The recent attack on the South African Reserve Bank (SARB) by the hierarchy from South Africa’s ruling political party the African National Congress (ANC) is most likely another attempt to regain the political narrative in the cloak and daggers world of South Africa politics. Rather than allow media to focus on state capture and South Africa’s economic crisis government officials will deflect attention and blame South Africa’s ills on the SARB’s policy mandate – inflation targeting. The Public Protector’s initial foray against the SARB has been repudiated but numerous ANC officials have questioned the SARB’s mandate ever since minister Zwane’s attack in 2016. The SARB mandate debt could be dismissed by the media as another plot by the Gupta’s to distract the public. However this line of reasoning misses an important opportunity to understand the role of the central bank and how it could improve the lives of South African’s. Any notion that economic ills can be solved by higher inflation is an egregious error that should be fought off with tenacity. In this piece we’ll understand why higher inflation is unequivocally bad for the poor and why a lower inflation target is required to promote the wellbeing of poor South African’s.
Deflection and blame are well-worn tactics by the Zuma regime but debating the SARB’s mandate actually has a history in South Africa. Numerous South African labour unions are longstanding critics of the SARB’s policies, arguing that that SARB is far too conservative and isn’t actively pursuing higher economic growth. In order to assess the merit of this claim we need to understand the primary role of a central bank.
Irrespective of the particular political mandate, which is different between countries, central banks control the supply of currency. There are numerous policy tools at their disposal like interest rate policy, asset purchases, currency intervention and banking regulation, but all of these tools merely effect the supply of currency in the economy at the end of the day. Currently the SARB’s mandate directs it to use those tools to keep CPI inflation within a 3-6% range.
Demystifying inflation – what is it and where does it come from?
Inflation is merely an increase in price levels and it is determined by the supply of currency in an economy (hence why the SARB uses it’s money supply tools to impact inflation). A simple example:
Let’s assume we live in a country called CarLand and the whole economy’s goods and services is represented by 10 cars. The CarLand central bank oversees the supply of CLD, the currency of CarLand, and it decides to put 100 CLDs in supply. This level of CLD supply immediately implies that the price of each car in CarLand is CLD10 (100/10=10).
If the CarLand central bank decides to increase the supply of CLD from 100 to 200 then the price of each car doubles from CLD10 to CLD20 (200/10=20). We can see from the example that the supply of currency has a direct impact on the price level in the economy. Higher money supply causes higher inflation but no actual change in the economic of value or overall well being of citizens. (for an explanation of cost-push inflation please see “inflation is inflation, is inflation, is inflation”)
In the real world the mechanism is very similar but not necessarily as direct as witnessed in the example because real economies are incredibly complex with millions of different products and numerous ways in which the money supply can change. For example, the origination of a new loan by Jeff in Johannesburg is an increase in supply of money. If the loan is big enough, Jeff’s increase in purchasing power might push up the price of the house that he purchases. But it’s unlikely that the relationship between the size of the new loan and the change in price level of the house is directly proportional on a transaction to transaction basis. Why not? Well because economic activity is complex with various other factors that influence each and every transaction.
However on a macroeconomic whole economy level the relationship certainly holds – greater money supply leads to higher price levels. There is often a strong positive relationship between money supply growth and subsequent changes in the household price level, as measured by CPI, and it’s quite easy to witness in South Africa. The bigger and more complex the economy, the murkier the relationship becomes statistically but this doesn’t refute the principle we established in the CarLand example.
Inflation – the ultimate free-lunch
The general attack wagered against the SARB is that higher inflation could improve activity and hopefully improve employment conditions as a result. The CarLand example shows quite easily that doubling the supply of currency from CLD100 to CLD200 has no real impact on the economy other than inflating the price of cars from CLD10 to CLD20. This makes complete sense because changing the supply of currency doesn’t create any new economic value or output hence their is no real economic improvement. Why then is the argument for higher inflation so often tabled?
Increasing the money supply has no real impact on the economy from a macro perspective but it can have a very distinct impact from a micro perspective. For example, imagine the CLD100 new supply created by the central bank of CarLand was given to Sally rather than equally to each person within CarLand. There is no change in whole economy value due to the change in money supply but Sally certainly feels richer and more inclined to spend than before. Inflation also has not been realised yet so Sally’s real purchasing power has increased. Sally’s emboldened spending might even encourage a few others to follow her lead, spend more than they were planning to and economic activity might rise at the margin. Analysts often see an uptick in economic activity after an increase in money supply and draw the conclusion that monetary expansion is a requirement for economic activity but this is false.
