Bananas, horses and Bitcoin

Definition of Money

Contrary to expectations, the question of the definition of money is not a straightforward issue that does not give rise to a diversity of opinion, and even controversy. In some way the difficulty arises out of technical considerations. In yet another, considerations of theory and ideology have also contributed, especially as part of the Keynesian/monetarist debate, although some leading proponents of either school have argued that this issue cannot and should not be settled on theoretical/ideological grounds (Coats and Khatkhate, 1980).

Although there is this diversity of opinion, there are some areas of agreement as to the functions of money, and to its evolution. Money serves three broad functions in the economy, namely as a unit of account, medium of exchange (or ‘means of payment’, Coghlan 1980), and store of value. Most economists agree that the distinguishing characteristic of money is that of the medium of exchange. In a barter economy goods are exchanged directly for other goods. If individual 1 wants to exchange good A for good B, which is held by individual 2, then they have to come together at an agreed place, at an agreed time, and swop the two goods. There is no intervening stage. The problems associated with this type of trade (i.e. barter) are well documented.

First, for trade to take place, there must be a ‘double coincidence of wants’. That is, individual 1 must want to exchange good A for good B held by individual 2, absolutely. But frequently individual 1 might want to exchange good A for good G held by individual 7, when individual 7 does not want good A, but instead wants good B. This problem is solved under indirect barter, when one commodity is used as an intermediate good (Rousseas, 1972). One good is exchanged for this commodity money (e.g. gold) and then this is used to purchase another good. This is merely an intermediate step that ultimately leads to the development of money as we know it today.

But the problems of the barter economy are by no means confined to the need for a double coincidence of wants. Because of the high costs of transacting (both in time and effort involved in trade), the volume and incidence of trade under barter is greatly restricted. Under indirect barter, with its slashing of transactions costs, the volume and incidence of trade is greatly increased.

Although commodity money serves well as a unit of account and a store of value, in some important respects it does not do so well as a means of payment. According to Coghlan (1980), money as a means of payment ‘must possess certain physical characteristics’: it must be durable, to act as a good store of value; it must be homogeneous; it must be generally recognisable and acceptable as money; in order to accommodate the different types and sizes of transactions that trade is comprised of, it must be divisible; it must be portable and it must have demand and supply conditions (Coghlan, 1980).

Clearly, on the last three characteristics commodity money does not stand well. First, First, there are limitations to the divisibility of certain commodities, especially those that have historically been used as money. Second, not all commodity money is easily portable, and there are generally great transportation and storage costs. For reasons of scarcity, and for political reasons, commodity money fails on the third and last characteristics. Thus, the introduction of paper and coins eliminates all these problems. That is, ‘modern’ money has all these characteristics and performs well as a means of payment, unit of account and store of value, although under inflationary conditions its function as a store of value tends to break down (Rousseas, 1972). More fundamentally, the introduction of modern money greatly increases the efficiency of the economy, thus permitting economic expansion and technological innovation to take place at an accelerated pace.

According to Coghlan (1980), the introduction of a modern monetary system results in the following:

• Improvements in efficiency resulting from the increased ability to take advantage of specialisation and division of labour in production and exchange.
• The release of resources previously engaged in the process of bartering and gathering information.
• A general reduction in uncertainty [which] should improve expectations of the future and encourage producers and consumers to adopt a more optimistic and expansionary approach (Coghlan, 1980).

Having dispensed with the issues of the definition of money at a ‘theoretical’ level, we now come to a definitional problem of a different kind. What asset or group of assets can be termed ‘money’, and how can they be measured? Here again there is great controversy. With regard to money as a medium of exchange some have argued that only notes and coins and demand deposits in commercial banks should be regarded as money. This narrow definition of money is what is usually termed M1. Others have argued for broader definitions of money to include savings deposits (M2) and time deposits and deposits with other financial institutions (M3). Monetary aggregates, however, are not confined to these three; many others have been defined (e.g. PSL2 in the United Kingdom). Different economists argue for the adoption of one or other aggregate, but according to Friedman and Schwartz, there is no principle involved in adopting any particular aggregate (Coats and Khatkhate, 1980). Coats and Khatkhate (1980) argue that this question is empirical in nature, and cannot be decided on theoretical grounds. They quote the Federal Reserve Bank of the United States’ (the Fed) report on “Improving the Monetary Aggregates” (June 1976), which argues that the choice of the aggregate should depend on ‘(1) how accurately the total can be measured; (2) how precisely, and at what costs including unwanted side effects, the Fed can control the total; and (3) how closely and reliably changes in the total are related to the ultimate policy objectives [of employment, output, the price level, etc. – author]’, “Improving the Monetary Aggregates”, Report of the Advisory Committee on Monetary Statistics, Board of Governors of the Federal Reserve System, June 1976 in Coats and Khatkhate, 1980.

