Popular myths about the world economy

New England Economic Review, July-August, 1997 by Norman S. Fieleke

In remarks before the January 1997 meeting of the American Economic Association, Professor Robert M. Solow of M.I.T. drew upon his previous experience with the President's Council of Economic Advisers to offer this advice for policymakers: "It ain't the things you don't know that hurt you, it's the things you know that ain't true." Many of us "know" such things, and sometimes act, or urge our representatives to act, on our mistaken beliefs. This article examines three common myths, or misconceptions, about the international economy. As with most myths, these embody grains of truth, but if accepted without qualification could lead to grievous policy errors.

I. Global Competition Prevents Inflation

Experienced analysts have been surprised by the low rates of inflation in the United States over the past year or so, because the accompanying relatively low rates of unemployment had been expected to generate significantly higher wages and prices. In seeking an explanation, numerous observers have focused on intensified global competition. They have argued that this competition inhibits firms and workers from boosting wages and prices and that it has forced much of the restructuring of the U.S. economy in recent years, including corporate downsizings. In this view, the firm that raises prices faces swift discipline in the form of increased competing lower-priced imports or decreased export sales, and the union that secures an inflationary wage increase soon finds its workers being laid off as the jobs they perform are transferred to lower-wage workers abroad. Thus, it is argued, there is little or no need to tighten monetary policy in order to prevent an acceleration of inflation.

Although such reasoning seems plausible, a nation's macroeconomic policies, particularly its monetary and exchange-rate policies, surely have much more influence on the nation's rate of inflation than global competition does, especially if the nation's economy is relatively large, as in the case of the United States. Indeed, it can readily be shown that, as a general principle, high involvement in the world economy provides no immunity against high inflation.

In Table 1, for example, data are presented for four foreign countries that have experienced bursts of inflation, in differing degrees, during the 1990s, even though their interdependence with the world economy (as measured by the ratio of their foreign trade to GDP) has been much greater than that of the United States. Other countries could be added to buttress the point, but the four selected comprise a diverse group, with marked differences both in economic structure and in per capita income. In spite of their diversity, all have endured periods of inflation that are high by U.S. standards.

All four countries have also experienced significant depreciations of their currencies against the leading exporting countries' currencies (whose weighted average value is represented in Table 1 by the SDR, or special drawing right, an international unit of account and reserve asset). The correspondence of high inflation and exchange-rate depreciation is, of course, no accident. With relatively high inflation, a country tends to lose competitiveness in world markets, and its currency must become cheaper in terms of other currencies to preserve or restore that competitiveness. Global competition need not stop the country from continuing along the dual paths of high inflation and exchange-rate depreciation.

Some analysts would argue that exchange-rate depreciation in such cases may well be excessive - more than is required to compensate for the country's loss of competitiveness caused by the underlying inflation - and that the depreciation therefore exacerbates the inflation. If so, growing interdependence, or [TABULAR DATA FOR TABLE 1 OMITTED] globalization, could render such inflation-prone economies even more, rather than less, vulnerable to inflation, through the feedback effects of exchange-rate depreciation.

While general international involvement and global competition do not immunize countries against high inflation, one particular form of international interdependence can do so. If a country successfully fixes the value of its currency in terms of the currency of a second country with low inflation, the first country will share a similarly low inflation. The fundamental reason for this outcome, however, is not global competition, which is present whether or not the country fixes its exchange rate in this way. The true reason is that linking its currency to that of a low inflator requires the country also to link its monetary policy and prices to those of the low inflator.

An extreme case of such linkage is one country's use of another's currency, rather than issuing its own, such as Panama's use of the U.S. dollar. As long as U.S. monetary policy prevents high U.S inflation and thus protects the purchasing power of the dollar, Panama will enjoy the same sound currency and a similarly low rate of inflation.