It was reported in the media that the finance minister, while chairing a meeting of the National Price Monitoring Committee on July 10, 2013, suggested that the sharply rising prices of essential commodities could be controlled through administrative intervention of the government. In this context, he proposed to activate district-level price control committees for fixing, monitoring and enforcing controls on prices of essential items.
If he has been quoted correctly, the minister needs to be reminded of the real causes of, and remedies for, inflation in Pakistan. His prescription to cure the disease of inflation is even worse than its diagnosis. Price controls are not effective even in the time of war when patriotism usually runs high. Such an approach would prove totally counterproductive in normal times.
But before dwelling on the causes and cure of inflation, it may be useful to digress a bit and raise some basic issues relating to the price situation. First, the attempt, at least by the last government, to manipulate official price indices to show a lower rate of inflation cannot conceal the actual situation that the people face in their daily lives.
The government should work on a correct and consistent method of constructing price indices with commodity weights that are representative of the budget of an average household and prices that reflect what people pay in actual practice. The use of unrepresentative commodity weights, tampering with the base year and using more favourable prices in constructing the indices in order to fool the people ultimately hurts the government’s credibility and backfires on it.
Second, focus on the prices of individual items in certain situations and markets, and at certain times, may be good public relations strategy but in the ultimate analysis it is the gap between the aggregate demand and the aggregate supply of goods and services over an extended period of time that is the fundamental determinant of inflation. Shifting the focus from the macro picture to micro details and from macroeconomic policies to administrative controls on individual items is a wrong way to control the price situation.
Third, in addition to the actual trend in the aggregate demand and supply, inflationary expectations play a key role in building up price pressures. If the historical trend is of a sharp increase in prices and people expect that trend to continue, price increases will take place even when the supply-demand gap does not change. Inflationary expectations, in turn, are not only affected by the historical price trend but also by public perception about the resolve of the government to undertake proper measures to address the problem in future.
Fourth, inflationary expectations give birth to hoarding and black marketing of goods as a means to reap large profits which should indeed be tackled through punitive government action. But it should also be remembered that hoarding and black marketing is a consequence of inflationary expectations rather than the fundamental cause of inflation.
In the matter of the real factors affecting prices, it remains true that prices may go up temporarily because of floods and earthquakes, a rise in world prices of certain items, or a temporary shortage of a particular commodity created by supply and distribution bottlenecks or lack of market competition. However, a high rate of inflation experienced for a long period is always a phenomenon created by expansionary and irresponsible fiscal policy and/or a highly accommodative and inappropriate monetary policy.
The main cause of inflation in Pakistan is that too much money is chasing too few goods. In the last five to six years, the government pitched its level of expenditure much higher than the amount of its revenue and the availability of budgetary support from abroad, and then began to meet it by borrowing excessively both from the State Bank of Pakistan and commercial banks. As a result, the growth rate of money supply has been about five times the real rate of growth of the economy in the last five to six years.
The excessive liquidity pumped into the economy put pressure on both domestic prices and the exchange rate. A large depreciation of the rupee in the last five years, in turn, contributed to a sharp increase in prices of imported goods in rupee terms and in the rising cost of production. But the exchange rate depreciation was caused, in the first place, by excessive domestic liquidity. The increase in domestic prices also made it necessary to increase wages, particularly in the public sector, financed by printing more notes as well as by bank credit leading to a familiar wage-price spiral.
At the same time, inflationary expectations that became entrenched in the minds of the people began to push up prices. But the origin of both these factors was a persistently large gap between aggregate supply and demand.
The second major cause of inflation is that the government has increasingly relied on indirect taxes for revenue generation. Unlike direct taxes, an indirect tax is always passed into prices. Any increase in sales tax, excise duty or customs duty finds its way into prices immediately and fully. In certain situations, particularly in an inflationary environment, the private sector may add a mark-up of its own over and above the increase in the rate of an indirect tax.
Third, inefficiencies and corruption in the production and supply of utilities, like gas and electricity, add to the cost of production which is ultimately translated in higher prices paid by consumers. Poor governance practices thus contribute to higher prices.
Fourth, heavy dependence of the country on imported oil has led to its rising import cost reflecting a sharp rise in the international prices of oil. The consequent frequent increase in oil prices not only affected the cost of living of ordinary people directly but also indirectly with its impact on the cost of transportation and production.
The attack on inflation needs to start with tightening fiscal and monetary policies, initially to work off the excess liquidity pumped in the economy for the last several years. Later on the rate of money growth may be kept in the range of only a few percentage points above the rate of growth of goods and services in the economy. This cannot be achieved without the government putting its fiscal house in order by raising revenue, containing unnecessary expenditure and reducing borrowing from the domestic banking system.
Once it happens, the consequent better availability of bank credit to the private sector and a fall in nominal interest rates would also help accelerate the rate of investment and growth and thereby the supply of goods and services.
A restructuring of the taxation system to reduce dependence on indirect taxes would reinforce the positive effect of reduction in the gap between the growth in the GDP and growth in money supply. A relatively stable price level will also slow down the rate of depreciation of the exchange rate and thereby reduce pressures on prices emanating from the external sector and from other domestic cost-push factors.
An intensification of exploration and discovery of mineral resources, particularly oil and gas, and increased availability of electricity for productive purposes, would also have a favourable effect on production and prices in the long run. We all know from experience that with the continuation of heavy downstream flow of river water, the sandbags placed to save a locality from flooding can divert the water in another direction but cannot save the country from flooding. The same is true of inflation.
Without restructuring fiscal and monetary policies, and ensuring a reasonable balance between aggregate supply and demand, the genie of inflation cannot be put back in the bottle by administrative measures.
The writer is a former governor of the State Bank of Pakistan.

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