Analogously, money may be defined as that ‘financial aggregate whose demand is empirically most stable’ (Coats and Khatkhate, 1980). Furthermore, ‘empirical validation is necessary for each country’. To us, this approach looks to be the more promising one. There is no a priori decision as to which monetary aggregate to use, but the question is deferred to empirical testing.

Theories of the Demand for Money

There are two main approaches to the demand for money, one being neoclassical and the other being Keynesian. The neoclassical approach stems mainly from Milton Friedman’s restatement of the quantity theory of money. But it is also argued that Friedman’s theory of the demand for money was in many ways a restatement  [also] of Keynes’ theory of the demand for money (Gowland, 1985; Coghlan, 1980).

According to the neoclassical approach, money is considered a normal good. Therefore, the demand for money should behave like that of any other normal good. That is, it should have positive income elasticity and negative price elasticity (Gowland, 1985). The price of money, that is the opportunity cost of holding it, is considered to be the rate of return on alternatives to money. Since both financial and real assets are alternatives to money, the demand for money should depend on the rates of return available on these. In addition, of course, it should also depend on the price level, and the level of real income.

Gowland identifies six variables on which the demand for money should depend:

1. The general price level, with a positive elasticity. (With respect to the price level, the demand for money is considered to be homogeneous of degree one);
2. The level of real wealth, with a positive elasticity;
3. The level of real income (or output), with a positive elasticity;
4. The rate of interest on short-term financial assets, with a negative elasticity;
5. The rate of return on other assets, including real assets, with a negative elasticity;
6. The own rate of return, with a positive elasticity (Gowland, 1985)

The Keynesian approach postulates motives for holding money, namely the transactions, precautionary and speculative motives. The transactions motive for holding money derives from money’s function as a medium of exchange or means of payment. Individuals will hold money in order to carry out current transactions. Although according to Hicks this is really not a demand, but a “requirement” for money, Coghlan (1980) argues that this “ignores the temporal aspect of exchange, the lags in the system between receipts and payments. Once these are taken into account it is only sensible to consider a demand for transactions balances” (Coghlan, 1980). This transactions demand is a function of expected income, and it has positive income elasticity.

The precautionary demand is also a transactions demand, but it differs from the above insofar as it is a forward-looking concept. That is, individuals will hold certain money balances as a precaution against unforeseen future expenditures. It caters for the uncertainty in transactions to be carried out in the future. It also depends on expected income, with a positive elasticity.

The last motive for holding money is the speculative motive. In the Keynesian view, there are only two kinds of assets, money and bonds. Bonds are government debt (that is, they are claims on the government), and they pay their holder a fixed coupon rate. Because of this, bond prices move inversely with interest rates and so their attractiveness is affected by the movement of interest rates (Gowland, 1985). Therefore, when interest rates are falling, individuals will move out of bonds and into money. This is because individuals have a view about the ‘normal’ rate of interest, and hence when rates fell below this rate, they were expected to rise. Thus, when bond prices are rising, bondholders would sell, with the view of buying them at a lower price when prices have fallen. This, then, was the speculative demand for money. It was postulated to depend on the rate of interest, with an almost infinite interest elasticity (Gowland, 1985; Coghlan, 1980).

Although the different ‘motives’ have been attacked on specific issues, a general criticism is also levelled at the motives approach. If money is a normal good, then its demand should be analysed like that of any other normal good. Using the demand for television sets as an example, Gowland (1985) argues that just as we postulate a downward sloping demand curve for television sets, without specifically analysing “the ‘news demand’, the ‘opera demand’, …” we should postulate a downward sloping demand for money function, without analysing the motives for holding it (Gowland, 1985).

But the monetarist-Keynesian debate regarding the demand for money does not end there. There is also disagreement about the nature of assets that can be regarded as substitutes for money. Keynesians regard only short-term financial assets as substitutes for money. Hence, for them the opportunity cost of holding money is the rate of interest on these assets.

