My 1991 London paper as cited in 2014.11.30. 12:01 Italo Romano
MONEY AND RELATIVE STABILITY
2.1. Economic performance and capital
A second brief remark on a question of first principles is surmised to be appropriate at this point. (The first has been made at the beginning of the previous part. Neither one is meant to say that all the rest derives from them.) One reason for considering monetary equilibrium conditions within the network of capital phenomena is the dependence of successful long-term stabilisation efforts on the regulating impact of profit motivation. There is a negative feedback between prices and market competition which is modified but not eliminated by monopolies. Technical progress with its intellectual requirements is an exigency for every actor of business life interested in getting hold of assets with added value returns. The latter is an attribute of an asset in its quality of capital. In a capital economy private market actors are the main risk- bearers and inefficient activities are eliminated on this elementary (micro) level. It is fool-proof in this crucial respect even if the profit maximisation is not an exclusive pattern of behaviour. /cf.1.7./ Efficiency remains a first principle of a capital-money-market system even if its functioning is consciously restricted with regard to labour participation /cf.1.1./ and long- term capital requirements /cf.1.4./The expansion of this system so that it embraces public welfare goods and services remains a contorversial issue. Here marketisation and demarketisation follow each other in a cyclical way.
In a command system the economic organisations are interested in getting hold of assets in the quality of the latter as production factors in general but not in their specific quality of profit- making factors. Without profit motivation and market there is no capital. Asset formation is called ‘capital investments’, assets are treated in many ways as if they were capital, even capital/production ratios are computed. Technical progress requirements and the intellectual tasks related to it are commanded from above, on behalf of an antiintellectual in its nature establishment. /cf.1.8/ Some workings of capital are simulated but nothing can substitute for the profit drive as an incentive of the economic performance. Accordingly, the system is not fool-proof on the level of national economy being the main risk bearer instead of the market actors themselves. For the last two decades the Hungarian economy has not been a traditional command one. Economic reforms amounted to the beginning of systemic change. Economic performance nevertheless remained weak because of the lack of capital stimuli of development and technical progress. It was not fool-proof either. For some 20-30 years there existed, in terms of animal-farm connotations, quite a number of dinosaur-like big enterprises with net incomes syphoned out of the state budget. That was equal to syphoning away net revenues from more efficient producers thus restricting their investments. Output volume and pattern developed independently of comparative advantages. Lack of competitiveness resulted in a downward shift of overall efficiency. Income- producing capacities of the national economy were not enough to sustain growth and welfare.
All this resulted in a creeping, and, after some time, gallopping inflation. Price rises escalated from a 7% average in the mid 80-ies to 16% in 1988, to 17% in 1989 and to 29% in 1990. /20/ The recent rate is estimated at more than 35%. As there exists a trade-off between the balance of payments and inflation the payments situation became better last year. While in 1989 the balance showed a 1,5 billion dollar deficit, in 1990 there was a modest surplus. (Ibidem.) But, as a result of domestic inflation it cannot be a lasting achievement.While the drive to achieve an ever better competitive performance is a longterm condition of a dependable and relatively stable economic environment inflation should not be explained away by the absence of this powerful motivation. Price stability existed in the fifties and sixties. Business is on an upward slope recently but so is inflation. Equilibrium depends also on how macro-policy meets the requirements of capital towards money supply.
2.2. Capital requirements towards money
It is well-known that market forces alone cannot stabilise the economy without proper macro-policy measures. An expectation- climate promoting capital accumulation and investments can be created only by a complex approach of which the relation of money and capital is an essential component. Capital as a determining factor of money-supply requirements is overlooked by one-sided analysis of money. There are autonomous value-preservation consequences of the capital stock. For example, accelerated depreciation-amortisation increasing after-tax profits leads to changes in velocity of circulation. The ceteris paribus rule applies here as well as in the whole of this paper. The relation of the volume side and the price side of productive capital is a determinant of the equilibrium of commodity markets, which is a main component of the overall equilibrium. Dynamic effects emanating from inner characteristics of capital pertain to the purchasing power of money. Efficiency and competitiveness exert a powerful impact on the dual /price and volume/ capital structure asynchronity of which is one of the roots of inflation. Some other parameters of capital structure are quoted below.
