International disinflation

In Malta, annual inflation dropped from an average 5.6 per cent in the Seventies, to 3.6 per cent in the Eighties, to 2.9 per cent in the Nineties and to 2.4 per cent in 2000-03. During some of those years, the economy was under the thumb of a socialist government that dictated a wide range of prices and generally wrecked the economy. Yet, in common with other economies that rely heavily on foreign trade, even then Malta's economy could not but be affected by what was going on in the world at large.

The data come from a recent study, "Globalisation and global disinflation", by Kenneth Rogoff, an economist at Harvard University and a former director of research at the International Monetary Fund. The article, in the fourth-quarter-2003 issue of the Economic Review of the Federal Reserve Bank of Kansas City, is available on the bank's Website at www.kc.frb.org.

There has been a spectacular decline in inflation across the world. In the advanced economies, average annual inflation dropped from 8.7 per cent in the 1980-84 to 2.0 per cent in 2000-03. Given the upward bias in inflation measurement, and also given the policy preference for a small dose of inflation - to render relative price and wage adjustments less painful, and to ward off a general drop in prices - the slowdown in inflation in the industrialised world probably has gone as far as it will go.

As Rogoff puts it: "If one takes into account technical biases in the construction of the (consumer price index) as well as central banks' desire to maintain a small amount of padding to facilitate relative price adjustment and avoid deflation, then disinflation has already run its course in most industrialised countries."

In the developing world, the slowdown in price increases was as remarkable: up from 31.4 per cent in 1980-84 to 53.2 per cent in 1990-94, and then down to 5.7 per cent in 2000-03. In inflation-prone Latin America, inflation accelerated from 82.4 per cent in 1980-84 to 232.6 per cent in 1990-94, but has since receded to 8.2 per cent in 2000-03. Rogoff predicts that "in the developing world, if current trends persist - with the emphasis on 'if" - inflation will be tamed within a decade."

One is struck by just how pervasive disinflation has been. You strain to spot any country where average annual inflation was higher in 2000-03 than in 1990-99. Triple-digit and even double-digit inflation have become harder to come by. Only three countries had triple-digit inflation in 2000-03, down from 25 with triple-digit inflation (or worse) in the Nineties.

One exception: Zimbabwe's inflation soared from an annual 28.5 per cent in the nineties to an annual 180.6 per cent between 2000 and 2003. But of two other standouts, the Democratic Republic of the Congo, disinflated from 3,369 per cent to 236.4 per cent, while Angola's inflation decelerated from 1,011 per cent to 165.5 per cent.

Why?

Greater central bank independence is one reason credited for the inflation slowdown. One measure that serves as a proxy for central bank autonomy is the turnover of central bank governors. Rogoff acknowledges that this is not a perfect measure, but "it appears to track the degree of independence and continuity reasonably well." The average turnover rate for central bank heads has declined in the industrialised countries between the pre-1990 period and after. The reduction in turnover was more pronounced for the developing countries.

The evidence does not provide an unambiguous link between fiscal balances and disinflation. What is fascinating is the impact of the technological revolution and globalisation. Rogoff finds the connection between productivity and disinflation to be weak in Europe, though stronger in the developing world.

On the other hand, the effects of globalisation and the liberalisation of trade are much more evident. Globalisation, deregulation and a diminished role for governments have combined to increase competition and reduce monopoly power. On the direct effect of globalisation, Rogoff notes that trade with emerging Asian economies has been putting downward pressure on prices and costs. These economies now account for a fifth of world trade.

In the US, internationally traded goods amount to only between a fifth and a quarter of GDP (a far smaller proportion than in Malta), but lower prices are likely to spill over into the wider economy. Rogoff refers to the additional argument that with increased price flexibility and reduced monopoly, there comes a reduction in the gains from unanticipated inflation and reduced motivation for central banks to inflate.

Rogoff's conclusion: "In sum, globalisation, acting in synergy with deregulation and privatisation, puts downward pressure on real prices and weakens the incentives that central banks may have to produce unanticipated inflation; thereby it leads to lower nominal price inflation over the long run."

The other side of disinflation

As attractive as falling or stable prices are to the buyer, there is a flipside to disinflation. With heightened competition, there is the shock that such competition conveys to sellers of products and recipients of income. In Malta, we have been observing the adjustments necessary in industries that previously operated in protected markets. We are noticing it in our exporting industries as foreign industrial locations undercut our prices and threaten to bid away our productive potential.

This phenomenon is observable even in high-tech activities. It can be countered by improving the flexibility of our resources. They have to be able to adapt to technological change. That is why the industrial incentives that served to attract industries based on low-cost labour were replaced by incentives that recognise the centrality of adaptability and productivity growth.

European Parliament

This week I attended the European Parliament from Monday to Wednesday, arriving at 3 p.m. on Monday for the first session of my committee on economic and monetary affairs and leaving at 5 p.m. on Wednesday after attending an extraordinary conference organised by the commission in preparation of the Spring European Council of Ministers regarding reforms in the EU. Despite the strike that hit Alitalia on Monday, I managed to pass through Rome without problems last Monday.

The committee on economic and monetary affairs had a really busy schedule this week. Apart from the discussion of around 11 reports, dealing with a varied range of topics from the regulation of investment services to legislation on credit for consumers, there was also a public hearing on the legal framework for a single payment area and an exchange of views with Professor Otmar Issing, member of the executive board of the European Central Bank.

The public hearing dealt with the current situation in the EU regarding the conditions of across borders payments and movement of funds. A number of interested parties from the financial sector, consumer organisations and the ECB gave their opinion on the current state of play.

This is a most effective method of getting various views heard before the legislation is published. In general it appears that the single market in the banking system is still not functioning seamlessly and there are still some modifications that need to be considered to have payments systems across countries as effective as payments systems in home markets.

The session with the member from the ECB focused on the recent surge in the euro. The ECB is not indifferent to the appreciation of the Euro and views the current situation with some concern. The view is that it is more a question of the US dollar showing significant weakness in the face of the high twin deficits, that is the trade and the budget deficits.

The US last year needed an inflow of funds to the tune of $500 billion. It seems that foreign investors are not willing to fund such huge sums, with the result that the US cannot afford to import as much as before. However, with the record budget deficit, in part due to tax reductions, the demand for imports is still rising. Given that this year is an election year, it seems that there is little hope for the US government or the Federal Reserve to take even mild corrective action.

In other words, an imbalance in the US budget and the current stage of the political business cycle are causing this dramatic fall in the US dollar which is putting pressure on the EU and the euro. The implication seems to be that if the Euro keeps appreciating, the ECB may be forced to act, even though the problem is in the US rather than in the EU. All in all a most interesting and productive week at the EP.

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