Do we go for growth first and inflation taming later, or inflation taming first and growth later? These are the two difficult options facing today’s policy makers. The heated debate on how central banks and corresponding fiscal sectors should respond to the current elevated cost-push inflation in the wake of the income destruction wrought by the COVID-19 firestorm reflects the dilemma the economic authorities face.

Inflation is not just anti-poor but also weakens the social fabric, apart from eroding the approval ratings of the authorities. So, to many observers, taming inflation first is task number one. That we can catch up on growth later seemed to be the lesson from the Volcker interest rate cure for oil crisis-initiated stagflation under US President Ronald Reagan in the early 1980s. Today’s problem is nascent stagflation: high inflation with output on the way south. The Federal Reserve Board and the World Bank seem the biggest rah-rah boys of the “inflation first” policy. But how to do this?

Paul Volcker raised the policy interest rate to levels that ravished market demand, causing a recession as investment and spending were shelved or aborted. In Volcker’s playbook, the retreat of output and the blip in unemployment is a small price to pay for a bludgeoned inflation expectation. The latter will repay later in a vigorous and longer duration recovery. Was not the “the Great Moderation” the payback, even if it ended badly with the Global Financial Crisis of 2008?

But people in economies still smarting from the income and asset destruction of the COVID-19 firestorm are already hurting to the bone. Hunger and homelessness are becoming stark prospects even in OECD (Organization for Economic Co-operation and Development) countries. Another recession will feed on the marrows!

The government of Prime Minister Liz Truss of Great Britain certainly thought so. But when, after token price caps on energy prices, it insisted on unfunded spending and lower taxes across the board to stimulate investment and get the supply side heaving higher again, it was severely rebuffed by the market as being irresponsible: at once stoking further inflation and, worse, being too indecently generous to the rich while the poor are already on survival mode. Portfolio outflow put a squeeze on the British pound towards a humiliating parity with the US dollar. A threatened pension bond fire sale and gilt yield going through the roof prompted the Bank of England to assume the role of purchaser of last resort in the bond market.

The conservatives’ thought collective insists on a similar favorable treatment of the investing class, arguing that ultimately it will lift all boats. That supply side exuberance, if and when it eventually materializes, will dampen inflation was the mantra of the conservative thought collective. But “eventually” no longer serves.

For many, Liz Truss’ being true to the Tory party’s conservative soul is not winning politics. Whatever the objective reality is, political time was certainly not on her side. With a general election looming, the Tories face a long exile from power, perhaps lasting decades. Liz Truss got the boot because her program came on the wrong side of politics when the optics had sympathy only for soft hearts not for cold minds.

The debate will continue, a witness to the fragility of Economics, especially Monetary/Macro-Economics, as a discipline despite the 2022 Nobel Memorial Prize being awarded to three economists in the money space. But Liz Truss’ historic exit also serves as a warning to others.

Beware! The market thought collective has its own dogmas and can bite recalcitrant members who dare defy its rules. If it can change destinies in an advanced economy like Great Britain, how much more in low-income countries like the Philippines.

Many emerging market economies today are caught up in the “basis points divination game”: how much will the US Federal Reserve (Fed) raise its policy rate? Being “behind the interest rate parity curve” can mean portfolio capital outflows which could blindside the currency as it did the British pound in the short Truss watch. Being too far ahead may mean lost investment and growth potential. The fates of these countries’ interest rates and their exchange rates are, after all, tied to how high the Fed goes to ravish US demand and tame US inflation.

Which countries are these? These are countries that tethered themselves to the “fear of fixing” thought collective. The tether is enforced by portfolio flows swishing ultra-fast through the autobahn of the open capital account. A fixed exchange rate runs the risk of being blindsided by sudden portfolio capital flight and defending the fixed level can result in a payments crisis as forex reserves run dry. Thus, the fear of fixing into whose lap low-income countries in the 1990s and beyond were stampeded into by the World Bank and the IMF on the strength of Mundell-Fleming impossible trinity.

But the original sin was, and is, the full opening of the capital account, which, in its turn, was argued to pave the way for more foreign investment. But what flocked to open capital account economies like the Philippines were distractive and often risky portfolio investment, not direct foreign investment. Portfolio investment made the wealthy who can afford financial placements even wealthier even as it made for boom-and-bust cycles and greater macroeconomic volatility. Portfolio flows are here-today-gone-tomorrow in endless pursuit of arbitrage.

Direct foreign investment by contrast creates stable employment and output; these flocked disproportionately instead into People’ Republic of Chinas (PRC), which refused to be stampeded into the fear of fixing club, adopting a regime of a dirty float supported with soft capital controls. Western trading partners railed for decades but to no avail against the suspected undervaluation of the yuan under this umbrella. When the yuan is undervalued, the only defense PRC needs is a printing press churning out endless paper yuans to exchange for dollars! If overvalued, the PRC would need to shed precious dollars in defense. For instance, when the Finance Secretary said he is prepared to lose $10 billion in support of the peso at P60/$, are we to surmise that he believes the peso is still overvalued at P60/$?

On PRC’s side famously was Nobel Lauriat Robert Mundell himself, who knew that the terror in the trilemma threat evaporates once the capital account highway faces speed bumps. Since the interest rate and the exchange rate determine the quantity and quality of investment of the economy, the contours of growth and inclusion in a fully open capital account economy is effectively surrendered to the Federal Reserve Board of the USA. By fully opening up to portfolio flows, we provide the oil with which we are fried.

How do economies which refused to be acolytes in the fear of fixing thought collective fare?

The economies who have experienced being either declared or threatened to be declared currency manipulators by the US Treasury or the US State Department include Japan, China, Denmark, Taiwan, Hong Kong, Malaysia, Singapore, South Korea, India, Germany, Norway, and Switzerland. And in 2020, Vietnam. I dare say they are faring quite well, indeed. Perhaps there are precious lessons to be learned from the club of currency manipulators!


Raul V. Fabella is a retired professor of the UP School of Economics, a member of the National Academy of Science and Technology and an honorary professor of the Asian Institute of Management. He gets his dopamine fix from bicycling and tending flowers with wife Teena.