Inflation is possibly the most serious economic risk, not just in SA

03 May 2019
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The key to understanding inflation is to first understand the nature of money.

The common perception of money among members of the public, and even some economists, verges on the fantastical.

It is seen as a means to achieve many ends that, normally, would lie beyond reach according to the rules of scarcity and exchange which are the foundation of economics.

So, what is it really?

It is important to remind ourselves that, before the advent of money, humans exchanged goods and services on the basis of the barter system.

Someone would produce more goat cheese than they needed and exchange the excess for grain, which they also needed.

This system obviously has problems if it is not easy for the person who has the goat cheese to reach the person with the excess grain.

And what happens if the grain producer does not want any cheese? If the producers of goat cheese or the suppliers of grain are reachable only through a sequence of transactions, that would add unnecessary costs for the person wanting cheese or grain.

To have one good that can denominate all others – for example gold – therefore, makes it all so much easier.

The person who has excess goat cheese could then simply exchange the cheese for a quantity of gold, from this they could then deduct the quantity of gold that represents the amount of grain they want and exchange this with the grain supplier.

Money is a good like any other, but it has the special property that it is convenient to exchange quantities of it for any other good in an economy.

The next question to ask then is what happens when the supply of a good exceeds demand for it?

The answer is that prices have to fall to accommodate the excess supply and encourage customers to buy. Prices in this case indicate how the product is valued by actors in the market.

Prices indicate relative quantities of goods or services. Therefore, when money prices for a good fall, it indicates that for the good in question less money is required to attain it than was previously the case.

How then, do we measure the price of money?

Since prices are relative, we can measure the price of money relative to other goods in the economy.

When the price of money falls relative to one good, it means more money is required in exchange for the good than was previously the case.

Inflation, roughly speaking, means that the price of money has fallen relative to all/most other goods and services, in other words money prices have gone up in general across the economy.

Prices, not just money prices, reflect supply and demand. Both of these things (supply and demand) depend on natural scarcity as well as individual preferences.

Therefore, whenever a central authority decides to take control of the entire money supply and make decisions on its own about the appropriate quantity of money, the risk of incorrect signals about scarcity, supply and demand for all other goods spreading throughout the economy is heightened.

Further, when this entity decides to arbitrarily select the good to use as money so as to minimise the costs of reproducing it while artificially increasing its value through force, then everyone else’s hard-won production is subject to the whims of this entity.

That is why inflation is possibly the most serious economic risk not just in South Africa but the world over.

The South African Reserve Bank has the power to steal all rand-denominated goods and services by simply increasing the quantity of money.

That explains why I have found the most recent CPI (price inflation) figure to be the most important variable in predicting the real GDP per capita growth rate for the following year.

I discovered this when analysing all the Economic Freedom of the World variables and their impact on GDP per capita.

Each 5 percentage decrease in the CPI is likely to add as much as 0.87 percentage points to the coming year’s GDP per capita growth.

Keeping in mind that GDP per capita is a better measure of national income since it accounts for differences in population among countries, the Economic Freedom of the World’s “Inflation: Most recent year” variable was found to be the single most important one out of all 43 component variables in the Economic Freedom of the World report.

This should not surprise anyone, after all, inflation plays a pivotal role in capital formation (a necessary precursor to economic growth) since the latter cannot happen without savings and it would be foolish to save when money is losing value faster than investments or saving are gaining value.

High inflation drives consumption instead of savings. This means that wealth creation is discouraged, meaning less of it will occur.

South Africa, based on the December 2018 CPI figure of 4.5%, would get 9.1 (0 is the highest inflation and 10 is the lowest inflation) for this variable and a ranking of 114th out of 162 countries in the index.

Economist Dawie Roodt has suggested a 2% inflation cap which would put us in the 84th position.

Ireland was the best ranked country in the last Economic Freedom of the World in terms of this variable and they had a GDP per capita growth rate of 6.50% in 2017.

It is of critical importance to maintain the independence of the Reserve Bank while intensifying efforts to preserve the value of the rand.

This is the only way South Africans can build wealth and get themselves out of poverty.

Mpiyakhe Dhlamini is a data science researcher at the Free Market Foundation

 This article was first published in City Press on 25 April 2019

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