Conference: Monetary Policy and Economic Developement of the Republic of
Macedonia, November 18, 1999, Skopje
Zoran Stavreski,
MA
Research Department Director
National Bank of the
Republic
of
Macedonia
Presentation
It is my pleasure that today we will discuss the role of the monetary policy in
the
Republic
of
Macedonia
- a subject that arises great interest among the
academics, professionals, politicians, businessmen, mass media, but also among
the common people, who facing the everyday economic problems wonder what the
monetary policy can do to improve their lives. I sincerely hope that today's
discussion will creatively contribute to the quality of the debate in the media
and in the public regarding the role of the monetary policy. I have the
impression that, unfortunately, it is sometimes populistic rather than based on
knowledge.
Many years ago, Paul Samuelson, who is regarded as father of the modern economic
thought, wisely emphasized on the need to be careful that macroeconomic policy
is not based on the so-called shibboleths, which means a slogan or a phrase used
by a certain group of people who, by its continuous repetition, substitute the
scientific truth with this phrase. The public discussion about monetary policy
has been increasingly dominated by two such groups: the shibboleth of the first
group is economic growth, and of the second group - price stability. It appears
that the central banks should either decide to stimulate growth and stop
worrying about the inflation, or decide on zero inflation rate
excluding the issue of growth from their observations.
However, we are not faced with such choice, i.e. we should eliminate both
extreme options, the one concerning easy growth, as well as the one concerning
the mystical price stability. My aim today is to discuss about the price
stability and economic growth as two complementary targets. Admitting that no
one, not even the Central Bank, has the right to a monopoly on the true answer
regarding the monetary policy objective, I would like to express my arguments
why I believe that price stability should be the fundamental long-term monetary
policy objective in the Republic of Macedonia, and it is the only way to create
preconditions for a long-run sustainable economic growth. So, I will try to
break the illusion that the monetary policy has to change the focus of its
interest and that it has to abandon price stability in order to incur economic
growth. As a matter of fact, I will try to justify the attitude that as long as
the Central Bank defends the stability of our national currency, it means that
it conducts a pro-development policy.
When we discuss the influence of the monetary policy over the economy, we must
define the time horizon, i.e. whether we are interested in the developments on a
short run or on a long run. Such distinction is necessary in order to determine
what exactly the monetary policy can do, what are its capacities and what are
the constrains. This is necessary because I am under the impression that
in our country, and in many other countries, sometimes the monetary policy is
expected and required to do more than it realistically can.
The most important constrain of the monetary policy is that printing money does
not directly create wealth. Most of the theories of economic growth are
non-monetary by their nature. However, in the 1970s, Phillips, with his
well-known Phillips curve disturbed the theory for neutrality of money and
imposed the doctrine of so-called trade off between inflation and growth.
Subsequent research demissioned this relation both because of its weak
theoretical background in which the rational expectations are neglected, and
because it was not confirmed through the empirical experience of many countries.
The possibility to exploit the trade off between inflation and growth, i.e.
unemployment, basically depends on the speed and manner of establishing the
inflationary expectations and their implementation in the nominal wages and
interest rates. Acceleration of the inflation can enhance the economic growth
only up to the level where there is rigidity of wages and interest rates, i.e.
if the real price of these two important production factors is reduced: labor
cost and price of capital. But, theory and experience prove that economic
subjects are expected to act irrationally only on a short run. On middle and
long run, the subjects react rationally and prices and wages become flexible to
the maximum, which implies that the Central Bank can not produce sustainable
higher output through expansion of money supply.
One of the best known contemporary economists, Romer, defines that economic
growth occurs always when the national economy manages to rearrange its own
resources in a way that is more productive than before. Accordingly, economic
growth has two basic determinants: resources and productivity. If we use more
resources, or we operate more productively with the existing resources, output
will increase and unemployment will decrease. What is the role of the monetary
policy? Monetary policy is engaged through the operations of financial markets.
