Lack of prudent macroeconomic policies

“The curious task of economics is to demonstrate to men how little they really know about what they imagine they can design” — Friedrich von Hayek

Pakistan is facing a substantial economic and financial crisis with an ever looming sword over its head of defaulting on its sovereign debt in 2023. Yet the current crisis does not only stem from external shocks, but rather our poor understanding of macroeconomic dynamics of the country that have caused frequent changes in Pakistan’s growth path.

This lack of understanding has led to the Pakistani economy having frequent and short-lived episodes of boom and bust periods since 1988. Over the years this has resulted in the average GDP growth to decline. Even the latest Pakistan Economic Survey for FY21 states that despite achieving a GDP of 5.9%; growth was unsustainable due to macroeconomic imbalances resulting in depreciation of the currency, high rate of inflation and widening twin deficits.

Why has this happened? To explain the reasons behind why we are heading towards a hard landing it is important to understand a simple point. Our most recent boom-and-bust business cycle is not a natural result of free-market capitalism, but rather of government intervention.

In an article “Inflation Must End in a Slump,” written in 1951, celebrated Austrian economist Ludwig von Mises (1881-1973) noted that all periods of government induced credit expansion must end in an economic crisis. Pakistan and with it most of the world, is presently going through a high period of inflation as a result of credit expansion.

As the quantity of money in circulation and deposits subject to check increases, there prevails a general tendency for the prices of commodities and services to rise. Business is booming. Yet such a boom, artificially engineered by monetary and credit expansion, cannot last forever. It must come to an end sooner or later. For paper money and bank deposits are not a proper substitute for non-existing capital goods. This is precisely what happened in the case of Pakistan,

The State Bank of Pakistan (SBP) reduced interest rates very sharply in 2021 and engaged in extensive money printing to influence the amount of money and credit within an economy carried with it the potential to set in motion the phases of the business cycle — that is, an inflationary boom followed by a recessionary bust.

It seemed as if the then Governor of SBP, Dr Reza Baqir, had gotten out of the central banking business and into the central planning business, meaning he devoted to raising up economic growth and employment through the dubious means of suppressing interest rates and printing money.

At the heart of Ludwig von Mises’ “Austrian” theory of the business cycle is that by expanding the money supply through the banking system and, as a consequence, tending to lower rates of interest in the financial markets, like any price artificially pushed below its market-clearing or “equilibrium” level.

But with monetary expansion, an illusion is created that there is, in fact, more real savings available to undertake more investments and more time-consuming investments that is actually the case. In this inflationary process, some demands and prices necessarily rise before others.

This influences the relative profitability of different economic and investment activities, which, in turn, influences the allocation and use of resources, labor, and capital goods in different ways across sectors in the economy. The entire structure of the economy is skewed toward greater and more time-consuming investment projects that, in fact, the actual savings in the economy cannot sustain in the long-run.

The inflation-induced distortions are not sustainable. The use of resources across time is out of balance with the desire and willingness of actual income-earners to consume and save. The “crisis” comes when these imbalances finally reach a breaking point, and it is discovered that the hoped-for investment profitability has been unmasked as serious malinvestments, many of which not only turn unprofitable but which cannot be brought to completion.

The economy then goes through an adjustment period, a process of “rebalancing” of prices and costs, as well as reallocations of labour and resources between various sectors of the market that is labeled the “recession” or the “bust” or, when severe enough, the “depression” phase of the business cycle.

Economic theory has demonstrated in an irrefutable way that a prosperity created by an expansionist monetary and credit policy is illusory and must end in a slump, an economic crisis. It has happened again and again in the past, and it will happen in the future as well.

Copyright Business Recorder, 2022