Against monetary dogma

“We’re captive on the carousel of time,” sang Joni Mitchell, “and go round and round and round/In the circle game.” The circle game is Pakistan’s dependence on stand-by credit, this time for the 24th round. The carousel is the monetary dogma imposed yet again by our creditors: extortionate interest rate to reduce inflation. It is time for the State Bank (SBP) to step off the carousel and slash the discount rate to 14%. Now.

Despite two welcome reductions this year, the still sky-high 19.5% interest rate is ravaging Pakistan’s economy. It is discouraging pro-growth investment and putting an unbearable burden on borrowers, which in Pakistan are mostly medium-to-large businesses and the federal government. Interest payments have decimated the state’s ability to serve the Pakistani people.

The largest item of government expenditure in 2024-25 is not defense. Far from it. At Rs 9,775 billion for FY 2024-25, interest payments are 460% greater than the defense outlay of Rs 2,122 billion.

Inflation in Pakistan is driven historically in part by increase in money supply. Devaluation and consequent cost-push pressures, and exogenous energy-price shocks are, however, equal if not more significant variables. As there is no consumer finance to speak of, consumer demand is inelastic on interest rates. So is government borrowing.

A rise in interest rate is ineffectual in curbing inflation in Pakistan. It benefits only the banks, which have reaped and continue to reap windfall profits by lending to the government at high interest rates mandated by the State Bank, crowding out lending to the private sector.

Business and economy journalist Khurram Husain identifies the source of the ongoing run of inflation: “From June 2020 onwards, the government issued the largest monetary injection the economy had received in at least a quarter-century via refinance facilities and low-interest rates. In less than a year, the State Bank bragged that the ensuing monetary stimulus applied to the economy was equal to 5% of GDP. The printing of money continued unabated.”

Three specific steps by the hybrid regime contributed to the catastrophe. First was the unending amnesty to the real-estate sector. The second was the inflow of ‘hot-money’ dollars in 2019-20 and their overhasty outflow. Between April 2020 and May 2021, the Temporary Economic Refinance Facility (TERF) haemorrhaged Rs 628 billion to the corporate sector at 5% annual rate for 10 years with a 2-year grace period.

When direct borrowing from SBP was no longer possible, the regime resorted to refinance and then to borrowing from private banks (OMO). In January 2022, SBP reported Rs 6500 billion of outstanding OMOs, nearly 23% of broad money. Horrors proliferated. During its term from August 2018 to March 2022, the regime nearly doubled central government debt from Rs 24690.4 billion on 31 July 2018 to Rs 43012.7 billion on 31 March 2022.

Headline inflation (CPI) hit double figures in November 2021 and climbed relentlessly. State Bank raised the discount rate in December 2021 by 250 basis points (bps) within a fortnight. In the twelve months following November 2021, interest rates were hiked by 875bps. In the four months that followed, they were hiked by yet another 500bps. “The State Bank was now injecting liquidity into the system with one hand while it worked to drain it out with the other,” writes Khurram Husain.

Weighed down by the vast debt it was taking, the regime borrowed more and more to pay interest on the debt, which itself was growing because of rising interest rates. A biblical flood of money-printing ensued. Interest rates were high, inflation stayed high, and Pakistan’s policy credibility worsened.

Until the caretaker government stabilized the Pak Rupee through extraordinary, non-economics means in autumn of 2023, persistently higher interest rates failed to cut inflation. The opposite happened, in fact. Prof. Christopher Sims has characterized this phenomenon as “stepping on a rake.”

John Cochrane’s 2023 monograph “The Fiscal Theory of the Price Level” builds upon Prof. Sims’s conclusion: “fiscal policy can be a primary transmission mechanism or a primary source for changes in the inflation rate.” Prof. Cochrane argues that government debt can equal in significance to money supply in causing inflation. “Prices adjust until the real value of all government debt, including money, equals the present value of current and future government surpluses,” he writes. Put another way, prices adjust so that the real value of government debt equals the present value of taxes less spending. When people do not expect the government to fully repay its debts, inflation arises.

Prof. Cochrane’s explication could have been written for Pakistan: an increase in the real interest rate – the cost of borrowing adjusted for inflation – means the government must spend more on servicing its debt. This extra fiscal burden is inflationary. Conversely, lower real rates reduce debt-servicing costs and are seen as disinflationary. This conclusion flies in the face of monetary dogma.

The theory suggests a most sensible conclusion: governments must maintain credibility when it comes to paying off their debts. When the public debt becomes too large relative to future tax receipts, the government is expected to inflate away the excess liabilities. The price level moves in line with changes in those inflation expectations. Central banks cannot stop inflation by raising the discount rate. The Executive branch must commit credibly to balancing the books.

“Inflation is always and everywhere a monetary phenomenon,” said Milton Friedman. Prof. Cochrane comes to praise Milton Friedman, not to bury him. His model emphasises that controlling inflation requires monetary and fiscal coordination. Central banks can reduce inflationary pressures temporarily but governments must do the heavy lifting. Second, Cochrane argues there’s no need for central bankers to raise interest rates above the prevailing rate of inflation in order to get prices under control.

This should be music to the ears of the current government. Every 1% (100bps) by which discount rate is reduced, the federal government will save, by one reckoning, approx. Rs 250 billion. Reduction of discount rate to 14% down from the current 19.5% will free up an already budgeted approx. Rs 1275 billion.

The additional Rs 1275 billion can double the development program for this fiscal year, halve the electricity circular debt, put a dent in the budget deficit, or, closer to most consumers’ hearts, provide substantive relief in electricity bills. Reduction in the interest rate will reduce financial burden on businesses and remove a major hurdle in new investment.

The 8.4% differential between 11.1% CPI and 19.5% discount rate is overcautious and detrimental to an economy that needs a jolt to decimate inflationary expectations. A discount rate of 14% still leaves a cushion that can be compressed if inflation reduces further. The government need not be trapped on the carousel of outmoded monetary dogma. Let’s end the circle game and embark on the path of bold ideas and bolder execution towards new jobs and economic growth.

Copyright Business Recorder, 2024