The Responsibility for the New Growth Cycle is Shared Equally by the Government and the HNB

We can be sure that raising the HNB’s discount rate from a long-held 4.5% to 9% has almost no effect on inflation, as it is a promotional indicator according to which transactions do not occur in real life.

Written by: Damir Novotny, managing partner, T&MC Group
[email protected]

Although the HNB should know that the money supply is not directly related to this year’s inflation wave, it reacted with additional monetary restrictions. Although the Government should know that such high inflation is not a transient phenomenon, but reflects the overall state of the Croatian economy, it reacted with inappropriate measures of administrative repression and further fiscal expansion.

The July inflation rate of 8.4% in Croatia, measured by the annual consumer price index, is twice as high as the inflation rate in the EU. In some member countries, this rate was higher, in others lower, but the harmonized consumer price index, according to data published by Eurostat, was 4.3% across the Union, and only 4% in the eurozone. Such a price increase has caused great concern for the European Central Bank and finance ministers. Nevertheless, the general opinion is that the EU has survived the first wave of global price increases for raw materials, energy, and food well, which can primarily be attributed to a very robust export sector. Although the real and monetary sectors of the Croatian economy are very closely linked to developments in the EU economy or the eurozone, this connection cannot explain the sudden rise in domestic prices in the first half of 2008.

The Croatian National Bank, whose legal responsibility is to maintain macroeconomic stability, reacted very nervously by significantly reducing the money supply – thus reducing the credit activity of banks and directly affecting the appreciation of the exchange rate. It has, of course, mitigated the rise in domestic producer prices under conditions of significant increases in import prices. The effect of reducing the money supply by about 20% compared to the end of 2007 is currently difficult to assess. However, we can be sure that raising the HNB’s discount rate from a long-held 4.5% to 9% has almost no effect on inflation, as it is a promotional indicator according to which transactions do not occur in real life. The HNB claims that it has done everything in its power and that it is now the Government’s turn to take action. However, it reacted politically, directly limiting price increases in its area of responsibility and exerting indirect political pressure on the private sector. There is no mention of anti-inflation measures and policies, which were expected from the Government.

Such high inflation is indeed a significant threat to the Croatian economy. Today, there is no serious economist who would advocate for ‘controlled’ inflation as a possible stimulus for economic growth. Many arguments have accumulated to support the claim that there is no ‘good’ inflation, making further discussion completely unnecessary. Today, we can only discuss the upper limit of price growth above which the national economy enters a cycle of long-term stagnation (stagflation). There are studies suggesting that this could be an inflation rate of 5%. The Croatian economy has thus entered this dangerous zone this summer!

Although inflation is ultimately a monetary phenomenon, the latest global inflation wave does not come from the monetary sphere. At the end of the last century, central bankers reached a consensus that expansionary monetary policy should not add fuel to the fire, so maintaining low inflation has been set as the highest goal of most central banks. Such behavior of issuing banks has resulted in a long period of very low inflation and low interest rates. The significant rise in prices of raw materials and food in recent years has not only surprised central bankers, given that it was not caused by monetary expansion, but has opened a series of serious questions about possible anti-inflationary and pro-cyclical measures.

Governors of American issuing banks had to admit that the expected anti-inflationary effect of globalization on the American economy has been absent. The opening of the markets of India, China, and Brazil, which have a lot of cheap labor and can produce various goods for mass consumption at very low prices, was supposed to compete with the rising domestic costs in the markets of developed Western countries. Distribution costs, as well as consolidated retail markets, have almost negated these effects. The crisis in financial markets, on which the American economy, as a predominantly service-oriented economy, largely depends, has further affected the reduction of domestic demand as the main generator of growth. The American Government and central bankers opted for state interventions, providing additional liquidity to broken domestic banks and granting tax breaks. The danger of the American economy entering a recession, despite the fact that we still do not see an end to the financial crisis, seems to have been avoided.

European finance ministers, however, believe that ‘cyclical programs’, with which the EU has had quite a few problems in the past, are not the right solution and that the competitive strength of European companies in the global market can still be trusted. On the other hand, the governments of large European countries are building very complex systems of economic policy of an anti-stagnation nature and creating conditions to protect the European economy from external shocks. In the EU, there is a significant debate about energy savings, increasing energy independence, developing alternative supply channels, and alternative energy sources. The latest political instability in relations between the West and Russia certainly does not suit the governments of large European countries, as the new energy strategy can still be described as ‘work in progress’.

The Croatian Government has attempted to explain the sudden rise in prices by the influence of global inflation. The world market in 2007 indeed experienced tectonic shifts that caused a significant imbalance. If the rise in crude oil prices and other raw materials can largely be explained by the inflation of bubbles in commodity exchanges, that is, speculation with futures contracts based on expectations of continued demand growth from the Chinese and Indian markets, the rise in food prices is a structural problem. Changes in dietary habits in the growing economies of the East have caused a rise in demand that foreign supply cannot respond to in the short term. We see how difficult it is in Croatia to improve food production despite more than favorable natural conditions. If the inflationary bubble of crude oil has somewhat deflated, and further price declines can be expected as the market is well supplied and demand stagnates, food prices will certainly rise over a long period.

Croatian inflation, however, has only a partial connection to global prices. It is almost impossible to explain the rise in wheat prices of more than 60% compared to 2007, despite an excellent harvest this year and large surpluses. Consumer prices for oil and derivatives have risen, but not nearly as much as in EU countries, so the rise in food products and other goods of daily consumption cannot be explained by the impact of the oil shock. Inflation has also not come from the monetary side as the HNB has further ‘tightened’ monetary policy. The reality is that deep structural problems exist in the Croatian economy that have surfaced at the first signs of inflation and manifested themselves in excessive price increases. Inflation will lose momentum by the end of the year, but it will still be high, so it is certainly not just a passing storm, but poses the most important question for all economic policy makers.

Although the HNB should know that there is much evidence that the money supply is not directly related to this year’s inflation wave, it reacted with additional monetary restrictions. Although the Government should know that such high inflation is not a transient phenomenon, but reflects the overall state of the Croatian economy, it reacted with inappropriate measures of administrative repression and further fiscal expansion. Full responsibility for combating inflation and opening a new cycle of economic growth is equally borne by the Government and the HNB. The five-year cycle of relatively strong economic growth in Croatia, based on the growth of public and private consumption, is behind us. Opening a new cycle requires significantly more than public works and car imports.

New large investments in the industrial sector are needed, such as those currently being realized by the Serbian Government on the ruins of the automotive industry in Kragujevac. Investments are needed in the processing industry and agricultural infrastructure that will not only cover transport routes but, above all, storage capacities. A deep turnaround in agricultural policy is needed, where public money is stubbornly redirected in favor of those agricultural producers for whom the growth of domestic agricultural production is not a priority. A quick and radical turnaround in industrial policy is also needed, where domestic shipyards and railways are stubbornly rehabilitated. But, above all, the Government needs to turn to savings and stop financing unfinished highway routes. The HNB must change the direction of monetary policy: restrictive monetary policies and restrictions on the credit expansion of banks have not affected and cannot affect inflation today. Quite the opposite! There simply must be enough money for those who invest and create new values, but not for those who consume values that someone will only have to create in the future.