Remember there has been no value creation in CarLand through the process of merely increasing money supply. Increased spending by any other people in the economy is merely a decision to spend in the present rather than the future – not a change in overall value. Similarly any increase in economic activity is merely shifting the time-frame over which the activity takes place from the future to the present and will not result in a sustained improvement in conditions.
Eventually the new money will cause an adjustment higher in price levels. Sally is merely spending the newly created money. She is however spending the money first, before the price adjustment takes place, which allows her to benefit at the expense of everyone else in the economy. Anyone who was holding CLD’s in the bank over this time will experience a loss in purchasing power because price levels in CLD moved higher over time making the purchase of cars more expensive.
There is effectively a wealth transfer from the rest of economy to Sally through the process of inflation and money supply creation. This brings us to the essence of inflation – a wealth transfer towards those who hold the assets/products where the inflation is taking place and from those who might want to buy those assets/products in the future.
Now imagine being in Sally’s shoes – experiencing an injection of new money supply at the expense of everyone else. A free lunch if you’ve ever seen one, particularly given that “everyone else” in society usually aren’t aware that they are being fleeced. Zimbabwe and Venezuela provide easy examples where politicians tasted the fruit of the printing press and rapidly accelerated the demise of broader society. Hence why independence between central banks and national fiscal authorities are often ingrained into the constitution to prevent politicians from creating a new revenue stream at the expense of the rest of the economy.
It is however important to consider the relationship between central bank policy and inflation at all levels of inflation, not merely in a hyperinflation scenario.
Inflation is unequivocally bad for the poor
We’ve now established that targeting higher inflation through higher central bank money supply is essentially a wealth transfer to the people who get their hands on the new money supply first. By default certain sections of the economy will always have better access to new money supply than others. Poor people will almost always be the last to access new money creation and are very unlikely to experience the benefits of spending it first.
Over time the new money is spent, inflation develops in the real economy and prices adjust, which is where the secondary impact of inflation finds expression on inequality. Poorer people spend a large proportion of their disposable income on food and energy, which are very price sensitive and often face much higher rates of inflation than other goods and services. Wealthier households protect themselves against inflation through owning assets which benefit from inflation. Owning property and equities are the two most common examples. Poor people do not have the luxury of this option and face disproportionately negative consequences from inflation as a result.
What it all boils down to at the end of the day is where about in the inflation chain an individual is situated. There are plenty of grey areas here but it’s pretty clear to me that the poor are unreasonably negatively impacted. Some might argue that this asymmetry can be corrected through better access to credit or perhaps even a state bank that can level the playing field. It is however difficult to believe that these provide more sustainable solutions than actually limiting inflation in the first place.
Even if it were feasible to provide world class banking services in all South Africa’s informal settlements, a well connected person in business or government will almost always find it easier to access credit through his/her relationship with a private banker. It’s nigh impossible to level this playing field, even in highly developed nations.
State banks are a well worn policy tool that attempt to solve this thankless task, providing credit to those people/companies that don’t grab the immediate attention of the banks. Optically this appears a sound moral argument. However in order for this option to be viable we require certainty that national authorities have the interests of the poor at heart and that the mechanism won’t be co-opted for ulterior motives in stead. The answer is questionable at best, particularly under current political conditions.
Even if we can overcome the political risks of state banks and can clearly conclude that capital injections to small businesses are required then a direct transfer of capital from the Treasury is a far more efficient mechanism of wealth transfer than clandestine credit creation by a state bank that runs a high risk of being co-opted. Even if access to credit could be solved, which is unlikely without serious capital investment, this unfeasible solution still doesn’t deal with the fact that no real economic value is created in the inflation process.
The case for a lower inflation target
Inflation is a tricky concept but I’ve given readers a basic insight into the core foundations of this stealthy policy tactic. Inflation at all levels in unequivocally bad for poor people who are very unlikely to receive the new money creation first, find it difficult to hedge themselves against inflation and experience a disproportionate impact from inflation due to the price sensitivity of the goods frequently purchased. If the road to economic riches were paved with higher inflation and money creation then we would all be infinitely wealthy and they would be no need to add value each and everyday but of course this defeats common sense. Policymakers who peddle inflation as a solution to economic ills are charlatans and should be quickly dismissed from any rational policy discourse. Understanding this concept should actually lead to a desire for a lower inflation target to limit the negative impact of this scourge on South Africans.