For monetarists, no financial assets are close substitutes for money. If individuals want to alter their money balances in response to a change in income, they would just as much sell/purchase financial assets, both short and long-term, as sell/purchase real assets, including consumer durables (Coghlan, 1980; Gowland, 1985). Therefore, the opportunity cost of holding money is the rate of return on all these alternative assets. The nominal rate of return on real assets is proxied by the expected rate of inflation on the grounds that the two should move in line (Gowland, 1985).

This controversy about the nature of assets that can be regarded as substitutes for money is also at the core of another disagreement, this time about the transmission mechanism of monetary policy. Because Keynesians believe short-term financial assets are direct alternatives to holding money, their transmission mechanism is an indirect one, acting through the interest rate. Therefore, as a policy prescription, Keynesians advocate ‘the’ interest rate as an intermediate target. On the other hand, because they view financial as well as real assets as alternatives to money, the monetarist transmission mechanism is a more direct one. If, in response to a change in their levels of real income and wealth, individuals desire to change their money balances, then they will as much move into or out of financial assets (both short and long-term) as they will alter their patterns and levels of expenditures on real assets, including consumer durables. If the economy is at full employment (that is, at its long-run equilibrium), then these changes of expenditures will have repercussions on the price level. Thus, at full employment, an increase in the level of income, ceteris paribus, will boost aggregate demand and so lead to inflation. Because monetarists believe that money causes income, therefore at the policy level they advocate the money stock as an intermediate target.

A controversy of a different kind has been over technical considerations. First, and largely stemming from the disagreement over the composition of substitutes to money, there is disagreement over the arguments to be included in the demand for money function. Second, there is no agreement over the form of lag to be incorporated in the demand function, and also on the form of expectations. Third, there is no agreement over the appropriate measure of the monetary aggregate to be considered. As Coghlan argues, the matter of the definition is very important as this affects the estimation approach (Coghlan, 1980). Also, empirical studies in the United Kingdom have shown that adopting different measures of money (that is, M1, M2, etc.) produces different coefficients, as do short and long-term interest rates (see, inter alia, Coghlan (1980)). However, according to Coghlan (1980), no study has as yet attempted to take explicit account of the problem of definition of money.

But, in the view of Coats and Khatkhate (1980), the issue of the definition of money should be decided on empirical grounds. That is, no a priori decision can be made on which monetary aggregate to use; “empirical validation is necessary for each country” (Coats and Khatkhate, (1980), see also section 2.1 above).

Monetisation

According to Chandavarkar, monetisation is “the enlargement of the sphere of the monetary economy…. It involves the extension through time and space of the use of money in all its aspects…to the non-monetised (subsistence and barter) sector” (Chandavarkar, 1977). Historically, the widespread use of, and familiarity with, money has not proceeded at the same pace in all parts of the economy. Certain parts of the economy, namely and mainly the urban centres, have come to embrace the use of money more than other parts. This worked to produce or to exacerbate the ‘duality’ between the urban and rural sectors of the economy. This is probably where the concept of monetisation was born to describe the process whereby the widespread use of money was extended to other parts of the economy, chiefly the rural sectors.

In developing economies a large part of the rural sector engages in subsistence activity. In this context, therefore, monetisation linked to two other simultaneous processes, namely ‘commercialisation’ and financial intermediation. Commercialisation is defined as “the pervasiveness of the behavioural assumption of profit maximisation”. Financial intermediation is simply the process whereby institutions mediate in the process of lending/borrowing and saving/investing. Although the two other phenomena are simultaneous with monetisation, it is essential that they be separated analytically and empirically (Chandavarkar, 1977).

Because monetisation means the extension of the use of money to other parts of the economy, thus bringing in activities that have hitherto been non-monetised, it is bound to have an impact on the demand for money. Simply put, ceteris paribus, monetisation increases the demand for money.

Thus, it has been argued, the level and rate of monetisation should be taken into account when estimating the demand for money function for a developing economy. According to Coats and Khatkhate, when estimating the demand for money function it is simplest to use income data from the monetised sector only, “as then the non-monetised, which uses and demands no money by definition, can simply be ignored” (Coats and Khatkhate, 1980).

