Coen Welsh | Aug 9, 2017 | 0
Who is scared most by inflation?
Against the background of the somewhat conflicting economic opinions expressed during the past month by the Reserve Bank in South Africa and the Bank of Namibia, it becomes important to consider the real reasons for inflation.
Despite what so many analysts claim to the contrary, in a modern economy, inflation is always the result of the debasement of a local currency. Granted, this take is very broad but it is not a waste of time to look at the many forms of debasement that take place, in our context, many of them simultaneously.
Historically, text book definitions got stuck on the supply demand curve. And indeed, supply shortages used to be the main driver of inflation but that was when the majority of the world’s population lived under conditions of constant under-supply, or outright lack. The most enlightening work on this topic that I have read is not an economics text book, but a short treatise on the two waves of Crusades from around 900 AD to around 1200 AD. In several instances, original texts are quoted to illustrate how dramatic the increase in the price of basic food becomes when a city is beleaguered.
Nowadays, I would assume we function against a background of chronic over-supply of just about everything we consume, and it is a very long time since I heard of a beleaguered city ala middle ages style.
The actual debasement of currency is an equally ancient concept. This happened first when the ordinary plebs got hold of a gold sovereign, scraping off a minute quantity of gold, before putting it back into circulation. When the sovereign returned to the sovereign, after more than one scraping, it had a noticeably lesser gold content than when it was first minted. Naturally, the debased coin’s value was reduced and the human sovereign had to make good the loss on the metal sovereign. The king did not like this.
At the same time, other kings, having heard of the many sovereigns held by one sovereign, hatched their own ideas to use the proven political strategy of war, to acquire some or all of that wealth. Since the other kings could not afford to pay their soldiers, they issued their own coinage, only these counterfeits were laced with copper or brass as substitute for gold. This also reduced the value of both the real coins and the alloy.
Fortunately, those times are long gone, but it has not stopped modern governments to debase their own currencies.
The first obvious means of reducing the value of money is by making more of it in the absence of a commensurate increase in productivity. Now that is the main problem today in our neck of the woods. Printing money to have more of it without working more, is a ubiquitous a phenomenon that have ruined many other governments, not only Zimbabwe’s. The more one unitises the total available purchase power, the more units one requires to obtain the same amount of goods and services. It is as simple as that. We call it inflation.
But there is another very serious form of debasement and that is the exchange rate. The relationship between inflation and a weak currency has been documented extensively in academic literature. However, what is often not expressed in such convincing terms, is the so-called Terms of Trade concept. In a nutshell, this means the more money required (demanded) by all participants in any economy, without improving productivity, the less that (more) money is worth. Once this start reflecting in the exchange rate, it becomes structured and it takes an enormous amount of political will, and a marked improvement in productivity to turn the ship. This is what was achieved so admirably by a previous South African finance minister, Trevor Manual, when he managed, over almost a decade, to take the Rand from a despised currency, back to a respected means of settlement.
Let me state it clearly so that every politician can grasp the basic fact. The more you inflate your local economy with spending that is not backed by an increase in productivity, in other words a positive move in the Terms of Trade, your currency will depreciate, and EVERYTHING you import, will be more expensive. This fuels inflation and the process is self-reinforcing – issue more money (inflation), weaker currency (inflation), more expensive imports (inflation), less domestic purchase power (inflation).
There is only one proven hedge against inflation and that is a strong currency. Stating this, in my mind I can already hear the choir of protests by economists on the government payroll, who feels nothing for the long-term growth prospects of the economy, and for the overall well-being of the country.
A strong currency and elevated levels of productivity are the only sound fundamental principles that create prosperity for every citizen. The rest is bluff and eyeblind.
And finally, it must never be forgotten that the mere conviction that inflation will remain long term provides sufficient push, to drive inflation short term.