The current disinflationary policies pursued by the Reserve Bank have serious implications for growth and job creation, writes Asghar Adelzadeh in the eighth of a series on economic policy
EMPLOYMENT strategies to be presented at the October job summit will remain frustrated if the costly effects of the current disinflationary policy of the Reserve Bank in terms of growth and employment are not addressed.
In April 1996, Reserve Bank Governor Chris Stals stated that “at this juncture, there is no evidence that the present model for monetary policy, which has served the country well over the past seven years, should be changed or abandoned”.
What are the main tenets of this monetary policy framework, which has remained unchanged since 1989, despite the drastic changes that have taken place in terms of the priorities of the new government since 1994? Are there reasons to be concerned about the current monetary policy regime?
The starting point is the bank’s belief that there is an “underlying inflationary pressure in the economy [which] requires continuous vigilance from the monetary authorities …”. Added to this is the proposition that inflation is a “fatal economic disease”. Thus, its objective is “to protect the value of the currency; that is, to eliminate inflation”.
On the basis of the conservative monetarist argument that the main cause of inflation is an excessive creation of money, the bank sees its main function in pursuing the fight against inflation as controlling the rate of increase in the money supply. This is done by restricting the amount of cash available to the banking system and influencing the total demand for money, emanating from both the private and the public sectors.
Thus, the bank sets a specific target range for the growth of money supply in each period. Other financial developments affect this core approach to monetary policy only in special circumstances.
The bank’s constriction of money supply policy used to lower inflation is coupled with a high interest-rate policy to contain the total demand for money in the market. The bank sees a close inverse relationship between the rates of growth in the money supply and the level of interest rates.
A more restrictive policy on money supply growth, designed to lower inflation, therefore requires a higher level of interest rates than a more expansionary one. Thus, the bank indirectly “fixes” the interest rate through its bank rate, which will inevitably filter through to the other interest rates of the economy – especially those linked to demand for credit in the private sector.
The combination of the bank’s objective of eliminating inflation and the postulated relationship between inflation and money supply on the one hand, and money supply and interest rates on the other, has led the bank to argue that in order for it to attempt to lower the current high interest rate and promote higher growth and employment will mean renouncing its prime responsibility of eliminating inflation.
In this sense, Stals has argued that: “No government can instruct its central bank to protect the value of the currency, and at the same time expect the central bank to maintain an artificially low level of interest rates in the country, particularly not if the virtues of the market economy should at the same time also be preserved.”
What makes this framework extremely conservative and out of sync with the country’s reality and transformation needs?
The Reserve Bank’s starting assumption that there is an underlying inflationary pressure in the economy is an imaginary threat that is being used to justify the upholding of a damaging monetary policy framework. The inflation rate in South Africa has been between 10 and 20% in the last 30 years, which is considered “moderate” even by World Bank standards.
Not only is it historically untrue that the South African economy has a tendency for an inflationary surge, the argument is also analytically unfounded in an economy with a high degree of under-utilisation of resources with incomplete and underdeveloped domestic markets.
Stals acknowledges that its approach to monetary policy is a monetarist approach. He defends this underlying framework for monetary policy-making by arguing that: “The alternative of a more expansionary monetary policy aimed more directly at the provision of more funds at lower costs for the many social and development needs of the country … sooner or later leads to higher inflation.”
This conviction, which is more ideological than based on the reality of South Africa economy, is an important source of pressure from the Reserve Bank on the government to scale down its desire to embark on a Marshall Plan-type investment in social and development needs of the country.
Stals has repeatedly associated the elimination of inflation with financial stability, arguing that “… financial stability is eventually determined by the rate of inflation in the country …”. Therefore, the current disinflationary policy is further justified by arguing that it will “create a stable financial environment that will be conducive to economic growth, and that will make optimum or maximum economic growth possible”.