In the past there were attempts to proxy the rate of monetisation with such socioeconomic factors as urbanisation’s industrial employment and production of cash crops. But these are not suitable indicators of the rate of monetisation (Chandavarkar, 1977). Also, the ratio of money supply to national income has been suggested as an appropriate proxy. But Chandavarkar points out that this is also not a suitable proxy because an increase in the supply of money might be confined to (or originate from) the already monetised sector. He suggests, instead, the use of the monetisation ratio. This is defined as “the proportion of the total goods and services of an economy that is monetised, in the sense of being paid for in money by the purchaser”, in relation to one of the gross domestic product (GDP), gross national product (GNP), population, etc.

However, this is a temporal indicator, and it should be used in conjunction with “time series of national accounts at constant prices, since this alone can establish the rate of monetisation (the annual percentage increase in the share of the monetised sector) as distinct from its level” (Chandavarkar, 1977).

While Chandavarkar goes further than others and actually suggests economic indicators of monetisation, there is no attempt to formulate a demand for money function that takes into account the suggested rate of monetisation. He suggests that “the net increase in the demand for money from monetisation per se would be much smaller, compared with the demand arising from an increase of economic activity in the monetised sector [although] in practice it would be difficult to disaggregate the increase between these two components…”

The portfolio effects of an increase in monetisation would be an increase in the demand for currency rather than for bank deposits. This is so because there is a “high ratio of currency to money supply in most developing economies”, while banking facilities are inadequate and the banking habit is backward. Even where the impact of monetisation is on bank deposits, it is more likely to affect savings deposits than demand deposits, given the greater number of savings banks in rural areas compared to commercial banks and “also given the greater expense and sophistication of checking accounts”.

The Demand for Money

The demand for money function captures the relationship between the intermediate target (the nominal money stock) and the ultimate objectives of monetary policy, namely employment, output, the price level, etc. Although there is disagreement over the specific functional form of the demand for money, there is agreement regarding some of the arguments to be included. The demand for money function is postulated to depend on expected real income, permanent wealth, the expected rates of return on alternatives to money, the expected price level and some other factors (like institutional rigidities). In functional form this may be stated as

Where   desired nominal money balances;

                expected real income;

                  expected price level;

                  the expected rate of return on the -th asset;

                  permanent wealth and;

                     other factors affecting demand.

The partial derivatives have the following hypothesised relationships with desired nominal money balances,

; ;

These partials indicate the signs of the elasticities of demand of the different variables. That is, desired money balances depend on expected real income, with a positive elasticity; on the expected price level, with a positive elasticity; on permanent wealth, with a positive elasticity; and on expected rates of return on alternatives to money, with negative elasticities. For simplicity, the expected variables will be represented by the current values Y, P, R. Following Guma and Coghlan (1980), we shall specify the following functional form, 

,                                                 (2)

If there is partial adjustment of actual money balances, , to this desired level, , then this lagged adjustment may be represented as follows,

                                                                      (3)

Where   actual money balances;

                money actually held in the previous time period;

                as before;

                the stochastic error term, which is generally assumed to                have zero mean and constant variance; and   

                 the constant coefficient of adjustment.

Taking logarithms of (2) and (3) above gives,

,                                               (4)

and

                                                                (5)

Where the lower-case letters denote the logs of the respective variables. 

Substituting (3) into (4) and rearranging gives,

                    (6)

Let the be replaced by ; therefore, (6) becomes

                          (7)

These coefficients will give estimates of the short-run elasticities.

This functional form gives the demand for nominal money balances in the short-run. In the long-run, of course, actual and desired money balances are identical, which implies that no adjustments to money balances are necessary. The long-run coefficients are given by the ,

i.e.

Crypto Currency

‘Crypto’ ‘Currency’ refers to digital assets created by private actors for the purpose of creating wealth and facilitating online transactions that are purportedly more secure than monetary or bank facilitated transactions. These digital assets do not meet the traditional definition of money or currency, although in a sense they do fit into the evolution of money. This is so because they do store value and they facilitate transactions. They, however, fail primarily because their use is restricted to a small number of economic actors, cutting out the majority who do not have access to digital infrastructure. They are essentially a novelty.

Their ‘crypto’-ness is also in question. Being digital instruments, albeit supposedly very secure, they may be vulnerable to hacking and theft. It is also the case that if you lose or forget your digital ‘crypto’ password you may permanently lose your ‘currency’ or money. It may also be argued that in reality they ‘solve’ a nonexistent problem. Fiat money is secure: in its legal tender status, it is guaranteed by the issuing authority (i.e. the central bank); bank deposits and bank facilitated transactions are guaranteed by the banks, who are typically very financially sound, and they in turn are guaranteed by insurers or the central bank and the state. Although bank deposits are linked to an identity, however money in your pocket or under your mattress is completely anonymous. It may burn or be stolen, but it is not linked to any specific identity, and therefore by that nature ‘crypto’.

