Academic journal article The Cato Journal

The Conquest of Worldwide Inflation: Currency Competition and Its Implications for Interest Rates and the Yield Curve

Academic journal article The Cato Journal

The Conquest of Worldwide Inflation: Currency Competition and Its Implications for Interest Rates and the Yield Curve

Article excerpt

In the United States and in virtually every country around the world, inflation has declined, and in most countries dramatically so. In addition, the volatility of inflation and expectations of future inflation have also fallen significantly. I will call these changes experienced around the globe the conquest of worldwide inflation.

I will begin by providing a few facts about the substantial improvement of inflation during roughly the past decade compared with the quarter century that preceded it. I will then try to understand why this remarkable decline in inflation has taken place. In particular, I argue that globalization, deregulation, and financial innovation, in part spurred by experiences of high inflation in the 1980s, have fostered currency competition that has led to improved central bank performance and, hence, the recent conquest of worldwide inflation. Friedrich Hayek (1976) had long ago advocated permitting greater competition among currencies, arguing that there would be a race to the top rather than a race to the bottom. Regardless of what one might think of Hayek's policy proposals, technological change in a globalized and competitive marketplace, I believe, has increased competition among currencies issued by central banks.

The increased competition among currencies has changed the ability and the incentives of governments and central banks to pursue high-inflation policies. As I will argue, such changes have allowed improvements in central bank independence, governance, and credibility, thereby leading to better inflation outcomes. In addition, greater central bank credibility has allowed the development of long-term bond markets in many countries where such markets did not previously exist and flattened yield curves around the globe as concerns about future inflation risks declined. Deeper bond markets with a wider range of available maturities encourage long-term planning and investment, and thus convey lasting gains, particularly in emerging markets. The important issue is whether the conquest of worldwide inflation will persist or be a temporary phenomenon.

The Worldwide Decline in Inflation

From the 1950s until the late 1960s, inflation rates were relatively contained, and episodes of high inflation were rare. Following the collapse of the Bretton Woods fixed exchange rate system in the early 1970s, however, inflation became a worldwide phenomenon. Even in Germany, where prices had been the most stable of any country in the world as tracked by the International Monetary Fund (IMF), the purchasing power of the deutsche mark declined by more than half between 1972 and 1995. (1) For the United States, purchasing power declined more than 70 percent over this period. For roughly half of all countries reporting to the IMF, the erosion of value of the currency was more than 90 percent.

To express this erosion in terms of cumulative inflation, $370 would be required today in the United Sates to purchase $100 worth of goods and services at 1972 prices. Brazil has by far had the worst experience of any country in the world during this period: The price level in Brazil is approximately five trillion times higher today than it was in 1972.

Since the early 1990s, however, worldwide inflation has significantly declined. In the advanced economies, for instance, the median inflation rate has fallen from 7 percent in the 1980s to 2 percent in the current decade. In emerging markets, the median inflation rate has fallen from 9 percent to 4 percent over the same period. Indeed, the latest issue of the International Monetary Fund's World Economic Outlook shows that average inflation rates in both the advanced economies and the developing countries in recent years are at their lowest levels since at least the early 1970s. (2) Indeed, the worst performers over the past five years have had inflation outcomes close to the average outcome in the 1970s. (3) Thus, the worst inflation today is not nearly as bad as it once was. …

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