At the beginning of the last century all economists would have told you that general price increases are caused by inflation. That is when the word inflation still meant an excessive increase in the money supply. Since then the meaning of the word has become perverted. The word for the fundamental cause (printing too much money) has come to mean the consequence (general price increases) and now no one knows what they are talking about.
At the end of February 2002 we had the Reserve Bank reporting that M0, the base money supply (notes and coins and bankers deposits with the Reserve Bank), had increased at a year on year rate of 30.51% to R49.75 billion. And yet we had a Commission of Inquiry wondering why the rand had fallen so precipitously, while financial writers and commentators have ascribed the accelerating price increases to everything under the sun except the monetary inflation. Participants in the money markets obviously understood that rapid monetary inflation would result in a decline in the purchasing power of the rand and responded by selling the currency. On the natural assumption that the Reserve Bank may continue to increase the base money supply at more than 30% per annum, with potential catastrophic consequences, some holders of rands sold in a panic and drove the rand to over R14 to the US dollar at the end of last year.
The good news is that by 31 August 2002, M0 was R49.09 billion, having declined by R660 million from its February 2002 high. Strangely, this heartening news did not feature in any economic reports. That the quantity of high-powered money had remained in a narrow band for six months was telling us that the rand was likely to strengthen on the foreign exchange markets and that the Reserve Bank had laid the foundations for a reduction in the inflation rate. The bad news is that during September 2002, M0 increased by R2.98 billion to R52.07 billion, which is a 6% increase on the August and 22.5% on the September 2001 figures, a disturbingly high rate of increase. Hopefully this is not the beginning of another bout of monetary inflation and strict control will be maintained in the coming months. The Reserve Bank probably expects the public to have faith that it will not cause another crisis of confidence similar to the one we experienced at the end of last year although the observance of a strict monetary rule for control of the money supply, without sudden increases, would perhaps be more likely to inspire confidence.
The FMF is in the process of publishing a new monograph by Dr Richard Grant with the title The Real Reason for the Fall of the Rand,
that explains the sequence of events from excessive base money supply increase to decline in the purchasing power of the currency to general price increases. When the rate of increase in the base money supply halts or slows, the sequence of events reverses first in stabilisation and strengthening of the currency, and then slowing and reduction of inflation. However, while exchange rates react swiftly, there is a time lag both ways in the effect on prices they take longer to rise after excessive money is fed into the system and are slower to stabilise when the rate of increase in the money supply declines. Unfortunately, the damage that is done by rapid money supply increases could take up to two years to wash through the economy in the form of higher prices, the overall effect depending on the publics inflationary expectations.
Many authors have written on the subject but some of the clearest descriptions of the inflationary process appeared decades ago. In a 1977 essay with the title Inflation and the stock of money,
Professor David I. Meiselman wrote Every episode of inflation for at least the past four hundred years which has been studied has conformed to the general rule that prices on average depend on the ratio of money to output, that prices rise when the quantity of money increases faster than the output, that prices fall when the quantity of money declines relative to output, and that prices are stable when the ratio of money to output is stable. The explanation is clear and logical, but as Professor Meiselman wrote in his article, everybody insists on trying to reinvent the wheel.
If the Meiselman rule is applied to the recent economic history of South Africa, it is patently clear that the quantity of money has far outstripped the output of the economy. If we once again use M0 as a measure, we find that the quantity of base money increased from R4.8 billion on 1 January 1985 to R49.75 billion on 28 February 2002 a tenfold increase. Keeping pace with the increase in the money supply would have required an average growth rate of 14.6% per annum for the 17-year period an impossibly high rate when one takes into account that the economy was shrinking at an average rate of 1.4% per annum between 1985 and 1994, and is only expected to grow at 2.8% this year. Getting the money supply under control is therefore the only feasible way to observe the Meiselman rule and avoid perpetual high price inflation.
Our Reserve Bank has a duty towards citizens to act in a predictable manner that will not damage the economy by eroding the purchasing power of the currency. According to the Constitution the primary object of the South African Reserve Bank is to protect the value of the currency in the interest of balanced and sustainable economic growth in the Republic. The bank has arguably not been fulfilling that object in recent times.
Studies show that economic growth is steady and sustained when central banks maintain monetary stability, and consequently, relative price stability. It is not true, as some people claim, that a steady decline in the internal and external value of the rand is good for the economy. Such a policy is contrary to the constitutional obligations of our central bank and merely benefits some and imposes costs on others. Over the longer term everyone will be better off with a sound and stable rand. That is what the Reserve Bank should be aiming to achieve, but it will not succeed in this task if it does not maintain strict control over the money supply.
Eustace Davie is a Director of the Free Market Foundation. This article may be reprinted without prior consent but with acknowledgement. The patrons, council and members of the Foundation do not necessarily agree with the views expressed in the article.
FMF Article of the Week\29 October 2002