Economic growth means optimum allocation of resources in the most productive
areas, which requires clear signals from the price system. Well-conducted
monetary policy strengthens the clarity of price signals, unlike the badly
designed monetary policy that leads to ambiguity. Accordingly, monetary policy
that prevents the inflation from growing into a factor which influences the
investment decisions of economic subjects, is a
monetary policy that supports economic growth. In that way we come to
practically the best definition of the term price stability - it exists when
economic subjects do not expect possible change in prices when making economic
decisions.
In the monetary policy it is probably a truism to say that money supply has a
role in establishing the level of prices in the economy, and that inflation is a
monetary phenomenon. Continuous growth of the general level of prices, which is
actually inflation, can not be sustained if it is not supported by an
accommodative growth in the money supply. So, the first and the most important
lesson from the economic history with respect to what the monetary policy can do
is - the monetary policy can prevent the money from becoming a source of
economic instability.
High inflation, meaning a two digit annual increase in prices, is harmful for
the economic growth, for several fundamental reasons: first, it causes a decline
in investments. In conditions of inflation, the financial market is dominated by
short-term, primarily speculative investments; second, inflation is the worst
enemy of sound competition. Deteriorated purchasing power of the domestic
currency flattens the struggle for increasing the productivity and decreasing
the operational costs; third, inflation reduces saving, especially in the
national currency, thus narrowing the potentials for long-term growth. This can
be associated with the negative social effect, with the unexpected erosion of
the nominal value of assets necessarily causes redistribution of wealth, which
mainly affects the poorest layers of population.
Conclusions regarding the destructive influence of inflation on the economic
growth have been confirmed through numerous empirical researches. The results
pointing to the negative correlation between inflation and growth vary
dependently to the analyzed period and the number of observed countries. Most of
the research shows that 10 percent increase in average inflation results in a
decline in the average investments to GDP ratio from 0.4 to 0.6 percentage
points, i.e. it causes a decline in the average economic growth rate between 0.2
and 0.7 percentage points. Esterley's research show
that the rapidly growing countries, which he defines as countries with 4%
average annual economic growth, have an average inflation rate of 8.4%.
Especially illustrative is the example of
Singapore,
Malaysia
and
Thailand,
which in the past decade have accomplished average rates of annual real growth
of GDP of 8% - 9%, with an average annual inflation rate between 3% and 5%. The
slow growing countries, with an annual GDP growth rate of -0.2%, have achieved
an average inflation rate of 16.5%. The best illustration of the effect which
the irresponsibly conducted monetary policy may have on the economic
growth, is the fact which shows that the permanent increase in the
inflation rate by 10 percentage points annually, 30 years later will result in a
decline in the GDP by 4% to 7%!
On the basis of the aforesaid arguments there is almost a consensus among the
monetary economists that on a long run price stability should be taken as a main
objective of the monetary policy. However, that does not quantify the term price
stability yet, i.e. it does not set the rate of inflation - whether stability
means an annual inflation of 2%, as it is defined for the EMU countries, or
maybe for the countries in transition it is an annual increase in prices of 5%
or 8%. The empirical experience regarding the harmful influence of the inflation
on growth has been undoubtedly confirmed only for inflation rates over 10%. For
all nuances between 0% and 10%, there is no clear correlation between inflation
and economic growth, neither in positive, nor in negative sense. In each country
there is a certain threshold of sensitivity, under which it is empirically
proved that inflation on a short run has no impact on growth, i.e. there is no
negative correlation between inflation and growth. Different analyses determined
that this threshold is at the level of approximately 8% annual inflation rate.
Focusing on price stability as a monetary policy objective is sometimes
presented as neglecting the objective for economic growth. On the contrary,
price stability gives credibility and capacity to the Central Bank to fight
possible cyclical weaknesses of the economy. If the long-term price stability
incurs economic growth, why do Governments and Central Banks of many countries,
in different periods and with different intensity, try to use inflation in favor
of encouraging the development? Simply, the orientation toward long-term price
stability does not eliminate the need of considering the short-term effects of
the inflation on the real economy. As a matter of fact, most of the
macroeconomists, including, of course, those from the NBRM, agree that on a
short run monetary policy has an influence on the real sector of the economy.
But there is also a widely accepted opinion that countries which continuously,
or too frequently use the monetary expansion as means for artificial
encouragement of economic growth, almost without an exception end up with higher
inflation and lower average growth.
