His paper focused on three variables: inflation, fiscal deficits and the black market premium on foreign exchange, and their effects on growth in a cross-country study covering the period 196088. One finding was that a “stable macroeconomic environment, meaning a reasonably low rate of inflation and a small budget deficit, is _conducive_ to sustained growth” (italics added). On _causality_ , Fischer concluded that the weight of evidence pointed to a flow from high inflation to low growth, rather than vice versa. However, he also noted that low inflation is _not necessary_ for growth, although high inflation is not consistent with sustained growth.<sup>16</sup> Abstracting from the econometric problems, one may summarize Fischer’s main result as in equation (1) above.<sup>17</sup> The _channels_ through which inflation reduces growth, identified in Fischer (1993), include reduced investment as well as a reduced rate of productivity growth, while larger budget surpluses are associated with more rapid growth through greater capital accumulation and greater productivity growth. Interestingly, “debt dynamics” is mentioned only once, though crucially, in Fischer (1993), while noting that a high deficit may be consistent with low inflation for a while; but that a more detailed assessment of debt dynamics may be needed to see if the deficit is sustainable and therefore consistent with macroeconomic stability. This brings in the government’s intertemporal budget constraint (GIBC), which pulls together the fiscal deficit (primary fiscal balances and interest payments), inflation (seigniorage) and growth. It also properly measured pulls in contingent liabilities associated with state enterprise losses, borrowing guarantees and poor supervision of banks, in short, the potential impact of soft budget constraints for banks and enterprises. Box 4 illustrates these linkages with the stabilization experiences of Poland and Russia during the 1990s.

# **Box 4: Poland and Russia: Contrasting Stabilizations**

Poland successfully stabilized between 1990 and 1999. It initially used the nominal exchange rate as an anchor for the price level but abandoned its fixed peg with the dollar after 17months when competitiveness became an issue. Rapid inflation reduction was never an obsession; it took eight years to attain single-digit inflation. Instead, the focus was on reducing the fiscal deficit and hardening enterprise budget constraints while maintaining a competitive real exchange rate. Growth rates increased and, aided by the resulting higher taxes and expenditure control, deficits and inflation came down gradually but credibly.

The importance of microeconomic hard budgets for growth and lasting stabilization is illustrated by the contrasting experience of Russia between 1995 and 1998. Russia succeeded in its quest for single-digit inflation by February 1998—its exchange-rate based stabilization was launched in mid-1995; but suffered a macroeconomic crisis six months later. The issue turned out to be the “soft budgets” implicit in the “nonpayments” system, which mushroomed during the stabilization program of 1995-98. The manufacturing sector received subsidies equal to 7-10 percent of GDP, financed by a combination of government borrowing and transfers (in the form of unpaid bills) from Gazprom, the gas monopoly and RAO UES, the electricity monopoly. Trying to stabilize in this milieu required high real interest rates, which only prodded enterprises to economize even more on cash transactions and run further arrears. The government also participated in this process. More non-payments meant lower taxes and rising government debt and interest rates and hence poor growth, which fed on each other leading to the 1998 crisis.

These experiences underline that sustainable inflation reduction ultimately depends upon keeping fiscal deficits and public debt dynamics under control. This is turn depends upon adequate generation of fiscal revenues, which requires solid micro foundations for growth, namely, healthy enterprise and financial sectors based on hard budget constraints and competition.

> 16 Other notable studies include de Gregorio (1993) and Bruno and Easterly (1998), who argued famously that once inflation crossed 40 percent per year, growth would not be sustained . 17 A survey of the econometric problems may be found in Temple (2000).

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