‘Imported inflation is generating the greatest damage in Latin America, even when domestic demand remains strong,’ says Paola Pecora.

Buenos Aires, Argentina May 28, 2008

Frequently I ask my macroeconomics students: “Why is it so bad to have an inflationary economy”? I can assure you that the answers I get are quite varied, at times even funny. In my opinion, if I had to choose two reasons why inflation is bad for an economy I would have to say, unquestionably, that first – it generates negative effects for an economy’s growth because it increases uncertainty for investment. Second, and possibly more important, inflation has an aggressive nature in that it adversely affects the poor – for in times of high inflation they often cannot afford the things they need.

Inflation tends to hit the poor people the hardest because they have fewer mechanisms in place protecting them against its effects. Also, due to inflationary pressures occurring in the region the effect on the poor is even greater because the increase in the cost of living typically affects essential items such as food and energy.

In the past, Latin American countries typically resorted to increasing interest rates in inflationary times. Also a very basic and widely known policy used to cool down the economy is to remove inflationary pressures on prices through lowering the aggregate demand.

But are these kinds of policies really useful when it comes to controlling inflation? I have already commented in past articles in my opinion that if inflation is caused by internal factors, then the policies that are most effective at controlling this inflation must be internal as well. But if the reason for price increases is external to the economy, then implementing more restrictive monetary policies tends to do very little to assist. Recently in Latin America, we have found instances of the effects of both internal and external pressures (i.e. domestic demand is strong while at the same time “imported inflation” is creating the most damage).

So the operative question is what can governments do when facing the impossibility of applying a restrictive monetary policy to effectively control inflation rates? One alternative could be the implementation of policies following the lead of other countries in the region, such as Mexico.

Currently, the Mexican government is implementing policies to fight the increases in basic food items. Instead of setting up price controls, a policy that ends up creating the opposite effect, Mexico is eliminating the importation duty on these items and creating a situation where the levels of supply are increased.

In keeping with this method, Mexico has decided to eliminate import tariffs on several food items such as corn, wheat, rice, and soy paste. This way, it fights inflation directly at its origin and at the same time it protects the population of the poor. This policy is complemented by a farmer support policy to increase production (a $1.9 billion package has been adopted to finance farm machinery), the elimination of tax on fertilizer and manure, and stronger aid to disadvantaged families.

Speaking about this policy, Calderón, Mexico’s president, noted: “In order to alleviate the effect of this international phenomenon in our country and to insure that it does not spread and effect those that are less fortunate, my government will implement several policies, starting today, to supplement the income of families in the face of the current international food price increases.”

These measures must be stressed because they are the ones that are most likely to have the greatest effect on containing external inflation without creating distortions in the economy. The significance of this policy is that it promotes the additional production of domestic food supplies, which in turn will decrease the dependency on external food supplies, which currently are experiencing great volatility in prices.

But maybe these are not the only benefits created by these types of measures to fight the causes of inflation…. Are there, in fact, any additional benefits to this type of economic policy?

In relation to this question, I believe that in this way, easing the monetary policy through much lower interest rate increases will benefit economic activity. And the final cost of the support for agricultural production and the elimination of import tariffs will be offset by the creation of a stronger level of economic activity.

We will meet again tomorrow,

Horacio Pozzo

Editor’s Note: Imported inflation is generating the greatest damage in Latin America, even when domestic demand remains strong. When it comes to economic policy, México is doing the opposite of some populist Latin American governments. Send your comments to me at: paola@latinforme.com