The trap of monetary tightening – Jayati Ghosh

Excessive reliance on raising interest rates will likely lead to economic disaster in low- and middle-income countries.

The man in the gray suit whose ‘shock’ reverberated around the world: the late Paul Volcker (center), with his successors as US Federal Reserve Chairman Alan Greenspan (left) and Ben Bernanke (Federal Reserve)

The famous Hispanic-American philosopher George Santayana warned that “those who do not remember the past are doomed to repeat it”. But sometimes even those who can remember the past have selective memory and draw the wrong conclusions. This is how the global policy response to the current inflation spree plays out, with governments and central banks across the developed world insisting that the only way to bring soaring prices under control is to raise interest rates. interest and tighten monetary policy.

The Volcker Shock of 1979, when the United States Federal Reserve, under his then chairman, Paul Volcker, sharply raised interest rates in response to runaway inflation, provided the model for today’s monetary tightening. Volcker’s rate hikes were intended to combat a price-wage spiral by increasing unemployment, thereby reducing workers’ bargaining power and depressing inflationary expectations.

But high interest rates triggered the biggest decline in US economic activity since the Great Depression, and the recovery took half a decade. Volcker’s policies also reverberated around the world, as capital flowed into the United States, leading to foreign debt crises and major economic downturns that led to a “lost decade” in Latin America and the rest of the world. other developing countries.

Price increase

The context for this authoritarian approach was very different from current conditions, as wage increases are not the main driver of inflationary pressures. In fact, even in the United States, real wages have fallen over the past year. This has not, however, prevented some economists from arguing that higher unemployment and larger consequent declines in real wages are needed to control inflation.

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Even some of the staunchest advocates of monetary restrictions and rapid interest rate increases recognize that this strategy trigger a recession and significantly damage the lives and livelihoods of millions of people in their own countries and elsewhere. There also seems to be little disagreement that rate hikes have not slowed inflation so far, likely because the price spike is due to other factors.

One would expect the supposed “adults in the room” of global macroeconomic policy to recognize the problem and seek to craft more appropriate responses. But national policymakers in advanced economies, as well as multilateral institutions such as the International Monetary Fund and the generally more sensible Bank for International Settlements, seem uninterested in alternative explanations or strategies.

Intellectual inertia

This intellectual inertia seriously misleads politics. Research has increasingly shown that the current inflationary push is driven by supply constraints, big business profits in critical sectors such as energy and food, and increased profit margins in other sectors, as well as commodity prices. Tackling these factors would require sensible policies, such as fixing broken supply chains, capping prices and profits in important sectors such as food and fuel, and reining in speculation in commodity markets.

Although governments are well aware of these options, they have not seriously considered them. Instead, elected officials around the world have left it to central banks to control inflation and central bankers, in turn, counted on the dull tools interest rate hikes. While this will inflict unnecessary economic pain on millions of people in developed countries, the consequences for the rest of the world will likely be even worse.

Part of the problem is that the macroeconomic policies of the world’s major advanced economies focus only on what they perceive to be their national interest, regardless of the impact on capital flows and the business models of other countries. The 2008 global financial crisis originated in the US economy, but its impact on developing and emerging economies was far worse as investors fled to the safety of US assets. And when massive liquidity expansions and subsequent ultra-low interest rates in developed countries spread speculative flows of hot money around the world, low- and middle-income countries were exposed to volatile markets over which they had little or no control.


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Likewise, today’s rapid monetary tightening has revealed just how deadly such integration can be. For many developing and emerging economies, financial globalization is like a carefully constructed house of cards.

Debt crises and defaults

A important new document by Dutch economist Servaas Storm shows the extent of the collateral damage that monetary tightening could cause in low- and middle-income countries. Interest rate hikes in the United States and Europe will likely lead to more debt crises and defaults, large output losses, higher unemployment, and a sharp rise in inequality and poverty, leading to economic stagnation and instability. The long-term consequences could be devastating. In its latest annual report Trade and Development Reportthe United Nations agency UNCTAD estimates that interest rate hikes in the United States could reduce the future incomes of developing countries (excluding China) by at least $360 billion.

Of course, rich countries cannot remain immune to such harm. While policymakers in the United States and Europe ignore the impact of their policies on other countries, the effects are sure to ripple through their own economies. But for low- and middle-income countries, the stakes are much higher. To survive, developing and emerging economies must seek greater fiscal autonomy and monetary policy freedom, which would allow them to manage capital flows differently and reshape business models.

As the ongoing pandemic and climate crisis have shown, pursuing greater multilateral cooperation and an equitable recovery is not just a matter of kindness or morality: it is in the enlightened interests of rich countries. Tragically, however, almost no one in these countries, let alone their economic policymakers, seems to recognize this.

Reproduction prohibited—copyright Project Syndicate 2022, ‘The trap of monetary tightening

Jayati Ghosh is Professor of Economics at the University of Massachusetts Amherst and Executive Secretary of International Development Economics Associates. She is a member of the Independent Commission for the Reform of International Corporate Taxation and the United Nations Secretary-General’s High Level Advisory Board on Effective Multilateralism.