This does not mean, however, that ‘crypto’ assets have no role to play as a form of money. After all, in its early days money or currencies also had challenges, including public mistrust and defaults. As they evolve, these mediums of exchange will most likely become more robust, gain wider acceptance, and solve their other weaknesses. Instead of being opposed to them, central banks should be investing resources to understand them better and devising regulatory frameworks that will facilitate their wider use and security. Indeed, a forward-looking central bank or banking system might consider creating their own crypto assets, that would then enjoy the status of fiat money.

Let them eat cake

Many leaders, even democratically elected ones and former revolutionaries, tend to take their people for granted. They demonstrate an insensitivity to their feelings and plight.

Nelson Mandela and Franklin Roosevelt possessed a rare ability to bring their people along with them, even as they embarked on difficult political projects in their nations’ histories.

Leaders would do well to emulate these iconic individuals.

Benefits of a Governmental Digital Strategy

Want to reduce corruption, reduce the cost of doing business and serve citizens? Studies show that digitization is one of the biggest drivers of a nation’s economic success. Digitization reduces the costs of doing business for both the state and private economic actors, in turn benefiting the economy as a whole. Digitization also markedly reduces the incidence of corruption and increases access for citizens to services at reduced cost.

For example, digitizing procurement increases competition, reduces costs, reduces arbitrary decision-making, reduces human interaction in the submission and evaluation of tenders, thereby eliminating or reducing opportunities for corrupt or collusive behaviour. Downloadable tender documents and digital submission also benefit the environment in many ways: it reduces the need for printing and for driving to collect and submit documents, etc.

In another example, a pilot study in the US involved the use of Artificial Intelligence/algorithms to allocate bail for various categories of offences. This showed a marked reduction in the prison population of awaiting trial prisoners. This clearly has budgetary and justice benefits.

With no human bias in decision-making, algorithms can take over a lot of decision-making, especially those decisions dependent on quantitative data. For instance, decisions about the Repo rate by the SARB can be made by algorithms without any political or other bias, purely on the numbers. Incorporating machine learning means computers can also make increasingly better decisions even where qualitative data are necessary for decision-making.

The use of digital technology in education and health care are well documented. All that is required is a clear strategy and improved implementation efforts. Building computer labs in township and rural schools, and then leaving these to be completely vandalised or at the mercy of corrupt teachers is pointless and a waste of public and donor funds. We have also seen the impact of digital technology on access to financial services for unbanked or underbanked people.

At the other end of the scale, access to government services may be greatly improved through improved ICT infrastructure across the country, including poor areas and rural areas. This should be complemented by a continued reduction in data charges.

Investment in digital services can prove comparatively inexpensive because once the systems are in place, the marginal cost of adding users are close to zero. For example, when you have a computer in each village (a “digital centre”) with the birth certificate program installed, extra birth certificates cost almost zero. And adding more apps to the computer, allowing for help with other government services (like agricultural extension services) adds little cost too.

The Maritime Economy and its Potential for Economic Upliftment in South Africa

South Africa has a long coastline and is blessed with two contrasting oceans. Indeed, our colonial past was founded on this. It is a surprise and disappointment that our maritime economy is not reflective of this. While other countries are deriving significant benefits from marine gas and oil deposits, coastal tourism and robust fishing industries, we are underperforming.

Instead of flogging a rapidly diminishing mining sector, there should be a bigger focus on the maritime economy[1], which could be grown to rival any in the world. Specific areas to look into include:

·      Gas and oil

·      Fisheries

·      Coastal tourism and cruises

·      Desalination technology that could be marketed around the world

·      Scientific and other deep-sea exploration expertise

·      Boat building and repairs

·      Refineries

·      Revitalisation of the Cape trade route (e.g. in competition with the Suez-canal)

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[1] The maritime economy has the potential to be bigger than the mining sector. Examples like Singapore, Egypt with the Suez or Panama with the canal, Angola and Nigeria with the oil can be studied to see how their fortunes were transformed by their marine economies

Dual mandate for the South African Reserve Bank

1     Introduction

This paper is a response to the invitation by the Hon Tito Mboweni, Minister of Finance, to provide comments on the economic proposals published by the Minister. 

