressure. I think Rogoff has something here, but I don't think this is the whole picture, not by a long stretch. In particular there is the dificulty in assessing the impact of price reductions and increased competition in the traded sector on prices and productivity in non-tradeables. Still, the evidence of a long wave tendency towards historically low levels of inflation (or, of course, deflation) is compelling indeed. (BTW if the hard work was being done here by improved monetary policy, then inflation targeting - using the same effective central bank devices - should prevent deflation. So if it doesn't...........).

In recent years, inflation around the world has dropped to levels that, only two decades ago, seemed frustratingly unattainable. If one takes into account technical biases in the construction of the CPI and central banks’ desire to maintain a small amount of padding to facilitate relative price adjustment and help avoid deflation, then disinflation in most industrialized countries has already run its full course. Even in the developing world, if current trends persist, inflation will be tamed (if not virtually eradicated) within a decade. What factors explain this extraordinary shift?

Has the inflation process changed fundamentally? This paper argues that any explanation of the recent episode of disinflation has to take a global perspective, and recognize the near universality of the phenomenon. The story in the advanced countries is well known and has been widely discussed: inflation averaged 9% in the first half of the 1980s, versus 2% since the beginning of this decade. But the performance of the developing countries is even more remarkable, with inflation falling from a 1980-84 average of 31% to an average of under 6% for 2000-03. From 1990-94, inflation in Latin America averaged over 230%, over 360% in the Transition economies, and roughly 40% in Africa. For 2003, all three regions are projected to have inflation around 10%.

The data are even more stunning when one looks at individual countries. In the 1970s, 1980s and 1990s, high inflation and hyperinflation countries abounded, especially in Latin America, Africa and the Transition economies. Argentina’s price level has increased a 100 trillion times since 1970, Brazil’s a quadrillion (thousand trillion), and the Democratic Republic of the Congo’s almost 10 quadrillion.2 Today, of the IMF’s 184 member states, only 11 are projected to have inflation over 20% in 2003, and only 6 over 30%. If one takes the 40% inflation threshold that some researchers have argued is particularly damaging to economic growth3, only Mynamar (40%) Angola (over 75%) and Zimbabwe (over 400%) seem reach or exceed this level in 2003..............

The global economy now appears immersed in a long wave of low inflation, but experience suggests that many factors, notably heightened conflict that reverses globalization, can bring it to an end.............

There is little controversy about the fact that improved central bank design has been a major factor in improved inflation outcomes, and I will not try to parse the different elements (greater independence, better communication strategies, improved techniques, etc.) here. My main focus is on whether other factors such as more prudent fiscal policies, higher productivity growth, deregulation, and increased globalization may have also contributed to make disinflation both less painful and more successful than would otherwise have been the case. Has the success of global monetary authorities in engineering lower inflation had anything to do with having the wind at their backs?

I shall argue that the most important and most universal factor supporting world-wide disinflation has been the mutually reinforcing mix of deregulation and globalization, and the consequent significant reduction in monopoly pricing power. This increased competitiveness lowers the gains a central bank can reap via unanticipated inflation because it reduces the gap between the economy’s monopolistically competitive equilibrium and the socially desirable competitive equilibrium..................

One view of the past fifty years is that the monetary authorities just got bamboozled by bad Keynesian theories in the 1960s and 70s. The great inflation of the 1970s and 1980s was the by-product of macroeconomic teaching malpractice. Once the world’s central bankers started coming to their senses in the 1980s, ending inflation was just a matter of communication and technique. Perhaps, but this interpretation probably gives too little credit to previous generations of policymakers, and too much credit to modern day monetary authorities, not to mention 1980s monetary theory. The global nature of modern disinflation suggests looking elsewhere..............

There are, of course, several examples of countries where inflation has been coming down despite rising deficits and debt ratios. India has been recording general government deficits of roughly 10% of GDP for almost half a dozen years now, yet inflation has declined. Recession-ridden post-1980s-bubble Japan, with sustained deficits of 6-7% of GDP and a debt/GDP ratio exceeding 150%, is actually experiencing deflation. More generally, as Reinhart, Rogoff, and Savastano (2003) document, many emerging market and developing country economies have seen a substantial buildup in market-based debt over the past fifteen years, due to various factors including financial liberalization (e.g., paying market interest on debt formally forced on banks at sub-market interest), lower tariffs and, in some cases, higher government budget deficits. Yet most of these economies have succeeded in lowering inflation.

Unexpected productivity growth at least temporarily reduces pressure on the central bank to inflate.........True, the productivity story works well for the United States since the latter half of the 1990s. However, in its simplest form, the productivity hypothesis falls far short as an explanation for global disinflation. In the case of Europe, for instance, the simple correlation goes the wrong way, with inflation falling through most of the period, yet trend productivity
growth declining as well. Indeed............amongst the largest European economies, productivity growth slowed substantially in the second half of the 1990s, continuing the trend decline in the largest continental economies. In the developing world, productivity – especially in traded goods – probably has been a factor in many cases, though it is hard to separate it from globalization.......

There is little question that in many economies, the mutually reinforcing effects of globalization, deregulation and widespread reduction of the role of government, have sharply increased competition, and lowered “quasi-rents” to monopolistic firms and unions. Blanchard and Philippon (2003), drawing on results from a broader OECD study of deregulation (Nicoletti et. al., 2000, 2001), argue that quasi-rents in the OECD have fallen steadily since the 1970s.

A reduction in monopoly pricing power per force leads to lower real prices, holding monetary policy constant. Monetary authorities can, of course, offset the nominal price level effects of this impulse by suitably adjusting monetary policy to stabilize inflation. As I elaborate below, however, they will generally choose to let some of the effects pass on to lower inflation......

Trade with emerging Asia has certainly put downward pressure on the real cost of goods, that is, workers in most countries can now buy more with a given income than prior to globalization. Although China alone accounts for 5% of world trade, emerging Asia combined accounts for almost 20%. The exact quantitative impact of Emerging Asia’s growing trade on global prices, however, is difficult to estimate, in part because there are large indirect effects in addition to the direct effects. For example, even though traded goods arguably only constitute at most 20-25% of US GDP (Obstfeld and Rogoff, 2000), sharp reductions in traded goods prices almost surely have spillover effects to other sectors. Many traded goods are intermediate goods (e.g., computers), and also there is some degree of substitution between various traded and non-traded goods.

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