The Central bank (CB) says inflation is coming down. But the average housewife asks what prices have come down. In fact they will point to the prices of essentials like rice, bread and milk foods and say since a year ago their prices have gone up. They are not wrong. But they do not understand that inflation refers to the rate of change in the price level as measured by the prices of a basket of goods used by the average household during the base year which is taken as 100 and the value of the same basket calculated according to current prices; and not to the price index of the basket as such.

If we compare the latter with a previous period we know whether prices have risen or fallen. When inflation is a positive number, greater than one, then it means that the price level of the basket has gone up. But if the change in the Index is 5% currently while it was 7% earlier then inflation is coming down. This rate of change must be negative (less than 0) if the price level it to come down. If this occurs economists say there is deflation –the opposite of inflation. Deflation occurs when the general level of prices is coming down. People can’t even visualize such a situation because they are so used to inflation.

Is deflation good or bad? Generally the consensus of opinion among economists is that it is better to have low inflation say below 3% rather than deflation because under inflation it is easier for business people and there is the risk of deflation turning into a depression. They are going by experiences in the past in the developed countries such as the Great Depression of 1929 which began as deflation and turned into a depression later. But there are several distinguished economists who argue that there is good and bad deflation and that under good deflation the real incomes of the people will increase and enable them to buy more goods and that the risk of it turning into a depression does not arise since there will be no lack of effective demand.

During periods of rapid technological change, new products are introduced and existing products have to compete with those incorporating innovations. Then prices come down all round and the general level of prices will fall. Will this lead to a fall in output or Gross Domestic Product? There is historical evidence from developed countries which show that output has grown during periods of deflation and GDP even increased at a faster rate. W. Samuelson points out that this has happened in USA six times since the American Civil War, namely in 1879, 1885, 1922, 1928, 1939 and 1955. He quotes figures from the American National Bureau of Economic Research which has done a study on the business cycles that have occurred in the period since 1854. GDP expansion took place in all these six years.

So during periods of negative Consumer Price index changes the economy has expanded. Samuelson concludes that deflation is not synonymous with contraction in the economy. Consider our own experience in the 1950s. There was little inflation. The CCPI (1952=100) rose only to 100.5 in 1955 while the growth rate was a positive 5.9%. After 1956 when SLFP governments took office growth rates fell while inflation as measured by the change from the previous year which was negative in 1954 started rising up to 1959. This shows that there is no reason to expect the growth rate to become negative merely because the price level keeps falling.

Falling prices increase the real incomes of the consumers enabling them to increase their demand for goods & services. There need not be a reduction in Aggregate Demand. Last year the world prices of food fell from their previous years peaks. The prices of rice, wheat sugar and milk foods all fell. Wheat prices fell by 37% below 2007 record highs and rice fell by 53%. The prices of maize also fell by 3%. But the FAO points out that the benefits of these price falls has not been felt in the developing world. This has constrained the poor’s access to food.

In our own country the benefits of lower food prices has not been passed to the consumers because of high taxes levied at the point of import and VAT impositions. The monetary expansion carried out by the Central Bank has also contributed to holding the food prices locally without the consumers benefiting from the decline in world food prices. In the case of petrol the government refused to comply with the Supreme Court order to reduce its price after taking into account the lower import price and allowing for reasonable tax rates. So deflation is not bad and may actually be good not only for the consumers but even for business since deflation also brings down the rate of interest. This makes credit cheaper for business. During deflation consumers receive more purchasing power and businesses borrow more cheaply. So output could increase and productivity improves due to technological innovations.

But there could be a situation particularly in developed countries where deflation may reduce consumers’ purchasing power if their asset prices fall. Then output could contract. This is bad deflation where consumer purchasing power declines despite the fall in prices because their incomes in money terms have fallen owing to unemployment and output contraction. But there are plus points too. During deflation bad investments have to be written off. We have had no such experience because we are not a manufacturing country. But we have seen a different phenomenon.

Strong economic growth boosted by large public expenditure on the war and on infrastructure investments have led to large and increasing deficits in the current account of the balance of payments. The Government in order to find more tax revenue has siphoned off private sector incomes and wealth to the public sector. The government uses up over 35% of the Gross Domestic Product. It has now found that its tax revenue is falling heavily owing to the global economic recession affecting our businesses and the reduction in imports. So the economic growth fueled by the government from domestic borrowings and from money creation is affecting adversely the private sector growth.

But we are aware that government expenditure is driven by political rather than economic factors and its contribution to economic value addition for a given amount of money is far less than by the private sector.  So the expansion of the public sector reduces the growth potential of the country as well as the quality of such growth.

Controlling inflation is important

Why is the control of inflation so important? We have taken for granted that high inflation does not matter. But when our exporters complain of the lack of competitiveness owing to the high inflation, the government invariably resorted to depreciation of the rupee. Each year the rupee has depreciated by 7.5 to 10% except during the aftermath of the tsunami when a large inflow of foreign funds took place for tsunami reconstruction. So while the Sri Lankan rupee, the Indian rupee and the Pakistan rupee had the same parity to the dollar in the 1950s, today the dollar costs SLR 117 while the Indian rupees convert to a dollar at Rs 40 and the Pakistan rupee at Rs 60.

There is no better measure of the disastrous macro-economic management in our country by successive governments. As a trading nation we cannot afford to have a higher rate of inflation than that which prevails in our export markets. Nor can we tolerate a situation where inflation here is above the rate of inflation in countries that compete with our exports like India, Malaysia and Thailand. The sooner we bring inflation under control and maintain it at a low level the better for our economy.

It is only if the value of our currency, in terms of its purchasing power, remain stable over time can the price system provide a mechanism to allocate resources in accordance with changes in supply and demand for each commodity. Where there is general inflation prices reflect not only changes in demand and supply for the particular good but also the general increase in prices due to excessive money supply. Then the signaling system breaks down and there would be a misallocation of resources as business people misread the changes in the prices of goods produced or supplied by them.