Fostering false prosperity

INFLATION targeting has been a major part of the South African economy for a few years now. It was first introduced in 2009, and there have been numerous debates for and against this policy.

The aim has always been to stabilise and strengthen our currency through pursuing a tight monetary policy.

Our Reserve Bank has set the inflation target range at 3% to 6%.

This objective is to be obtained by manipulating interest rates.

Inflation targeting has thus generated strong critics, who argue that this policy throttles economic growth.

Inflation describes a situation where the economy experiences persistent rising of prices in a sustained period of time.

It is caused by an increased demand for goods and services.

Once these demands outstrip supply, their selling prices increase substantially.

Similarly, if salaries and wages outstrip productivity, the economy will experience inflation.

Inflation is also influenced by investment directed to non-productive assets or expenditure.

An inflation rate is also fuelled by the expansion of money in circulation, through the relaxation of interest rates.

Economists argue that an oversupply of loanable funds through low interest rates raises the rate of inflation in a country.

Low interest rates encourage households and businesses to utilise all available credit lines.

The expanded investment, as a result of cheap money, leads to higher economic activity.

Excess aggregate demand and inflation forces government intervention to curb the money in circulation through tightening monetary controls.

The Reserve Bank uses interest rates as a tool to control money supply.

Inflation is of great interest to political leaders, because it distorts the functioning of the economy, and erodes the buying power of the fixed incomes of salaried and wage earners.

This effect is the reason why governments prioritise the fight against inflation when formulating their economic policies.

Inflation is not good for business people either, in the medium to long term.

Volatile inflation in an economy makes it very difficult for business people to plan.

It causes administrative inconveniences by having to constantly change price lists and for company asset valuations.

Inflation is also problematic for importers, especially those who purchase productive assets, such as machinery, expertise and technological know-how.

On the other hand, a weak domestic currency gives exporters an advantage and a competitive edge over their foreign counterparts.

This advantage is short-term in most cases, since their goods and services would be cheaper than the competition’s.

The demand for their goods and services would be higher than when your currency is strong, as a result of low inflation, driven by a strong currency.

Inflation is equally helpful to people with huge debts – with weaker money floating in the economy you can easily settle your debts.

However, inflation is bad news to the unemployed, retired individuals and old age pensioners.

The wealth of people who made life-long savings gets quickly eroded.

This does not only affect individuals, it affects commercial institutions and governments.

Other people who could “benefit” from inflation are unionised wage earners and producers if prices rise faster than production costs.

However, inflation impacts negatively on employment prospects for the unemployed.

Economically speaking, there are merits in the debate of those who want inflation to float.

Many people are basing their argument on the fact the growth levels of what was called the golden era, happened amid running inflation levels.

A case is made that inflation on its own could co-exist with positive economic prospects.

That possibility is not necessarily to apply to developing nations, especially those in Sub-Saharan Africa.

These countries face unique inflationary pressures.

South Africa’s case is similar to the stagflation that ravaged Latin American countries and some African countries in the late 1970s and 1980s.

The inflation we face is called stagflation, which occurs when an economy is stagnant, but has high unemployment and high inflation rates at the same time.

This is a situation that has been experienced by Brazil, Argentina, Mexico, Ghana, Nigeria and Kenya, among others.

Stagflation was created by the ill-advised attempt by these countries to grow their economies by developing their industries on the back of chronic budget deficits, financed by credit extensions.

This kind of monetary practice is socially costly in the long term.

The thinking of those who are opposed to the fight against inflation is that it boosts and encourages feelings of optimism, because money values are always rising – product prices, share prices, land values, savings and wealth values.

This is, in fact, an artificial feeling of being better off, even if households, businesses and the government are realistically not.

Perhaps we ought to heed the then British chancellor of the exchequer, Kenneth Clarke, when in 1995 he declared inflation as public enemy number one.

In a speech in which he was dismissing the idea of inflation being allowed to rise to accelerate growth, he said, “History should have taught everyone that such thinking is dangerous nonsense.

“Inflation damages growth. Inflation harms investment.

“Inflation damages prosperity. Inflation destroys jobs.”

Fighting inflation, Thabo Mbeki’s government was creating conditions to put South Africa on a sound monetary policy footing so as to grow the economic in real rather than nominal terms.

Inflation still remains a short-term false prosperity.

Mbeki was mindful of American economist Michael Todaro’s caution, where he says, “Today, few economists would seriously contend that chronic budgetary deficits financed by expanding bank credit and rising prices can be a significant factor in promoting Third World development”.

Instead, he says, it works exactly in the opposite direction.

Perhaps we ought to heed . . . Kenneth Clarke, when in 1995 he declared inflation as public enemy number one