Regardless of who is to be blamed the reality is that economy is in a mess! Economic activity has shrunk dramatically (I can quote from a reliable source that till July 10th, not a single bag of yarn was traded in the Faisalabad yarn market, the largest in the country); exports are consistently declining; Stock Market stands eroded; and investment (both domestic and foreign) is virtually absent. TV talk shows aside, the concern to an average bread winner is not what happened in the past, but what really does the future hold. And it is in this backdrop that the Governor State Bank held a press conference last week to assure the markets that the worst may be behind us, as the economy may in fact grow at a faster pace (3.2-3.3%) than originally anticipated or (more appropriately) indicated by the IMF (2.3-2.4%) and that we may have seen the last of interest rate hikes and Rupee devaluations, or, at least for now. Ironically, he was explaining this while announcing an interest rate hike of 100 basis points!

The real dilemma or challenge facing this government though is that the Pakistani economy may have well and truly entered ‘Stagflation’ – A phenomenon outlining an economic condition combining slow growth and relatively high unemployment with rising prices, or inflation. One believes that not only are the present economic managers cognizant of this situation, but also that the recent central bank measures largely comprise of actions, which are traditionally used to control stagflation. Taking the textbook monetarist view, the Governor State Bank, seems to have set his primary macroeconomic objective as reduction of inflation, even if this causes higher unemployment and lower economic growth in the short-term. By keeping the discount rate at such a high level (and still with a projected upward trajectory) his underlying argument being that unemployment is a ‘price worth paying’ for containing higher inflation – in essence the central bank prefers to prefer deflationary/contraction policies to get rid of inflation. The intentions may be noble, however, it may not be so simple. Monetary policy in essence controls inflation through increases in interest rates, in-turn increasing the cost of borrowing and reducing aggregate demand. Now this may or may not work well in reducing inflation in an economy suffering from stagflation, but one thing is for sure that the tool of aggressive discount-rate increases invariably cause a much bigger fall in the country’s GDP growth, in-turn exacerbating the very problem of stagflation itself, especially in economies where growth is already low (e.g. Pakistan).

In context of Pakistan and its ground realities, such a direction is likely to have even more shortcomings. To understand these one first has to truly understand the real drivers of inflation in Pakistan and the leverage that an interest rates actually has on spending or for that matter on influencing aggregate demand. To look at the recent inflationary phenomenon in Pakistan strictly through the Western prism will be a mistake to begin with. General international upward inflation cycles are caused mostly by rise in energy prices, rising wages despite low productivity (for example due to strong trade unions in the 70s) or by sheer international events like say a global increase in food prices or an unnecessary trade war like the one we are witnessing today between China & the United States.

However, in Pakistan, our today’s inflation push is totally different, as it is not being stoked by the traditional factors, but instead by elements like: A devaluing currency in an economy that is heavily reliant on imports of a fairly inelastic nature; An ambitious and fast track revenue drive by this government (meaning not only have the taxes gone up, but it has been done so instantaneously); and Due to a rapid and steep rise in cost of borrowing for the local manufacturing that is naturally reflecting in the end prices to the consumers. In effect what this means is that monetary tightening in the traditional sense will just not work in Pakistan. What the policymakers need to be mindful of is that the Pakistani economy does not work in the credit entrenched way as the western economies do and excessive raising of the discount rate will only further distort the supply side dynamics with little success in taming core inflation. Also, there is no real weightage of wages in the inflation at home, since the local wages in absolute terms are already very low or perhaps not sustainable to feed an average sized household. As explained above, the inflation here has completely different dynamics and is being largely driven by government’s own policy measures and not due to any external factors. With a substantially devalued currency over the last ¾ months and an already compromised average individual disposable income (due to an increased burden of new taxes), any further unnecessary cum unrealistic hikes in the interest rates will only further hurt the domestic manufacturing’s competitiveness, thereby further compromising employment generation and poverty level in the economy.

So the question that arises here is that what then are the solutions to overcome the prevalent stagflation? First, to start with the interest rates will need to be brought back down to a maximum of 10%. This can be done gradually, say by December 2019, but the sheer downward direction will deliver a powerful message that the government wants to enhance economic activity and not curtail it. Even at 10%, a double digit discount rate will still present the right optics for keeping a check on inflation, while at the same time remaining somewhat regionally competitive – India is at 6% and the Modi government has already indicated in its recent budget that it prefers to lower it further, Bangladesh is at 5% and Sri Lanka is at 6.50%. Second, it will do the government good to formally partner with the central bank in order to facilitate increasing of aggregate supply (in the economy) through supply-side policies, such as privatization or otherwise quickly resurrecting SOEs, deregulation reforms to increase efficiencies and last but least, announcing policy measures that directly aim at reducing costs of production for the domestic industry. For people following stagflation closely, the Phillips Curve that argued on the very assumption that concurrent rising inflation and unemployment was impossible, stands long buried. In fact, we are seeing this very contradiction take place right here in Pakistan today! As we know most modern or neoclassical economists argue against combating stagflation with higher interest rates: Milton Friedman was the first one to point out that once the markets adjusted to higher inflation rates, unemployment would rise again unless the underlying cause of unemployment was addressed; Austrian Friedrich Hayek’s has similar views to Friedman; and even Paul Krugman (who is known more as a Keynesian economists) argues that stagflation can mainly be understood through supply shocks and to overcome it the governments must act to correct the supply shock to ensure that unemployment does not rise during this period.

Third, and perhaps the most important factor that needs to be ensured is that any further devaluation should be avoided. By now it has become quite clear that the currency’s devaluation beyond a certain level has in fact proved to be counterproductive: In the process causing more pain, both to the government and the private sector, while in turn achieving scant little to boost the economy!