Inflation in Pakistan has today reached punishing proportions and unless checked timely, carries the potential of violent protests ultimately posing an existential threat to the very ethos of Pakistan as a nation. A good part of the trouble has been that in fighting this menace (of inflation) our economic managers have been largely using modern monetary tools. While these tools work in the developed economies and especially where countries support their own strong tradeable currencies, e.g. the US, UK, Euro-Zone and to some extent Japan, Canada and the Australian continent, for the most part of the developing world, these are either not enough or simply in-effective.
The reasons being that for such developing countries since their currencies are not freely tradeable or convertible, their real economic strength does not properly manifest itself in the respective values of their national currencies. This invariably leads to forced devaluations even when the going is good, in-turn, pushing them in a vicious cycle where a push for a needed growth (development and employment generation) instead sends them down the path of gross external account challenges leading to debt traps, lop-sided policy dictations by financial lending institutions and a resultant inflation of exorbitant proportions for the general public.
An economic vision thrusted from the outside calls for the age old rhetoric of an exaggerated independence for the central bank, whereas, in reality the demand tends to be meaningless, because central banks of these developed countries cannot truly act as the custodians of the national currency without effectively teaming up with the other key economic organs (finance, commerce and industry) of the State, since just on their own they tend to be visibly constrained in the very leverage they can exercise on markets through any monetary adjustments or even more importantly, in the value of the currency they can demand when exchanging theirs with the other leading currencies of the world. Pakistan today finds itself in this very predicament!
To understand this concept better and to trace the origin of using monetary interventions and currency devaluations as policy instruments, perhaps it would be good to have a brief look at the very origin of the concept itself. In this context, the landmark developments influencing financial markets in the post-war era occurred 50 years ago, when the international monetary system shifted from a fixed to a floating exchange-rate regime. The demise of the Bretton Woods system of fixed exchange rates was a milestone event that marked the end of a prolonged period of low inflation, strong economic growth and financial stability.
This is when President Nixon and his advisers reached an agreement to sever convertibility between the dollar and gold at $35 per ounce. When Nixon startled the world by announcing the decision on August 15, 1971, it set in motion a series of events that led to the breakdown of Bretton Woods. Over the next three months, the US Treasury negotiated the first devaluation of the dollar with its foreign counterparts. Treasury Secretary John Connally and Undersecretary Paul Volcker were concerned that a burgeoning US trade deficit would increase steadily if the US dollar kept the parity versus the Japanese yen and key European currencies.
They were also alarmed by a steady drain in US holdings of gold that had fallen to just 25 percent of US dollars held by foreign governments and central banks. At the Smithsonian meeting in December, a compromise was reached in which the dollar was devalued by 8 percent. To maintain the Smithsonian parities, the Federal Reserve was obliged to tighten monetary policy while the central banks of the surplus countries were obligated to ease their policies.
Both sides, however, were reluctant to do so and a standoff resulted. The breaking point occurred in February 1973, when officials threw in the towel and closed the foreign exchange markets before the second dollar devaluation. This time, officials realised it was senseless to commit to a new set of exchange rate parities unless they could agree on policy actions to reduce inflation and trade imbalances. Thus, when the foreign exchange markets re-opened, currencies were free to fluctuate. Looking back on what transpired, one can ask whether abandoning Bretton Woods was a good decision or not?
The answer to this is rather relative, in that while the general Western viewpoint today is that despite certain valid criticism it was soundly based, since flexible exchange rates were not just good for America, but also proved to be compatible with global growth of international trade and capital flows, the other side could argue it differently. For them from being a low-inflation countries they suddenly became high inflation countries ever since the 1970s—brief period of relief, but respites that never could be sustainable. This was the main reason that they never could progress or come out of the poverty trap as value of any gains in their productivity got systematically eroded by successive devaluations.
Here in Pakistan successive governments failed to grasp that this higher inflation largely stemmed from devaluations. In wake of on-going devaluations, the moment the economic managers of the time tried to make the country’s fiscal policy expansionary, inflation set in and at least for the external account the interest rates almost become irrelevant, because a significant chunk of the import basket consisted of essentials anyway—even today more the 50 percent of Pakistan’s imports tend to be inelastic. Also, any artificial measures entailing wage and price controls again tended to be counterproductive, because in essence they fail to address the root cause of the problem and only end up increasing the pain.
The other challenge that we face today (and after the collapse of Bretton Woods) is that in many ways for us the international capital mobility stands proliferated. Meaning it has become harder to maintain a stable exchange rate, as capital flows out of high inflation countries into the ones with low inflation. This situation that has been created is a recurring problem.
Milton Friedman maintained that the shift to flexible exchange rates was desirable because it allowed countries with low inflation to regain control of their money supplies. However, consistent with western arrogance, he did not bother to take into account that (post event) the developing countries no longer had control of their currencies. This is why for us the solution does not lie in giving unbridled autonomy to the central bank or its governor, but in finding ways to increase its coordination with the other national economic management tiers, namely finance, commerce, planning and industry, to adopt a holistic approach in seeing to it that the value of the Pak Rupee is genuinely defended—Ishaq Dar succeeded somewhat in doing so, even though his approach was more dictatorial in nature, ignoring any advice in the process from commerce and industry.
Also, it is time that perhaps the intra-central bank structure needs to be honestly revisited by ensuring a more tangible and active participation in its apex board of competent and qualified captains of Pakistan’s trade and industry.