Since 2011 several countries in the Middle East and North Africa (MENA) region have undergone significant political transitions, whether through regime change (Egypt, Libya, Tunisia, and Yemen) or through reforms undertaken by the existing governments (Jordan and Morocco). The central economic objective of all these countries is to create sufficient jobs for their young and growing populations. The only definitive way to achieve this objective is through sustained higher economic growth, and therefore generating growth has to be one of the top priorities for the governments in these countries. To make a significant dent in unemployment the countries need to push growth into the 6-7 percent range, whereas the average growth rate for the Arab transition countries during 2011-2012 has been less than 2 percent per year. The gap between the current and required growth rates is thus quite large.

While growth and employment have to be a major focus of the governments in the Arab transition countries, they have to address the other main demand of their citizens to control or compensate for the rising cost of living. Government assistance, particularly in the form of subsidies for energy and food, will continue to have to be provided, if not expanded. Without imposing higher taxes, this will mean that fiscal deficits will remain large. During 2011-2012 fiscal deficits in the Arab transition countries averaged 8.5 percent of GDP, and it is unlikely that these deficits will be reduced significantly if expenditures are maintained and governments are reluctant to increase taxes in a politically-charged environment. If these fiscal deficits are financed by borrowing from the banking system, as is currently happening, the money supply will expand and push up inflation.

The negative effects of high inflation are well known. Inflation imposes welfare costs on society, impedes efficient resource allocation by obscuring the signaling role of relative price changes, inhibits financial development by making intermediation more costly, hits the poor disproportionately because they do not hold financial assets that provide a hedge against inflation, and perhaps most importantly, reduces long-term economic growth. While it is possible to generate a spurt in the growth rate through expansionary macroeconomic policies, this effect cannot be sustained as inflation rises, and eventually growth will falter. In the long run, it is well accepted in the economics literature that the relationship between inflation and growth is negative.

If indeed this turns out to be the case and inflation takes hold in the Arab transition countries, the governments will face a policy dilemma. They may be able to deliver some increase in growth in the short run but ultimately they will face a trade-off between inflation and higher growth. They could well fall into a high inflation-low growth equilibrium, an outcome that would clash with their objectives and the demands of a restive and impatient public. This is a dangerous scenario that could create a repeat of the 2011-2012 turmoil and political protests. With inflation in the Arab transition countries running at an average annual rate of about 8 percent, and with growth averaging less than 2 percent per year, it is imperative that countries adopt policies to try to change these numbers.

So, if inflation is inimical to growth, it obviously follows that policymakers should aim for a low rate of inflation. But how low should inflation be? Should the target inflation rate be 10 percent, 5 percent, or for that matter, zero percent? Put into an operational context, what level of inflation should the central banks of Arab transition countries aim for? Single digits at first pass may be a useful rule of thumb; however, one can be more precise by using the relationship between inflation and long-run growth as a metric. That analysis can provide some guidelines for the Arab transition countries in choosing a target for inflation, and in designing policies to achieve this target.

Several recent cross-country empirical studies provide fairly convincing evidence that the relationship between inflation and growth is nonlinear in nature. At low levels of inflation, the relationship can be positive or non-existent, while at higher rates it becomes negative. In principle, one can estimate the threshold level of inflation, at which the relationship between inflation and growth would switch from positive (or zero) to negative.

While estimates of the threshold level of inflation at which inflation starts to significantly hurt growth vary across studies, there is clear evidence that inflation above 10 percent slows the growth rate. At the same time, going to the extreme of zero percent doesn’t help growth. Using an average of the empirical estimates in various available cross-country studies for different regions of the world, one can conclude that inflation should be kept in the three to 6 percent range to avoid adverse growth effects. Consistent with this conclusion, empirical estimates specifically for MENA countries show that the rate of inflation that maximizes growth is 3 percent, with the effect of inflation on growth turning negative at 6 to 8 percent.

Therefore, one should start to worry about the adverse growth consequences of inflation when it starts to get up near 6 percent. What does this result imply for the Arab transition countries? As mentioned earlier, in 2011-2012, the average rate of inflation for this group was close to 8 percent and has been projected by the International Monetary Fund (IMF) to rise to 9 percent in 2013. So even as a group, these countries are well past the optimal level of inflation and into the territory where inflation is already having a negative impact on long-term growth.

When disaggregating the group into individual countries the picture is better for some but worse for others. Clearly Egypt and Yemen, where the average rate of inflation is 10 percent and 15 percent per year respectively, are in the danger zone and have to be very concerned about the negative effects that their relatively high rates of inflation will have on long-term growth. They are already well into the high inflation-low growth equilibrium and thus will have to make determined efforts to bring inflation down.

By comparison, Morocco—which has not experienced the same sort of upheaval as the others—appears to be doing much better on the inflation front, with current inflation running at an average rate of around only 2 percent. Based on the arguments here, it is therefore not surprising that Morocco has experienced  the best growth performance of the group of Arab transition countries with growth of real GDP over 5 percent per year, as compared to half that for the whole group. Inflation in Jordan and Tunisia, running around 5 percent, is just below the threshold level and the policy imperative for these two countries is to keep it that way even though it may be tempting for them to engage in expansionary macroeconomic policies to try and push their growth rates up.

The Arab transition countries thus face a true dilemma. The political changes following the Arab Spring have thrown up conflicting economic objectives—to satisfy the population, which is demanding jobs and rejecting fiscal austerity. Although it will be exceedingly difficult for the governments in these countries to resist the demands of the public, they should not lose sight of the fact that short-term measures that push up inflation will have long-term costs in terms of economic growth and employment. Macroeconomic stability, as represented by low inflation, is critical for both the short run and the long run. Therefore, the task for policymakers in the Arab transition countries is twofold: first to get control of the government finances and the fiscal deficit to keep inflation from rising; and second, to undertake policies to raise long-term growth through increases in domestic and foreign investment, improvements in the skills of the labor force, increased openness to trade, and raising the general productivity of the economy. Hopefully, the governments will work on these two fronts and be able to persuade their populations of the necessity of doing so.

Mohsin Khan is a senior fellow at the Atlantic Council’s Rafik Hariri Center for the Middle East focusing on the economic dimensions of transition in the Middle East and North Africa. 

Related Experts: Mohsin Khan