Corruption, budget deficit and price instability

Principles of economics text taught us that a sustained increase in the price level is caused by a sustained increase in aggregate demand (AD) which is an algebraic sum of the demand for consumer goods, investment goods (equipment and structure), government purchases, and net exports (= exports(X) imports (IM)). That is, AD = C + I + G + (X - IM). Now what factors can cause a sustained increase in the four components of AD?

Economists widely believe that the money supply is the only predisposed factor that can continually increase and add stimulus to a sustained growth in all the four components of AD. One might ponder, "Can't government purchases continually increase and cause sustained increase in the price level?" This scenario is unlikely for two reasons. First, there are both real and political limits beyond which government purchases are untenable. The real limit is perceived to be 100 percent of GDP and the political limit, although unknown, is likely to be less than 100 percent of GDP. Second, government purchases that are not financed with newly created money may crowd out one of the three remaining components of total expenditures. Thus, increases in government purchases are not a guaranteed precursor to increased total expenditures because such an increase may be obliterated by a concomitant fall in private consumption expenditures. Thus a continued increase in the money supply can be the only lubricant to a sustained increase in the price level.

Budget Deficits, Money Growth and Inflation: The Central Bank of most free market economies conducts of monetary policy to achieve a target level of output growth, price stability and unemployment rate. Consistent with these policy goals, the authority sets an interest rate target and constantly adjusts money and credit growth to maintain that rate. However, in the process some exogenous factors may permeate into the authority's policy parameters. A government budget deficit is among the most common culprits. As budget deficits are monetised by the central bank, the money supply increases. The deficits monetisation by the monetary authority is triggered when interest deviates from its target range. This is because, as government issues new bonds to finance revenue shortfalls, supply of bond increases which causes bond prices to fall and interest rate rise. The central bank intervenes through open market operations to buy back some of the bonds to keep bond prices high in an effort to restore interest rate at the desired level. However, our central bank, the Bangladesh Bank (BB) acts as a service institution of the government of Bangladesh. The Ministry of Finance literally dumps bonds on BB for money, which then dumps a bulk of them on nationalised banks. What choice does BB has? It is not a constitutionally mandated independent central bank. These deficits induced increases in the money supply causes total expenditure to increase. The supply-demand imbalances in the goods market drive up the general price level to restore equilibrium.

Corruption, Budget Deficits and Money Growth: Like many countries, Bangladesh has been running into a significant amount of budget deficits year after year. But unlike most countries, a significant share of these deficits is attributable to "corruptions, hartals, and natural disasters."

There are at least six overlapping channels through which corruption leads to inflation. First, property owners, retail stores, and businesses evade taxes by bribing the tax officials. Tax revenues fall short of the projected amount which makes a gaping hole in the already deepening deficits. Thus deficits become larger by the amount of the tax revenues lost due to corruption. As a result, deficit financing by creating new money is larger than what would have been otherwise. This increased money supply continually creates inflationary pressure through increasing aggregate demand.

The second channel is a direct one. Bribe takers spend their "takes" on real estate properties, luxuries, and on goods and services that they could not otherwise afford given their income from employment. This exerts additional pressures on prices of a given market basket. The bribe givers, in all likelihood, could have saved the bribed money which business would have invested in to generate employment and output.

The third channel works through transfer of funds in hard currencies to foreign countries to buy real estate or other investments, or travel to neighbouring countries to shop for luxuries. Thus hard earned foreign currencies (mostly US $) are lost. This leaves domestic currencies weaker and depreciated in value through increasing its supply in the currency exchange market. As a result, foreign goods, especially high-tech machines, equipment and spare parts, become prohibitively expensive impeding business expansion, and or repair and replacement of worn out capital equipment. Thus corruption drags down productivity of both capital and labour causing price hikes and an economy wide inflationary pressure.