Does it mean that NBRM should be interested only in ensuring price stability and
does monetary policy really has no effects on the real economy? The answer is
negative. First of all, we need stability, but not rigidity. Second, monetary
policy should be focused on reduction of the inflation to the level that
maximizes output. Third, on a short run monetary policy undoubtedly has an
influence on the real economy, which means that through monetary illusion, by
acceleration of the inflation, in short intervals it is possible to intensify
the economic growth and reduce unemployment. Namely, monetary policy influences
aggregate consumption, and in case of insufficient utilization of capacities, as
it is the case with the
Republic
of
Macedonia,
it can intensify the economic growth. It seems as if there is nothing simpler
than to increase economic growth by pressing the pedal of monetary accelerator.
What is the problem with this scenario?
Simply, if it is continuously or more frequently practiced, the economic
subjects learn their lesson quickly and act rationally. The consequences at the
end are almost always: higher inflation and recession episodes interrupted from
time to time with short-term booms. It means that short-term fluctuations of
output and what is called long run sustainable growth,
should not be mixed up. The Central Bank is interested exactly in which way
monetary policy will most successfully enable the accomplishment of durable and
sustainable economic growth. It is my opinion that exactly because there is no
distinction among these nuances, which are very important, often there are
contradictory attitudes among economists and professionals in this area.
What does the experience from our short history of economic independence show?
Complex stabilization policy which was conducted in the
Republic
of
Macedonia
in the period after 1994, was directed toward
elimination of macroeconomic imbalances, expressed in the multi-digit inflation
rate (nearly 2000 in 1992, and over 230% in 1993), double-digit budget deficit
(13% of GDP) and frequent devaluation of the national currency. The heterodox
program based on restrictive monetary and fiscal policy and on wage control,
with the denar exchange rate as a nominal anchor in the economy, resulted in
permanent decline in prices. In the period 1996 - 1998, in the
Republic
of
Macedonia
the average inflation rate was 2.7% p.a., with an average increase in the GDP of
1.7% in the same period.
On this basis, can we think that long-term economic stability has been achieved?
In my opinion it has not been achieved yet, although we are on good track. What
the
Republic
of
Macedonia
has achieved is to reduce the inflation to a low level. However, variations in
the inflation rate from year to year, as well as the deflation realized during
1999, are, of course, not incorporated in the term price stability. Besides, one
should not abstract the fact that the term currency stability consists of two
elements: internal and external, i.e. stability of domestic prices and external
stability which leads toward equilibrium in the balance of payments. The
external value of Macedonian currency, and especially the
atrophied export sector, do not provide such equilibrium. In most of the
countries in transition there is a similar situation. It is my opinion that in
current stages of development of these countries, such disequilibrium is in a
way common, i.e. it is a logical consequence of the efforts of these countries
to accomplish a more dynamic growth and catch up with the developed countries.
Actually, by a definition, the deficit in the balance of payments is not a
problem until somebody is willing to finance it, i.e. until it is sustainable.
However, it doesn't mean that there could be continuity in accomplishing high
deficits in the current account of the balance of payments. The
Republic
of
Macedonia
has no more room and possibility to increase the deficit, nor to maintain it at
the existing level on a longer run.
Comparative analysis of macroeconomic indicators in the most successful
countries in transition in the past three years gives vague and contrary
conclusions regarding the correlation and the possible short-term compromise
among monetary supply, inflation and growth. The countries are grouped in the
following way: 1)
Hungary
and
Poland
are two countries with moderate inflation, which on average equals around 20%.
The money supply in
Hungary
achieved an average growth of 16.2%, and real GDP of 2.4%. Poland achieved three
times higher average growth of GDP (6.7%), with an average growth of money
supply of 39%; 2) Three other countries which reduced the inflation to high
single digits are Slovenia, Czech Republic and Slovakia, with an average
inflation rate of 7% - 9%. Monetary growth in
Slovenia
is on average 16.6%, and the real growth of GDP reached 3.7% on average.