In terms of how the optimum growth and development will be obtained given the adopted contractionary policy environment, Stals borrows from Adam Smith that “it is through the `invisible hand’ of the market system that optimum economic growth and development will be obtained”.
By arguing that as a prerequisite for sustainable economic growth, financial stability is equivalent to low inflation rates, and a low inflation rate is achieved through controlling money supply, the bank concurs with the monetarist position that instability in a market economy is produced dominantly by the operation of the government sector and primarily by allowing instability in the growth of the money stock.
If that is kept under strict control, the system is inherently smooth and optimal growth and employment will be achieved with no need for government intervention. As Stals puts it, the government just needs “to encourage the development of the market, to improve competition and to raise the quality of the decision-making process in the market place”.
In addition to its analytical problems and its unsuitability for the current transformation challenges, the negative impacts of the current disinflationary monetary policy on growth and employment requires emphasis.
The policy of disinflation initiated by the bank in 1989 has reduced the rate of inflation from an average of 15% during the 1980s to less than 10% in 1995. The cost of this programme in terms of reduced growth, lower national income and higher unemployment, while difficult to measure, is an important exercise to help us put the current monetary policy framework in a broader context.
In 1994, a World Bank study of South African policy options after the 1994 election raised the following question: “Would the cost of ending South Africa’s moderate level of inflation be substantial?”
And it provided the following response: “The recent disinflation in South Africa suggests a positive answer, confirming the conclusion that disinflation to low inflation rates implies a significant cost to output … Our work also shows that attempts to get inflation further below the 10% mark would imply a trade-off between income redistribution, growth and inflation rates.”
Using techniques drawn from New-Keynesian economics as well as new growth theory, the costs of disinflation can be quantified and it can be shown how the cost of incremental disinflation rises as average inflation falls.
The New-Keynesian economics provides a framework for estimating how shifts in trend inflation affect the inflation-output trade off which can then be used as a basis for quantifying the costs of the disinflation policy in South Africa from 1989 to 1996.
This approach has been used by Paul Krugman, the American economist, to estimate the cost of the disinflation programme in the United States from 1979 to 1984. Our study of the South African situation shows that the average yearly cost of the disinflation policy in terms of foregone gross domestic product (GDP) growth ranges between R9-billion and R13- billion in constant 1990 rand for the period 1990 to 1995.
An alternative measure of the cost of disinflation is to use the relationship between economic growth rates and macro- economic policy variables. Since the late 1980s, the Reserve Bank has relied principally on the bank rate as an instrument of monetary policy. As a result, interest rates are the main vehicle through which the effects of monetary policy are transmitted to real sectors of the economy.
The high real interest-rate policy of the bank negatively affects investment, consumption and government interest payment on its debt, among others. Using this method, the estimated average annual cost of high real interest-rate policy since 1989 amounts to more than R15-billion a year in constant rand in terms of forgone GDP growth.
Finally, disinflation, through high real interest rates, not only fails to contribute to economic stability, it actually promotes instability in the financial markets by encouraging speculative investment, attracting international short-term capital, which in turn increases the volatility and vulnerability of the economy to the international financial markets.
Clearly there is a need for changes in the bank’s conservative approach to monetary policy. Among options available for reconsidering the role of monetary policy in the economy, three proposals are worth consideration:
* To keep the current framework and mechanism and adopt a different, acceptable range for the inflation rate. This means to take cognisance of the trade-off that exists between inflation and unemployment, and the current economic environment characterised by a high unemployment rate, and choose a “stable-moderate inflation range” for guiding money supply and interest rate policies.
* To target the real interest rate and adopt an “inflation-indexed bond rate” monetary policy, where the rate on the government’s long-term bonds is indexed to inflation. A necessary component of this scenario is using prescribed asset policy and the utilisation of the reserve requirements.
* To allow for the nominal GDP rate to replace the monetary aggregates as a guide for monetary policy.
— This article is based on a National Institute for Economic Policy paper written by Asghar Adelzadeh, M Samson and J Bernstein