2     Monetary Policy and its Impact on Growth and Unemployment

2.1       Some Foundation

2.1.1      Macroeconomic Policy Objectives

The macroeconomic policy objectives of governments are typically the attainment of full employment, a stable price level, high and sustained economic growth, and a healthy balance of payments. Though this might be the case, different governments do not put equal emphasis on the various policy objectives; one or more objectives might be given priority over others, and these priorities may be revised from time to time in response to economic and/or socio-political pressures. Frequently, the objectives are in conflict with one another, either in the short-term or long-term, and a government may have to abandon attainment of one in favour of another.

This conflict is seen more dramatically in the conflict between full employment and a stable price level. With a few exceptions, governments that try to secure full employment in the economy tend to find themselves confronted by high rates of inflation, and those which try to control inflation find themselves contending with high unemployment. That is, the two objectives seem to be mutually exclusive[1]. Thus governments, for decidedly political ends, find themselves choosing either full employment or a low inflation rate, and generally leaving the other conflicting objective to find its own level. With the advent of inflation targeting, most governments (through their central banks) have tended to favour low inflation as the overriding objective, while utilising other policy tools to try and mitigate the resulting high unemployment rate.

Because governments in market economies cannot act directly to influence these ultimate macroeconomic objectives, they have instead indirect methods of influence open to them. These indirect methods are embodied in monetary or fiscal policy. Through the use of tools from monetary or fiscal policy (or a policy mix), governments can steer the economy towards the attainment of their macroeconomic objectives. Even though in practice a monetary and fiscal policy mix is virtually inevitable, particular governments typically favour one policy over the other.

2.1.2      Inflation Targeting and Interest Rates

Inflation targeting regimes typically use a benchmark rate as the instrument to ‘target’ the inflation rate; variously raising the rate in inflationary times or reducing it in deflationary times. In South Africa the target rate is the “Repo Rate” and raising or reducing it is the purview of the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB), the South African central bank. In a theoretical sense, since the inflation rate is a lagging indicator, the Repo rate targets expected inflation, and also serves as a signal on inflationary expectations within society and economic actors.

While the ostensible single target of the SARB is the inflation rate, the consequence of this is that it directly impacts the level of unemployment. So, in reality a choice of an acceptable level of inflation simultaneously implies a choice of an acceptable unemployment level (or, conversely, the level of employment in the economy). This is so because, simply, raising or reducing the Repo rate has an impact on the level of domestic investment activity and consumer demand, which in turn impact economic growth, thereby impacting the economy’s ability to create or not create employment.

Therefore, it may be argued that any inflation targeting regime is implicitly also an employment targeting regime.

2.1.3      Unemployment and Short-run Inflation

Monetary Policy, conducted through a benchmark rate, is the most potent policy at the disposal of any government and its central bank to affect the level of employment in the economy. The effect of a policy decision on interest rates has a more direct and immediate impact on economic activity, but also acts on the psyche of society and economic actors by signalling a relaxation or tightening of monetary policy.

A relaxation of monetary policy, at least in the short-term, can lead to an increase in employment. How long the ‘short-term’ lasts may be dependent on other factors, for instance structural adjustments and other industrial policies being implemented at the same time (some of which have been advocated in the Minister’s proposals). As has been shown above, this clearly will eventually lead to an increase in inflation[2]. The choice to be made, therefore, depends on which of these twin ‘evils’ is seen as the worst. High unemployment, which leads to societal breakdown and a vicious circle, or some extra inflation.

Such thinking is not unique, nor is it confined to developing economies. Debates around the continued relevance of inflation-targeting on its own without reference to output stabilisation have been ongoing for a while. Indeed, the thinking occupies a whole range, including the possibility of a dual mandate of inflation targeting and output stabilisation. “In this dual mandate framework, central banks’ decisions would be based not only on their views about inflation, but also on direct measures of output and unemployment gaps. Central banks would thus have more discretion to allow inflation fluctuations if addressing them would exacerbate cyclical downturns”. (IMF, April 2013)

The argument that is advanced for not wanting any high inflation rests on a (sometimes fallacious) argument that inflation erodes the buying power of people’s money and therefore leads to economic hardship. That may be true for those that are employed, but ignores the unemployed who suffer even greater hardship, both economic and sociopsychological. It also ignores the more immediate societal and economic harm of unemployment – high crime rates, high levels of government budgetary support (subsidies, etc.), etc.