Simultaneously, in
Slovakia
money supply achieved twice lower average growth of 9.3%, whereas the economic
growth was twice more intensive and reached 6.7% on average. On the other hand,
monetary growth in the Czech Republic reached only 2.1% on average, or seven
times less compared to Slovenia, but nevertheless, it managed to achieve an
identical average growth as Slovenia of 3.7%; and 3) Croatia, among the
countries in transition has realized macroeconomic performances most similar
with those of the Republic of Macedonia. In the past three years, this country
has had an average inflation level of 3%. The average growth rate of the money
supply is 27.8%, and the real growth of GDP is 6.4%. It is interesting that the
identical growth of the GDP was realized both in the year when money supply was
growing at the rate of 40%, and in the period when this rate was twice lower,
i.e. it reached 20%.
As it can be seen, experiences vary and they do not provide clear reply to the
dilemma whether the short-term trade off between inflation and growth is
successful. There are examples, such as
Poland,
which prove that this trade off on a short run is possible. However, there are
reverse examples, such as
Hungary,
which besides the fact that it has seven times higher inflation than
Croatia,
has achieved twice lower average growth of GDP.
Slovakia
is an example that with a single-digit inflation and single-digit monetary
growth, it is also possible to have growth of GDP by 6% or 7%. In order to draw
more sustainable conclusions, it is of course, necessary to make a dynamic
analysis of the tree-year period, having in mind also the time lag with which
the transmission mechanism acts, to observe the credit movements, but also the
implications from the loosened monetary policy on the disequilibrium in the
balance of payments. Besides macroeconomic policies, the comprehensive analysis
will cover structural policies, the speed of the reforms implementation,
privatization and presence of foreign investments, enterprises restructuring,
development of the financial system, functioning of the legislation, etc.
The
Republic
of
Macedonia
has ended its long-lasting recession and since 1996 it has started to realize
positive growth rates. However, the data on price increase, money supply and
real growth of GDP do not show stable correlation. Thus, the average growth of
money supply M1 in 1996 equaled 9.7%, in conditions of inflation of 3% and real
growth of GDP of 1.5%. In 1997, money supply accomplished zero average growth,
GDP increased by 1.5% in real values, and the inflation was 50% higher than in
the previous year and reached 4.4%. In 1998, inflation was reduced to five times
lower level of only 0.8%, although money supply increased by 14.9% on average.
This was followed by real growth of GDP of 2.9%. This year, with registered
deflation of 1% and increase in the money supply of over 30%, it is expected to
be achieved almost identical rate of real growth of GDP as in the previous year,
i.e. about 2.7%.
Accordingly, it can not be concluded that in the
Republic
of
Macedonia
there is a positive correlation between inflation and growth: the highest growth
rate of GDP of 3% was accomplished last year, with an average price increase of
only 0.8%. Simultaneously, inflation in 1997 was five times higher compared to
1998, whereas growth was twice lower, i.e. it equaled 1.5%. However, I want to
point to the fact that there is a certain, although not
completely confirmed correlation between growth of credits and economic growth.
Thus, in 1997, total credits accomplished an annual growth rate of 6.9%, and in
the following year it was higher and equaled 10.4%. It corresponds with the
twice-higher economic growth in 1998 compared to 1997. However, if we go back to
1996, growth of credits was highest and equaled 19.2%, and resulted in a GDP
growth of only 0.8%. This year, credit activity is of a similar dynamics as in
1997, but the growth of GDP is expected to be twice higher. It once again
confirms, also in the case of our country, the validity of the empirically
confirmed conclusion that development is primarily determined by the speed of
conducting the structural reforms, increased efficiency of the banking system in
the allocation of funds, development of the capital market, increased
productivity, openness of the country, attraction of foreign investments,
decreased level of public consumption, etc. In that context, sound fiscal policy
is a key factor in the intensification of national saving, which is a base for
long-term development of each country.
For these reasons, the debate in the economic circles today,
should not be directed towards arguing whether macroeconomic or structural
policies are more important, but what is the best way to combine them in order
to achieve efficient realization of the objectives within a certain time
horizon. Within the framework of the macroeconomic policies, the discussion is
not about which of the policies should have the priority - monetary or fiscal
policy - but how to achieve their most appropriate coordination, and how to gain
public support for their efficient implementation.
