Posted by: michaeldavidpower | November 18, 2009

Devaluation and Inflation

As more and more interest groups in South Africa agree that “the Rand is too strong”, less and less seem opposed to the idea of devaluation. This, at least, is progress.

That said, many of the newcomers to the devaluation bandwagon are bringing inappropriate baggage in their thinking with them.

The group I want to address today are those who are saying “Let’s devalue, but only if no inflation results.” Their logic is profoundly contradictory, a bit like saying “Let’s go swimming so long as we don’t get wet.”

There is no way of gilding the lily of devaluation: the object of the exercise IS TO GENERATE INFLATION and, by doing so, to bring about a realignment in relative price structures. Here’s an obvious example: devaluation will inflate the price of imported shoes from Italy and likely cause the consumer to switch to buying cheaper made-in-South-Africa takkies instead. This has the double advantage of reducing the current account deficit at the same time as stimulating supply at home; if enough supply is stimulated, new investment will be required and jobs will be created.

Devaluation then is precisely meant to make imports more expensive – to inflate their prices. Except for the label junkies and their ilk, where this increases the price of ‘luxury’ imports, the majority of South Africans will not complain because the majority of South Africans do not wear Italian shoes.  The trouble is however that many goods regarded as essential will also be caught up in this devaluation-causing-inflation drag-net. A classic example will be oil. Some will reason that if rand oil prices were to rise as a result of inflation, this would be a price they would not be prepared to pay for ‘a realignment in the relative price structures’ that devaluation would be destined to bring about.

Sadly, devaluation does not allow a nation to pick and choose between the ‘good’ and ‘bad’ inflation that will result. The translation effect increases will hit ‘luxuries’ and ‘necessities’ alike. This is the price that has to be paid. If a nation as a whole deems the  price to be too expensive, then the devaluation – if it is ‘optional’ – should be avoided. But remember there are gains that must be set against these losses, gains that are not realised immediately. Furthermore, the net benefits from devaluation will be spread unevenly across the population, and some well-placed minorities almost certainly will squeal louder than others.

Part of the problem with devaluation is that many of the negatives are felt immediately whilst some of the positives take time to arrive – in economics, this describes the so-called J-curve effect. Furthermore, the effects which reduce demand for imports tend to be easily and quickly measurable. True, existing exporters will also feel the benefits immediately, but the long-term winners – those suppliers who might in due course be able to meet domestic demand redirected from imports or foreign demand stimulated by more competitive prices – will take time to capture their gains and gear up their production, perhaps enhancing existing capacity with new job-creating investment.

Part of the problem that South Africa faces is that, as in much of the Western World probably as a hangover of the stagflationary 70s and cold turkey 80s, there seems to be a general belief that all price rises are evil. Nothing could be further from the truth. As the following article I wrote last year explains, price movements – be they rises or falls – are the heartbeats of capitalism.

Is inflation sometimes an angel in a devilish disguise?

The biggest economic surprise of 2008 has unquestionably been the return of high inflation. And it is not the usual suspect in the form of wages rising faster than productivity. Rather it is that dreaded lurgy last seen in the 1970s: cost push inflation. Why is the latter so feared? Because, like some highly contagious disease, if it is not quarantined quickly, it spreads rapidly into the wider economy and mutates into a highly virulent strain of that more familiar form of inflation: wage push. Both types of ‘in-flu-tion’ then feed off each other. And what was the outcome of this cross-breeding back in the 1970s? Stagflation. Ugh! Ugh! Ugh!

Western Central Banks have spent much of the last 30 years containing the fall-out of this economic epidemic from the 1970s. By the early 1990s, some semblance of stability had returned to Western price levels. This discipline was partly achieved through inflation targeting which, having been successfully pioneered by the New Zealand Central Bank, was then adopted in much of the Western World as the mainstay of their monetary policy. Even some non-Western Central Banks adopted it, including the SARB.  The Greenspan Federal Reserve stayed aloof from this new-fangled approach but when Bernanke became Fed Chairman, he made no secret of his desire to adopt it more formally in the United States too.

The essence of inflation targeting is that it tries to anchor the expectations of wage earners by reassuring them that future price rises will be minimal. Given that many Western economies have been close to full employment for much of the past decade, Central Banks have focussed on monitoring the output gap – broadly a measure of capacity utilization – which they use as an early warning of possible trouble ahead. Since the West had so little surplus labour to absorb, reaching full capacity would create bottlenecks which, for wages, would mean the only way out would be up. Proactive Central Banks therefore aimed to raise interest rates as the output gap narrowed and lower them when it widened again.

From 1990, cost push inflation was not only next-to-non-existent, for much of the decade it was actually negative. This fact was conveniently overlooked by Western Central Bankers eager to be lauded for being the St Georges who had at last tamed the stagflationary Dragon of the 1970s. And whilst these St Georges can claim some success with having cornered wage push inflation, ironically it was the Chinese Dragon that chased cost push inflation back into its lair. By undercutting the relatively high labour value-added margin that prevailed in the Western production of manufactured goods, a China that was still self-sufficient in the supply of raw material inputs breathed ice on labour cost mark-ups and froze Western inflation from underneath.

Some have called this period “the Great Moderation”. Prices stayed so low that even old style monetarism was abandoned. Money supplies were allowed to grow at up to five times nominal GDP. Still no havoc! Still no letting slip those Dragons of wage push inflation! Even Milton Friedman was bemused. Thus was born the era of monitoring ‘core inflation’, (food and energy price changes were dismissed as cyclical ‘noise’). This may have been a defensible idea back in the 1990s but how it flatters to deceive now!

By 2006, the Fed even abandoned the seemingly outdated practice of measuring the growth of monetary aggregates (M3). We should have guessed then that all hell was about to break loose!