Any concerns about the impact of such proposals on the independence of a central bank would be unfounded. Central bank independence is about operational independence, not about goal or mandate independence. Clearly, it would not do to change the mandate regularly at a whim but changing it for sound economic reasons and communicating these clearly and unambiguously should be fine.

2.1.4      Inflation Targeting and Exchange Rates

The proposals make mention of inflation targeting and flexible exchange rates, without elaborating much. Without fully understanding the intention of the authors, it is important to indicate, however, that it is a long-settled debate in macroeconomics that you cannot engage in both inflation targeting (using an interest rate instrument) and exchange rate targeting.

In any event, it has been demonstrated many times[3] in the past that an exchange rate target for a small open economy like South Africa is a fool’s errand. Unless you are the United States or the likes of China with their gigantic reserves, any attempt to target the exchange rate would lead to ruin.

2.2       Monetary Policy Practices from around the World

2.2.1      The recent past

During the recent Great Recession and its impact on economies, various developed economies adopted innovative and unconventional monetary policies to limit the damage and to drag their economies back from the brink. 

Central banks ordinarily conduct monetary policy by buying and selling short-term debt securities to target short-term nominal interest rates. These purchases and sales of assets change both short-term interest rates and the monetary base. This conventional monetary policy can potentially stimulate the economy through two types of channels: asset price channels (including interest rates) and credit channels. 

However, when interest rates are at the effective lower bound, increasing the monetary base is not, by itself, considered an effective stimulus. This is what the central banks of the United States, the United Kingdom, the European Union and Japan were faced with when they lowered their rates to zero and negative to alleviate financial distress and stimulate their economies (see figures below.)

Faced with this scenario, the Fed, the Bank of England (BOE), the European Central Bank (ECB) and the Bank of Japan (BOJ) “turned to two unconventional policy tools – quantitative easing programmes and increasingly explicit and forward-leaning guidance for the future path of the federal funds rate – in order to provide additional monetary policy accommodation to help end the recession and strengthen the economic recovery. These unconventional policy actions were intended to put downward pressure on real longer-term interest rates and more generally to improve overall financial conditions, including bolstering prices for corporate equities and residential properties. More favorable financial conditions would, in turn, help boost aggregate demand and check undesirable disinflationary pressures by providing increased support for consumer spending, construction, business investment, and net exports”. (Engen, Eric M., Thomas Laubach, and David Reifschneider (2015)) 

The Fed, BOE, ECB and BOJ steered their respective economies through these difficult times and further showed that their decision-making is empirically based. For example, in recent times whenever there has been an expectation that the Fed will raise interest rates, it has not done so in order to accommodate its other mandate of full employment. (See below)

The People’s Bank of China (PBOC) has shown similar responsiveness to shocks to the Chinese economy, for instance when there was a stock market collapse and the slowing down of the economy.

The purpose here has been to show that other central banks have been prepared to lower interest rates to zero and negative and then to further implement unconventional policies in order to stimulate economic growth and thereby affect unemployment. Indeed, “the [Federal Reserve]’s actions do appear to have appreciably sped up the pace of recovery from 2011 on as the private sector began to learn that monetary policy was going to remain substantially more accommodative than usual over a longer period of time”. (Engen, Eric M., Thomas Laubach, and David Reifchneider (2015))

2.2.2      The United States – The Federal Reserve

“The one-page well-written [Federal Open Market Committee] (FOMC) “Statement on Longer-Run Goals and Monetary Policy Strategy” (FOMC, 2019, first adopted in January 2012) clarifies the Federal Reserve’s monetary policy goals and strategy. The Federal Reserve’s statutory mandate is to promote maximum employment and price stability…. The FOMC provides further clarification on how it sets monetary policy:

In setting monetary policy, the Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee’s assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. (FOMC, 2019)

Furthermore, a “balanced approach,” and the statement “we put equal weight on those two things; [the inflation target and the natural unemployment rate] of Bernanke (2015b)” …can be interpreted as an equal weight of stabilization of inflation and stabilization of unemployment. Indeed, Yellen (2012, p. 13) states:

The balanced-approach strategy endorsed by the FOMC is consistent with the view that maximum employment and price stability stand on an equal footing as objectives of monetary policy.

