Monday, 24 December 2007

The Cost of Money in the South African Economy

Governments, the World Bank, The World Monetary Fund are all prone to fads in determining their economic policies.

Keynesian Economics

During the 60’s Keynesian economics was king. The theory worked! Western economies were boosted by increased government spending. They came close to achieving full employment. Government’s had found the solution to control the cyclical nature of capitalist economies.

What they forgot was that John Maynard Keynes’ theory was intended to be a short term solution. As he said, "In the long run, we are all dead."

As the Western World moved into the 70’s the phenomenon of rampant inflation caused havoc. Governments sought measures to control inflation.

Moneterist Policies

Milton Friedman coined the term “stagflation”. Soaring demand for goods and services – largely fuelled by credit - pushed prices higher as industry did not have the capacity to increase supply. Printing money referred to the increase in the supply of money in the economy without a corresponding increase in the real value produced in an economy. It meant that more money was chasing the same bucket of goods and services.

The solution lay in the carefully controlled use of interest rates to control inflation. We can control the money supply and therefore inflation through the use of interest rates.

Monetarist, neo-classical or ‘supply-side’ economic policy became the order of the day. In at least some cases with considerable success.

The South African Economy

The South African economy has adapted this model in its inflation targeting strategy, and the strategy has worked to a large extent.

But should this strategy be used to counter inflation in the economic climate of late 2007? The current spate of inflationary pressures is largely a result of rapidly increasing global oil and food prices. How will increased interest rates help to stem this inflationary pressure?

Can Higher Interest Rates be Inflationary?!

Many businesses use credit to finance capital expenditure and to manage their cash flows. The cost associated with this credit is interest. What happens when that cost of borrowing increases by 30% over the course of one to two years? That cost must be recovered. It can only be recovered by higher prices. Rapidly increasing interest rates can therefore be counter-productive in the fight against inflation. Higher interest rates in themselves are inflationary!

The effect on Growth

High interest rates carry a second side-effect. One that is very significant in the South African context. It slows growth. To finance investment at 8% is very different to financing that investment at 14%. At an 8% cost, a 14% return produces a 6% profit. The same return at the current cost merely serves to break even.

Under South Africa’s current circumstances, is there actually anything to be gained by raising interest rates, or does it merely serve to slow growth and cause additional hardship to the population? Perhaps it is time for another paradigm shift.

BM 23 December 2007

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