Externality is a term widely used in economics when dealing with issues such as the taxation of monopolies. In the context of inflation, it would not be out of place to use it, given the current condition of Pakistan's economy.
As Isaac Newton explains, all actions have an equal and opposite reaction. Some actions, though, may have some spillovers. Taxation comes up with a negative externality, whereas environmental protection or technology may produce a positive externality or net-positive social benefit. The question of interest is, does inflation always carry a negative externality? Contrary to popular opinion, this is not true.
Can inflation have a positive externality and can it be beneficial? The answer is yes. Single-digit inflation is always considered beneficial for encouraging producers. However, Pakistan is not only facing high inflation, but high double-digit inflation over 30%.
Pakistan is currently witnessing the dark side of inflation as it pushes past a rate of 29% on the back of the interest rate being raised to 22%. It impacts all aspects of daily life, from medicines to food, fuel, electricity, clothing, rent and other utilities. As a result, daily life is becoming unmanageable. At this point, it is important the country's economic managers focus on structural reforms instead of relying heavily on scaling the interest rate.
As per the Phillips Curve and Okun Law, unemployment and inflation have an inversely proportional relation
In economic terms, core and non-core inflation are rampant. The State Bank is trying to control it primarily via monetary policy tools. On the one side, high inflation brings down investments by reducing an individual's purchasing power and savings. On the other, inflation leads to the depreciation of the rupee (loss of money value), devalued exchange rate and many more evils.
Positive side of inflation
While it may be hard to believe given our current polycrisis, inflation has some positive sides in boosting economic activity. Rising product prices and their inflation-adjusted margins incentivise producers to sell more and, hence, supply more products. As per the Phillips Curve and Okun Law, unemployment and inflation have an inversely proportional relation. Hence, higher inflation helps reduce unemployment, according to the Phillips curve. Unfortunately for Pakistan, this is not proving true for a handful of reasons. Inflation in Pakistan thus far has proven to be an evil that is harming the country for the following reasons:
- High inflation has reduced large-scale manufacturing. Inflation has harmed the production/manufacturing sector in Pakistan. A decline of two percent in large-scale manufacturing is due to high inflation.
- The J-curve phenomenon (depreciation causes a decrease in exports followed by an increase) does not hold in Pakistan. The depreciation of the rupee (due to inflation) instead of increasing exports and improving the balance of payments is causing decreased production. Pakistan imports raw materials, which makes production expensive. Hence, exports, as well as all domestic industries, such as textiles, have demonstrated a reversal.
- Thirdly, inflation reduces savings. Economic growth models show a hike in savings (above the average level) may cause a nation to undergo a technical shift. New technologies can be introduced when high savings are converted into high investments in pursuit of efficiencies. However, in Pakistan, savings are on a decreasing trend due to rising inflation.
- The misery of people has increased. Items which could be easily accessed until a few months ago are no longer affordable or available. The concept of the middle class has almost vanished as income inequality increases, leading to extreme stratification between the upper and lower classes. The middle class, often dubbed the engine of the national economy, has lost its purchasing power. As a result, people are unable to save and draw benefits from the high-interest rate.
- High inflation leads to decreased exchange rates, precipitating high prices for imported petroleum products, consequently causing hikes in electricity prices and associative costs.
- The public's standard of living has deteriorated, challenging all sustainable goals. As a result, achieving Sustainable Development Goals (SDGs) seems to be under threat, particularly critical goals such as zero hunger and poverty alleviation. Other SDGs, such as access to clean water, environment, oceanic life and others, seem to have gone missing in Pakistani society due to rising inflation.
Controlling inflation is a priority, but one has to question the measures' efficacy as internal and external debt repayments mount
In such circumstances, claiming any positive externality or spillover effect of inflation makes no sense. The further tightening of the monetary policy, by raising interest rates from 21 to 22%, clearly exclaims the targets of the State Bank. Controlling inflation is a priority, but one has to question the measures' efficacy as internal and external debt repayments mount.
Prioritize real GDP rather than nominal GDP
The second-round effect of inflation is the new threat after core inflation. This is why inflation is spreading negative externalities in all business sectors. Stagflation has crippled Pakistan's economy as high inflation with high unemployment and negative real GDP growth requires serious restructuring of economic goals, and quick emergency measures need to be drawn. Any increase in nominal GDP is primarily due to inflation as real GDP has fallen to negative (recession). The increase of 29% in nominal GDP while a decrease of 0.30 percent presents a dire situation for the economy.
The country needs serious political and economic reforms so that true numbers can be quoted with an accurate estimation of challenges
A change in political behaviour is paramount. Politicians usually seek to score points by quoting nominal growth numbers without keeping sight of long-term impacts. There is an urgent need for the economic education of policymakers and politicians so that every government employee and politician knows the true picture of the economy. Attitudes need to be altered by focusing on solutions which can bring back the purchasing power of the public and subsequently appreciate the currency. Policymakers must stress real GDP figures. which are alarmingly negative in Pakistan and are expected to decline further in 2024.
The burden on Pakistan's already crippled economy can be foresighted, with high external debt payments worth $75 billion due over the next three years posing a major challenge. Moreover, the standby program by the International Monetary Fund is due to end in nine months. The country needs serious political and economic reforms so that true numbers can be quoted with an accurate estimation of challenges.
Without urgent reforms, it would be impossible to tackle inflation. Simply raising interest rates cannot provide a solution to high inflationary pressures coming from debt and external/global sources. The production and agriculture sides of the economy need to be bolstered on priority, with self-sufficiency the critical target. Besides managing the balance of payments, there is a dire need to invest in education and equip people with the requisite skills. For this purpose, it is critical to prioritize an alignment between industry and education.