The fourth channel exerts upward pressure on prices through cutting future profit potential of investments. In an environment of rampant corruption, cost of business investment and operations are high. Real estate developers, property owners, retail stores, and all other entrepreneurs who pay bribes for quick approval of permits, licenses etc. must raise prices of their products to recoup costs and raise profits.

The fifth channel can drive up prices through loss of foreign direct investment (FDI) which are discouraged if potential investments are delayed and investors are haggled for underhand dealings. Any loss of FDI due to unfavourable business environment (such as corruptions and hartals) retards future growth potential. Such losses of investment potential affect future output, prices and employment and depress prospective domestic investments as well. Bangladesh offers the cheapest labour, but its per capita share of nearly $5.00 trillion of global outsourcing is probably the lowest among the South Asian countries.

There is yet a sixth channel, the banking sector. This sector suffers from the dual mishaps of adverse selection and moral hazard when it extends business loans under political pressure and or bribes driven greed of the bankers. Inexperienced and unscrupulous borrowers mismanage funds, businesses fail and loans end up in default. The government takes the heat and the economy ends up with unproductive excess money supply which transforms into increased aggregate demand.

Hartals, Natural Disasters, and Inflation: Unlike corruption, which is essentially a demand side factor, hartals and natural disasters act as supply side shocks and affect the economy the same way energy price or labour boycott affect production, and distribution of goods and services? Natural disasters add to the already burgeoning budget deficits, money growth increases and funds for private investments are drawn dry. However, natural disasters must be accepted as fait accompli. On the other hand, hartals are mostly brought upon by politicians who failed to hold on to power.

Government Interventions and Price Control: DS editorial on March 22 forcefully argued that authorities should enforce punitive and disciplinary measures against non-price competition such as hoarding, price gauzing, and market manipulations. Government intervention does not bring solution, instead impedes solution, and breeds corruption. These anti-competitive acts cannot cause a sustained increase in prices. They are essentially outliers, and can cause a short term price spike. The real solution is to allow competition and the forces of supply and demand, free of any externalities such as government interventions, to work their way into increased production and supplies of substitute products.

Inflation Expectations: An important factor that fuels inflation and price instability is the so called expected inflation. We know that inflation feeds into itself and breeds a spectre that fuels further inflation. People come to realise that as soon as their pocket gets emptied; even before buying daily essentials less than what they wanted. The result is a growing fear of a runaway inflation for an unknown period into the future. This expectation of inflation is self-fulfilling and in an effort to beat tomorrow's price increases people buy up goods today to hoard them aggravating the already vicious price spiral. Unless inflationary expectations are curbed by immediate monetary and fiscal restraints and increased supply of goods whose prices run away faster, price instability would be a nightmare.

Conclusions: The confluence of both demand and supply shocks have become so corrosive and contagious that only an irresponsible and self-indulging government can be oblivious to its consequences. With nearly 35 percent unemployment rate, slow use of available energy resources (natural gas), slow adaptation of digital techniques of production, lack of technically skilled workers, the economy's real GDP must be well below its potential. Government's claim of a 5 percent GDP growth, even if believable, accompanied by the scourge of inflation is showing signs of a dreaded prospect of topless price spirals. The presence of a large unrecognised body of "un- or under- employed" worsens the spectre of price spiral. Within the private sector, slow growth, corruption and hartals discourage businesses to expand plant and equipment investments, driving the elusive prosperity further into out of reach and sight. Fiery slogans with promises of affluence and prosperity by political parties in power or those in opposition are simply unattainable if growth deterrent factors and high unemployment continue unabated. It is a miracle that an economy which is continually subjected to so many anti-growth externalities (e.g. corruptions, hartals and natural disasters) have come a long way to avoiding an episode of a hyper inflation or an economic depression during its nearly 34 years of existence. Questions that crop up in my mind are, how can a country go on like this? Who runs it? Adam Smith would have said, "Stupid! Have you forgotten about the Invisible Hand?" I would have replied," Sorry sir, I certainly did."

Dr. Abdullah A. Dewan is Professor of Economics, Eastern Michigan University, USA