On the recent stage of development the exposure of market actors to a number of non-market influences distorts security prices. Under such conditions capital ratios provide an independent measure of assessment in supplement to security prices. In particular, capital ratios are widely in use for the analysis of bank activity. For example,the ratio of share capital to the total of assets. Regulating authorities control this ratio in narrow brackets. In the U.S.A., it should be within the brackets of 6%-12%. The larger the bank the smaller the ratio. In London clearing bank groups, between 1976-1983, total capital measured both against deposits and liabilities oscillated around 7%. Free equity capital measured against banking assets oscillated around 2%. /21/ These ratios in normal conditions provide some leverage for regulation in a degree necessary in a market economy. If that degree is not complied with, quantitative and institutional changes are called for.
Financial markets are the precondition of fiscal, monetary and credit incentives applied in conformity with international practice and requirements of business life. For example,necessary regulatory functions,such as open market operations or reserve requirements presuppose financial markets in the absence of which monetary flows can be influenced only through taxation or direct price and wage controls which increase market imperfections and interfere with property interests. Programs for coming decades should include monetary scenarios based on the growing role of long-term treasury bonds and other state-backed securities. These market instruments finance the budget deficit through increasing government debt. Long-term bonds may provide a yield producing, value preserving, profitable reservoir of wealth for private investors. Beside real estate and private securities, state bonds are also elements of wealth as an object of decisions on what is the advantageous allocation of individual financial resources. As elements influenced by open market operations they are instrumental in regulation of money supply.
2.3. Liquidity versus transactional approach
Monetary dynamics are partially under the impact of capital creating functions of the banking system. A well-known distinction between money demand and credit demand is adopted here. Credit demand expresses the needs of economic actors investing/spending more than their resources allow. Money demand is determined by transactional, liquidity and saving requirements. In Hungarian practice the main monetary aggregate is the stock of all liabilities of the banks minus intrasystem claims and foreign exchange.(M3) With set-aside or frozen deposits deducted from M3 one arrives at M2. Deducting from this long-term deposits gives M1. These definitions /in conformity with the definition of Hicks, 4./ rely on the liquidity approach, viz. on how quickly an asset can be brought into circulation. The most liquid asset is cash, not much different are current account balances. Equilibrium interests require that transactional needs are distinguished from the above. These needs derive from the fact that income and expenditure of economic units do not coincide in time. This asynchronity is bridged by transactional reserves which is causal foundation that the latter be selected within the M1 as subject to special regulation. The other part of recent M1, namely other assets up to one-year liquidity may be separated into some special aggregate.
The significance of all this is connected with deficit financing at high speed of inflation. The surplus of printed money which goes together with the increase of state expenditures has no autonomous mechanism of disappearance like the one in the case of credits created by banks. Increasing transactional needs are able to absorb a part of this surplus. Deficit financing beyond this level can be thought of as money- diluting emission. The proposition is that in Hungary inflation comes about mainly in result of this factor. Main economic indicators may be quoted as evidence. /21/ While additional working capital credit in l989-1990 was 148 billion net government credit took 99 billion Forints from the banking system or approximately 40% of credit growth since other items were not significant.
2.4. Redistributive effects
One of the main effects of inflation is the redistribution of real income. The owners of production factors try to compensate inflation by raising factor prices. The latter restricts the real demand for capital goods and though in accordance with the above paragraph aggregate nominal demand will not diminish partial equilibrium may be restored. But there are also actors of final consumption who are not owners of production factors. Among them the inactive population and governmental or any other public agencies insofar as their expenditures on health, education, social welfare and the like are financed by the state budget. Price rises diminish the real value of their respective budgets. That has, in itself, a boosting effect on their deficits and creates pressures on the whole of public finances. There is no negative feedback between deficit financing and inflation. The self-reinforcing effects of inflation increase even more if the government tries to compensate to a considerable degree the diminishing real purchasing power of final users who are not owners of production factors. Indexation which is a controversial practice even in conditions of creeping inflation, at galopping speeds works to the effect of further speeding up inflation itself. Price, wage, welfare, interest rate or tax measures are unable to stabilise the economy if they are taken in isolation. And even if they are taken together,but in a fictitious independence from their underlying conditions: their impact on the money supply and its impact on them, the state of savings and their trend,the speed and structure of growth , expectations,etc. The responsiveness of the economy to the same measures, e.g. 1%-point change in interest rates is quite different in different situations. As regards gallopping inflation, it puts in another perspective even the governing principles commonly agreed at in a normal setup.