What are the estimations of the monetary policy strategy in the following
midterm period? The selection of an appropriate strategy for implementation of
the monetary policy includes three options: monetary targeting, direct inflation
targeting, and exchange rate targeting. The current strategy conducted in the
Republic
of
Macedonia
is exchange rate targeting. It has been conducted since 1995 and its
introduction arose from the well-known weaknesses of the strategy of monetary
aggregates targeting, which in the
Republic
of
Macedonia
was conducted from 1992 to 1995. Namely, in conditions of thorough reforms in
all segments of economic life, money demand, as well as the relation between
money supply and inflation, becomes unstable and difficult to predict. It means
that the basic condition for efficiency of this strategy was not met, which
was the main reason to switch to the strategy of exchange rate targeting.
Due to the impossibility of efficient implementation of the strategy of monetary
targeting, and since there was no need and possibility to implement the strategy
of direct inflation targeting, the existing concept of the monetary policy in
the Republic of Macedonia seems to be the best solution for the following
several years, especially until entering the EURO zone. This actually derives
from the fact that the Republic of Macedonia meets all four standard factors for
implementation of a fixed exchange rate regime: it is a small and open economy;
largest part of the trade is conducted with the country (countries), whose
currency is a nominal anchor; inflation is maintained at the level, which is
rather consistent with the anchor country; and there are institutional
conditions, which provide credibility to the fixed arrangement. Maintaining the
fixed denar exchange rate provided the necessary control of the increase in
prices and despite of the occasional criticism, raised the credibility of the
Central Bank. However, the five-year continuous implementation of this strategy
implies the need of finding an exit solution, in order to avoid the essential
weaknesses of the existing concept which are: complete inflexibility of the
monetary policy and impossibility to reduce the possible shocks to the economy.
Having in mind the tradition and behavior of the economic subjects in the
Republic
of
Macedonia,
it is clear that the changes must be very carefully implemented, in order to
maintain the stability, and not initiating inflationary expectations.
Due to the importance and power of the EURO as a currency of the most important
trading partners of the Republic of Macedonia, there is a naturally imposed need
of determining the fixed parity of our currency against the EURO, which covers a
much larger quantum of the total trade and financial flows than the Deutsche
mark, and it is based on much more liquid and deeper financial markets. The
large capital inflows and the increase in labor productivity, which are present
in the past couple of years, could impose a need of higher flexibility of the
nominal exchange rate in future - and therefore the option for determining
margins around the central fixed parity is acceptable. It means that the Central
Bank will still be strongly obliged to intervene whenever the exchange rate
approaches the margins, which will enable the maintenance of the credibility and
will keep the inflationary expectations under control. On the other hand, the
introduction of margins will enable to flatten the possible inflationary
disparities, and also to adjust the disequilibrium in the balance of payments.
The width of these margins should meet three criteria: to be sufficient in order
to maintain the exchange rate at the level determined by fundamental factors; to
provide enough room for anti-cyclical performance of the monetary policy; and to
respond to possible speculative pressures. I think that variations of +-5% are
quite sufficient for meeting these objectives.
Considerations for setting a long-term target for inflation, which would assume
an annual increase in prices up to 5% and a regime of central parity of the
exchange rate with margins of +-5% will probably be
disapproved by the shibboleths of both provenances. The proponents of growth
will treat this as a defeating proposal, insisting that we need higher inflation
for more dynamic growth, or more precisely, to solve the problem of unemployment
and improve the standard of living; the proponents of absolute price stability
will treat this strategy as irresponsible, or as a drawback toward old unpopular
inflationary periods. Unfortunately, the economy is not only what we would like
to achieve, but rather what we are able to achieve. Economic growth is
undoubtedly good, but its realization requires something more than a sole
desire. The reality is that monetary policy can never take the economy where we
would like it to be. As for the shibboleths, they are unquestionably an
alternative for the difficult considerations and hard long-lasting reforms, and
due to the frequent repetitions, sometimes they become popular in the public.
However, monetary policy is far too serious matter to be based on sticky
phrases.