Alert readers will know from whence the trouble came. Around 1995, China started running out of domestically sourced raw materials. By 2000, the Dragon’s breath turned from ice to fire as it heated up the prices of raw material inputs not just required for the production of manufactured goods now exported to the West but also for the construction of an infrastructure now needed by a rapidly urbanizing East.  Result?  Cost push inflation bounced back with a vengeance! China’s was so “successful” in its growth of GDP, it managed to turn the terms of trade against it. Oil prices have increased more than 10-fold in less than 10 years; commodities, both hard and soft, have now been on a 7 year tear.

Today’s tragedy for South Africa is thus two-fold: inflation targeting cannot be used as an antidote for either strain of inflation. Even in the West, Central Banks are finding it a flimsy defence against imported, cost push inflation. For its part, the Fed has all but abandoned any pretences of being an inflation buster; their overriding aim today is to prevent a stagnation that could morph into serious asset price deflation in a heavily debt-laden society. Meanwhile the Bank of England’s Mervyn King is preparing to write another letter to the UK Prime Minister to explain why his team has yet again been unable to keep inflation within the target range. Three words would suffice: “raw material inputs”.

As for inflation targeting being used to fight wage push inflation in South Africa, such a policy was always based on inverted logic. To repeat, inflation targeting works best when it tries to contain wage push inflation in an economy operating at or near to full employment. It was never appropriate for a developing country in South Africa’s position to adopt what was essentially a policy made for developed countries. With our significant semi-skilled labour surplus, our labour market was never tight and even now our unemployment is in excess of 25%. Our most important output gap was never mechanical; it has always been human. Our overwhelming focus should be on reducing unemployment first before eventually graduating to the relatively privileged status of being a Bank of England or an ECB where inflation targeting might indeed have been appropriate (at least back in that now vanished Goldilocks “not-too-hot, not-too-cold” Nirvana that was largely devoid of cost push inflation).

Instead, by putting the broken bones of the price structure underlying our labour market into a cast not having first realigned that price structure internally and most especially externally (best achieved by devaluing the Rand), our fractured labour market never had the remotest chance of mending properly. Devaluing the Rand however is by no means enough on its own – in order not to undo any gains from devaluation, deregulating our labour market is also to some degree required. Otherwise we could give back in wage push inflation what we would have gained in (US Dollar) cost depreciation.

Since 2001, we have avoided such a quandary altogether. Instead, in the wake of a Rand pumped up by a commodity bonanza, we have ended up freezing over a quarter of our workers out of the global market. Instead we danced in the delusion of the Dutch Disease: it was heavenly for the import-addicted privileged-by-being-employed South African (at least it was until the credit cycle turned down); it was hell for anyone unlucky enough not to have a job.

Realizing that inflation targeting would not stand a chance of working for us until we achieved near full employment made me think much more deeply about the question: “What exactly is inflation?” Ultimately, it is the arbiter of the relative pricing powers of factor inputs and in particular labour. When wages are fluid, those whose income rises faster than their expenses – meaning that the prices of the labour they sell rises faster than the prices of what they buy – are the winners. And those whose fate is the opposite are the losers.

Why then do politicians generally regard inflation as ‘bad’? Because it usually amounts to a gross violation of Pareto’s Principle: many more tend to be harmed by inflation than benefit from it. In other words, more people usually lose from any material realignment of relative pricing powers than gain from it. Usually, but not always; for labour markets that are chronically oversupplied – like that of South Africa – what inflation targeting does instead is hamstring the realignment of relative pricing powers and so prevent the clearing of that severely imbalanced market.

This means it is possible to see inflation – the adjustment of relative pricing powers –

as not being all bad. With this insight in mind, it then dawned on me that beneath the iron-fisted glove of inflation lies – amazingly! – capitalism’s most precious mechanism: Adam Smith’s Invisible Hand. How so? Because relative price movements are the signalling mechanism by which the Invisible Hand allocates resources. If a price of a product is rising more than its cost, its widening profit margins say ‘come hither’ to unemployed resources. If a product’s price is falling relative to its costs, it warns spare resources: ‘stay away’; indeed, it even says ‘go away’ to resources already employed in that negatively affected activity. And if there are no price movements relative to costs, in other words what if profit margins remain static, the result is stasis. No hands are waving. No resources are being reallocated. In extremis, if there is no movement in relative prices and so no change in profit margins, there should be no growth! And capitalism would stall.

Reviewing the 20th Century history of inflation, especially those periods blighted by the dreaded cost-push variety, led me to conclude that there were times in the evolution of the global economy when the Invisible Hand seemed to gesticulate manically rather than with the slow-motion grace of an Indian dancer. This seemed to happen during those relatively rare occasions when big new national economies were entering the global stage and stoking cost push inflation via their voracious (for which read price inelastic) appetite for those resource inputs being used by all. In the late 1960s and 1970s, this would have included the born-again Japan and Germany. Today, it includes China and, increasingly, Asia at large.

Bees sting but, more importantly for the human race, they also pollinate. If we confined all the bees in the world to their hives, our food supply would collapse and do humanity untold harm. Like bees, inflation also stings. And like bees, inflation also ‘pollinates’. Whilst few would disagree with the generalization that inflation usually does more harm than good, the idea that inflation is all bad is not only wrong, it is dangerously wrong. Again, in extremis no relative price movements would kill capitalism by manacling the Invisible Hand.

So we in South Africa must think about inflation targeting in a much more profound and far less facile manner than we have been doing so up until now. And we must ask, in an economy stuck in the quagmire of a patently clogged labour market, how can South Africa expect to see the beneficial reallocation of that most precious of its resources – its HUMAN resource – without permitting rather preventing than some fairly dramatic gesticulations from that velvet fist in an iron glove, the Invisible Hand of Adam Smith?


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