As briefly mentioned above /cf.2.1./ marketisation is a controversial issue in the realm of public welfare services. Capitalization is a distinct matter and may be introduced independently of the above controversy. For example it offers some inflation shelters for the inactive population in the form of pension funds. Up to now pensions were paid from the state budget, with all problems resulting from that. There was no pension capital. The financial sources of pensions were accumulated on a yearly basis from old age security payments on behalf of active employees and from taxes. Under a planned new system anyone can make old age security payments into the pension fund he likes. The fund acts as capital, as a long-term investment fund subject to portfolio management. Long- term nature of these funds determines that a fair share of them would go into real estate business. Under specific circumstances of gallopping inflation the chances for preserving the real wealth in this form are better than in other forms. Pension funds may provide a part of purchasing power for privatisation of state enterprises especially in the service sector. They by no means can mitigate inflation in general but may be instrumental in preserving the purchasing power of pensions.
2.5. A diagnostic phase
Some exclusive schools of economic thought have offered one-causal therapies for curing the diseases of recession and inflation. These cannot be successful forever. Their application results in improvements for discrete periods of time. In scientific theory the purity of the main attitude is a precondition of creating a logically consistent system as a single, descriptive or presciptive, positive or explanatory approach to the object of investigation.
Macropolicy creates mixtures by taking and processing a multitude of components in order of attaining some particular objective. But, as in chemistry, it is not enough to have a variety of components. Their relative weight, the sequence of the operations and the temperature in which they take place must be set up in a conceptually proper way. A balanced mixed approach poised to slow inflation in a considerable degree may not be reduced to a composition with 2-3-4 elements. It is a matrix of tools applied to a matrix of circumstances. It needs to make use of a number of various schools of economic thought which all would be wrong if taken alone because each of them one-sidedly operates in a restricted zone of regulatory power of respective fiscal and monetary, expectational and supply side, exchange rate and securities market instruments. In 1980 Professor Samuelson said he could not see any plausible application of his theoretical synthesis which had performed perfectly when he was an invited member of the Council of Economic Advisers. The theory was designed so that it could not be utilised in stagflation.
The above is to draw attention to an example of researchers’ self- reserve. As it has been mentioned their analysis like a software exists independently of its users. In way of self-reflection one may admit that it is independent also of the new suggestions made by the researchers themselves. If they try to apply their knowledge beyond its radius of action this amounts to assigning a job to a software which does not contain a related algorithm. To try to answer questions unanswerable because of lack of necessary information would mean the same. No one from outside the science is authorised to pass critical judgments on the views of the specialists. Self-reserve controls their assessment-making within the limits of their competence. And that is not just a moral question. As a scientist should mind the quality of a microscope which is placed between him or her and the investigated object, similarly an economist is obliged to be conscious of the relevance of available analytical tools.
This paper is not conceived so as to give a whole therapy. To try to do so would amount to the pretension that a proper diagnosis has already been done. Strategic schemas are indeed being built on this assumption which does not hold. The analytical phase attained so far is a pre-therapeutic one, i.e. that of diagnosis no matter how badly the economy would need a real cure. A relevant diagnosis often consists some elements of the treatment. The point of the above is that this should not be exaggerated. If it is then no matter how much one would like to be a doctor he may all right become the sickness itself.
