Inflation, Inflation Uncertainty, Political Stability, and Economic Growth

Several authors report regressions where inflation slows economic growth. These results have been criticized because of their sensitivity to the sample analyzed and because there does not appear to be a strong theoretical reason for believing that inflation significantly lowers growth. Indeed, researchers have suggested that inflation proxies for inflation uncertainty or poor economic policy. More specifically, empirical and theoretical work suggests that political stability may create both high growth and low inflation. In this paper, we investigate the possibility that political stability may be behind the inflation-growth nexus. We also employ a better measure of inflation uncertainty that is derived from surveys of forecasters. We find that political stability can explain the negative relationship between inflation and growth in our sample. Further, our new measure of inflation uncertainty is unable to overcome the multicollinearity problems with inflation and is also outperformed by political stability. Fischer (1993) and Barro (1995) presented evidence of a significant negative relationship between inflation and economic growth. However, the source of the negative relationship remains a subject of dispute. Fischer argues that inflation proxies for generally poor policy. Salai-Martin (1991) suggests that the role of inflation may be created by spurious correlation arising from an omitted variable. For example, high inflation uncertainty may be the cause of slow growth, but the high cross-country correlation between inflation and inflation uncertainty may cloud the true underlying relationship. More generally, he argues that inflation may proxy for government failures that are to blame for the sluggish growth. In this paper we present some evidence that political stability may lie behind the inflation-growth nexus. The lack of political stability may directly disrupt production or may hamper growth by threatening property rights that are essential to material progress. Since Barro (1991), the number of revolutions and coups per year has been a standard variable in growth equations to capture this effect. More such disruptions tend to lower growth. Alesina, Ozler, Roubini, and Swagel (1992) (hereafter AORS) and Mauro (1995) using different measures and methods also find that political stability promotes economic growth. Cuikerman, Edwards, and Tabellini (1992) (hereafter CET) argue that politically unstable countries are prone to high inflation. In the CET model, a high probability of a political regime shift dissuades the incumbent government from investing in the infrastructure necessary to collect income taxes. Instead, the incumbents will rely on seigniorage. Davis and Kanago (1996) argue that in the CET setting a more unstable government also causes greater inflation uncertainty. Cuikerman and Meltzer (1986) make a similar point from a different perspective. In their model, political instability refers to changes in the preferences of the Central Bank, and preferences that change more frequently cause both higher and more uncertain money growth. Combining arguments, political instability may generate both high and uncertain inflation, and slow growth. This, in turn, poses the possibility that inflation uncertainty and inflation may be significant in growth regressions only because they proxy for political instability. Earlier studies of the effect of inflation uncertainty on economic growth used the sample standard deviation of inflation as the measure of inflation uncertainty. This measure implies that 1 There have been other criticisms of the cross-country results for the inflation and growth relationship. For example, Clark (1997) shows that the inflation-growth connection is sensitive to the countries included in the sample and the sample time period. Our results compliment these earlier results by suggesting why in some samples there is a negative relationship between growth and inflation. the expected rate of inflation over the period was constant and equal to the sample mean. This simplification was forced by the absence of survey data and the cost of constructing a regression based measure of expected inflation for each country; and amounts to replacing uncertainty with variability. We have compiled from the pages of Business Asia, Business Europe, and Business Latin America annual forecasts of inflation for a cross section of 44 countries which allow us to construct a standard deviation of inflation that is a measure of uncertainty. We use this measure below to study the effect of inflation uncertainty on growth. We find that when our measure of inflation uncertainty alone is added to a typical growth equation, it exerts a significant negative influence on growth. This is consistent with earlier studies that used variability. However, once inflation is included in the regression, inflation uncertainty no longer affects growth, but neither does inflation. Bruno and Easterly (1995) argue that times of inflation crisis, inflation episodes that equal or exceed 40% per year for two consecutive years, may be the cause of low growth rather than the inflation itself; but in this sample, inflation crises and the other inflation measures are collinear, and their individual effects cannot be disentangled. We then bring political stability into the analysis. As in CET, inflation and political stability are negatively related; greater inflation is associated with lower political stability. When both inflation and political stability are in the growth regression; inflation loses its significance, while political stability retains its significance. Similar results hold when we include inflation uncertainty or inflation crisis in a regression with stability. In the next section we describe the data. In Section 3 we first discuss the basic growth equation and then our results. In Section 4 we discuss the robustness of our results and we conclude in Section 5.