What causes inflation?

Submitted by Philip Copeman

Inflation, the old enemy, is back. With a few exceptions, this has not been a severe threat to the world economy since the early 1980s. Inflation now threatens us all. South Africa and a number of other countries seem well on their way to succumbing to this monster. Why is inflation bad? Surely we can all bear with slightly rising prices?

At first inflation feels like a small problem. My economics professor described it as similar to being “a little pregnant”. The problem keeps growing and, unchecked, will eventually lead to a catastrophic Zimbabwe-style outcome. Only firm action by the government can stop it.

The reality is that inflation eats into the productivity and viability of any economy. Business decisions become uncertain. In its simplest form, the damage that inflation causes is that it complicates and makes business outcomes more uncertain. Inflation, in any economy, will hamper economic growth, which in turn will raise unemployment and poverty.

The current price drivers are rising oil and international food prices, simply because demand outstrips supply in the international markets for these products. The two are linked because the immediate effect of increased fuel prices is that it becomes more expensive to produce and deliver food, but this on its own does not necessarily lead to a general price rise. It takes the economic stupidity of the government, born out of desperation, to turn this into general inflation.

In an ideal world, the solution should be simple. Prices of food and oil rise relative to other goods and services. Those who produce food and oil are paid more for their output and the rest of us have to adjust to the fact that our output is worth relatively less. We redo our budgets, tighten our belts and stop driving around on Friday nights. The food and oil producers see the benefits; the rest of us suffer correspondingly. There is no need for a general and sustained price rise.

Attracted by higher prices, resources switch from other goods and services to producing more food and energy and we end up with increased supplies of food and energy, greater employment in the food and energy sectors and stable prices.

However, this is not an ideal world and governments are not voted in by food and oil producers. They are voted in by consumers, usually consumers who have a greater understanding of hunger than they do of economics. This problem is particularly acute in South Africa where the poor spend as much as 50% of their income on food. They start lining up taxis in highway protests or riot for food in the streets, but the worst they can do is to threaten to place their votes elsewhere. This spurs the government on to illogical actions. You can see it all happening all over the world.

The first step is to instigate price controls in an effort to keep prices artificially low. This is through laws and committee investigations, effectively price-control witch-hunt. The effect of this is to keep prices for food and oil artificially low and demand above supply. There is no incentive for producers to increase supply, and the result is a very unhappy ending. Excess of demand over supply is what leads to load-shedding, food rationing and empty shelves.

The next desperate step is to subsidise the consumers. The strategy is to tax the producers and use the surplus taxation to subsidise the voters’ habits of eating and driving. The effect is to take away resources from the producers and put these into the hands of the consumers. The problem is that this has an effect known as crowding out, which means that the cost of production rises, interest rates rise and economic growth is reduced. With reduced growth it becomes harder to collect taxes and foot the food bill. The spiral is higher rates of taxation. This is essentially the strategy that we have followed in South Africa, where we have one of the highest tax rates in the world at 29% of GDP.

The idea of this fiscal strategy is that it gives consumers more available income and enables them to buy more food and energy. The nett effect is to make the scarce goods affordable again. But demand cannot exceed supply, and another round of price increases ensues in the markets. This is particularly problematic when there is a high level of government employment of soldiers, teachers, police officers, politicians and municipal workers. In a short time, the government is back to having to raise wages again to meet the newly increase prices, this time at a higher rate, and we start to notice that there is a kicking feeling in our stomachs and the warning of yet another mouth to feed.

Now comes the medicine. Increase interest rates to reduce general demand. This strategy is like administering an antibiotic and hoping that the pregnancy will stop. Yes, it may stop the pregnancy, but it also kills everything else, including possibly the mother. The problem with this approach is that there is a lag effect in this strategy, and inflation rises faster than the dampening effect. By the time that governments realise this, it is usually too late. In cases like South Africa, where we did this from 1982 onwards, it took 15 years and great pain to bring inflation under control.

In South Africa’s case this is disastrous. Increased rates hit all sectors, including the production of food and energy. This will only create more hungry mouths. Increased interest rates will have a direct effect on tax collections and therefore a direct effect on subsidising the poor. This will lead to a rapid depletion of the budget surplus, and to fill this gap the government has no option but to print money to fill the gap.

The end result is horrific: either runaway hyperinflation or the similarly uncomfortable stagflation, where the economy has been killed off and unemployment is rife, yet inflation remains. Further use of interest-rate policy becomes ineffective. In South Africa we are already there. We have raised rates by nearly 5% and inflation has been even greater. It is questionable whether interest-rate tinkering has any effect. The poor are still hungry, so the subsidisation continues. This is the route that Zimbabwe followed. There is a ratchet effect; it is easier to increase prices than it is to reduce them. Only swift and early action can avoid these scenarios.

The only means for avoiding inflation, namely allowing the relative price of the scarce goods to rise and for everyone else to grit their teeth, is the one that in the short term is most unpalatable. Any solution that favours rich producers over poor consumers is viewed as a “let them eat cake” option. Economics is a dark science, and while it may seem heartless to make the poor suffer this way, it is important to know that the latter strategies only solve matters in the very short run. In the long run, moving any resources away from production leads us all to poverty. We have to plan to increase supply, not artificially prop up demand.

The strength of a government to do the unpalatable is based on the ratio of its political support. Does it come from the large numbers of poor consumers, or does it come from the fewer relatively rich producers? It can never be popular to support the fewer rich. In developing nations, this is more acute that in developed nations. Inflation is usually higher in developing nations because their governments are weaker, and in particular depend on the support of the poor consumers. This is also why inflation has the devastating outcomes that we are starting to witness in developing countries.

Does your government have the strength to make these unpopular decisions?

Philip Copeman is an economist and the leader of the TurboCASH Accounting project