2.6. Some features of a general diagnosis
It hardly needs to be said that circumstances in Central and Eastern Europe differ from whatever situations experienced before in the West. To draw attention to that Economics as a generalised understanding based on past situations is unable to cover this new one is not to underrate the significance of the tools of this science. What may be questioned is their direct applicability to a whole new situational matrix which does not fit into the system of assumptions of traditional economics as they are represented by neoclassical, keynesian-neokeynesian, monetarist, and neo- neoclassical schools.
It has been mentioned that East-European history has produced mutant societies /cf.1.8./ The mutants, inter alia, were antieconomical or noneconomical societies. Under the necessary impact of the past on the present this feature continues to exist well into the post-mutant stage of the nations in question. This scheme gives by no means an exhaustive picture but inasmuch as it is relevant one may ask if Economics can be applied to a non- economical situation. Assumptions on the state of affairs should be made explicitly anyway. If the violation of behaviourial rules has been built into the cellular information system of the organism then the immediate cure must not concentrate on the application of these same rules because the governing principles of the organism had changed. The importance of the impact of deficit financing on investments, monetary aggregates on trade cycles, or taxes on supply side need no restating. But not any of the well-known cures making use of these cross-relations could have been conceived so as to be able to overcome the non-traditional disease of Central and Eastern Europe. This is demonstrated e.g. by the fact that the situation is neither Keynesian nor monetarist.
2.7. Non-Keynesian situation
Hungary is not in a keynesian recession situation where effective demand ought to be increased so as to reduce incompletely utilised capacities and manpower reserves. Certainly both of the latter exist but the nation is interested in further reducing inefficient capacities and therefore growing unemployment – however hated by everyone – should be tolerated. That even substantial unemployment benefits cost less than maintaining the production culture which existed up to now is not a relief for people who are to lose their jobs. But this cost-benefit explanation is just an emasculated rhetoric in this case. It is absolutely impossible to preserve the old structure. Therefore the recent state of the national economy calls for some more recession, not for the recession itself but in order to get rid of its uneconomic structural elements. The impact of relative wage and productivity level on the growth of unemployment which according to the actual shape of the Phillips- curve trades off with the price index is an essential determinant of macropolicy. In Hungary employment level was maintained in an artificial way and against any indications of the Phillips curve for a whole decade which amounted to compelling the national economy to support a situation which it could not afford. An inflation of significant speed has been going on for several years but unemployment has begun to grow by hundreds of thousands only in this year. Without inflation it could have reached even a third of the labour supply or more. Or else, without unemployment the price index could have approached a hundred per cents or more. Both would cause social unrest, nor the recent situation can last long.
There are two powerful economic exigencies which call for curbing the inflation. The first one is the long-term equilibrium of the balance of payments. In short term the price index trades off with the balance of payments. /cf.2.1./ More specifically, it exerts its impact through the trade balance. Payment problems resulted in accumulation of a heavy debt burden in time when inflation was relatively moderate. Recently the debt service absorbs a significant share of domestic savings. In 1989 and 1990 only the foreign income part of the debt service (interest payments) required more than 1600 millions of US dollars each year.// The savings can be transformed into foreign payments through the expansion of exports in general and net exports in particular. This is likely to boost inflation. The trade-off will work in a reverse way: while corroborating payments and debt situation it will add to the inflationary pressures. In other terms it will stimulate imports and slow down exports and result in worsening the trade balance situation.
The second one is the contrast of gallopping inflation with the long term interests of capital expansion, saving and accumulation. Efforts to involve more foreign capital into privatisation may come down to jejune rhetoric when elementary conditions of financial stability are lacking. Capital does not fear uncertainty or risk. But gallopping inflation generates an environment of unpredictability which is unbearable to business. Couragious risk- takers would go on with investments, but the bulk of medium-sized enterprises would rather stay off. Insofar as the crisis is multi-dimensional a multicausal approach to its treatment is indispensable. However the multitude of influencing factors should not be identified with a multitude of objectives of the operation. Factors are many, but, beyond 30% slowing down the inflation must be the objective in terms of macro- monetary policy. Beyond that speed the price expectations appear to have a propensity to remain positive, the price index can double the next year, treble in the second year and so on. Growth incentives of the inflation are switched off at this speed. Self- accelerating effects are switched on /cf.2.4./