Furthermore, Clarida (2019, p. 5) notes

As a practical matter, our current strategy shares many elements with the policy framework known in the research literature as “flexible inflation targeting.” However, the Fed’s mandate is much more explicit about the role of employment than that of most inflation-targeting central banks, and our statement reflects this by stating that when the two sides of the mandate are in conflict, neither one takes precedent over the other”. (Svensson, Lars E.O., (June 10, 2019)

The Fed has also indicated a strong understanding of where its mandate derives from and the need to re-examine how it applies monetary policy and do so transparently and invite views from outside itself. A recent speech by Jerome H Powell, Chair of the Board of Governors of the Fed, illustrates this point well. Said Powell, “This year’s symposium topic is “Challenges for Monetary Policy,” and for the Federal Reserve those challenges flow from our mandate to foster maximum employment and price stability.… Thus, after a decade of progress toward maximum employment and price stability, the economy is close to both goals. Our challenge now is to do what monetary policy can do to sustain the expansion so that the benefits of the strong jobs market extend to more of those still left behind…” He continues, “Finally, we have a responsibility to explain what we are doing and why we are doing it so the American people and their elected representatives in Congress can provide oversight and hold us accountable…. We are conducting a public review of our monetary policy strategy, tools and communications – the first of its kind for the Federal Reserve. We are evaluating the pros and cons of strategies that aim to reverse past misses of our inflation objective. We are examining the monetary policy tools we have used both in calm times and in crisis, and we are asking whether we should expand our toolkit. In addition, we are looking at how we might improve the communication of our policy framework. Public engagement, unprecedented in scope for the Fed, is at the heart of this effort. Through Fed Listens events live-streamed on the internet, we are hearing a diverse range of perspectives not only from academic experts, but also from representatives of consumer, labor, business, community, and other groups.” (Powell, August 2019)

2.2.3      Japan – The bank of japan

Haruhiko Kuroda, the Governor of the Bank of Japan, explained the BOJ’s Monetary Policy this way:

“Now, I would like to explain the Bank’s conduct of monetary policy. The Bank currently adopts the policy framework of “Quantitative and Qualitative Monetary Easing (QQE) with Yield Curve Control.” Under this framework, it sets the short-term policy interest rate at minus 0.1 percent and the target level of 10-year JGB yields at around zero percent…. By conducting this operation, short- and long-term interest rates in financial markets have been stable at low levels and lending rates for firms…have remained at extremely low levels”.

 

2.3       What is to be done in South Africa?

2.3.1      Current Mandate of the SARB

On its website, the SARB states its monetary policy objectives in the following way:

“The Bank has been entrusted with the overarching monetary policy goal of containing inflation. The Bank can use any instruments of monetary policy at its disposal to achieve this monetary policy goal. This implies that the Bank has instrument independence in monetary policy implementation but not goal independence in the selection of a monetary policy goal”. (My emphasis)

2.3.2      Repurposing the SARB

The proposals make passing remarks in various places to monetary policy, and yet this is the most potent policy instrument available to the government and the South African Reserve Bank (SARB) to influence the growth rate and reduce unemployment. The apparent failure to realise that it is the contractionary policies of the SARB that are negatively impacting growth and employment is puzzling as there’s ample theoretical and empirical evidence to suggest this. As economics is about choice, policy makers make choices that ultimately harm or benefit their economies and citizens.

There’s general consensus that high interest rates lead to lower levels of economic growth and therefore lower levels of employment (or higher unemployment). High interest rates may attract speculative international financial flows, but these are generally fleeting and mostly do not lead to productive investments. On the other hand, they negatively impact demand and domestic investment expenditure. All things being equal, the current inflation target (range), with the resultant relatively high interest environment, is incompatible with the stated growth and employment objectives. In other words, the current monetary policy stance of the SARB harms the country’s growth prospects and is not supportive of the government’s stated growth and employment objectives.

The minister and the SARB should dispassionately and non-ideologically take stock of the situation and accept, as evidence seems to suggest, that the government and the current proposals will not attain the growth and employment targets with the current policy incompatibility. Since the mandate of the SARB comes from government and/or parliament, it is inconsistent to persist with an inflation target range that clearly is at odds with the growth target and the creation of employment. What compounds the situation is the observed, unstated goal of the SARB to target the median of the range. What is the point of the 6% upper limit if the SARB conducts policy in such a way that the rate of inflation is generally restricted from testing this upper limit? The SARB should, therefore, allow inflation to overshoot the target in order to foster employment; alternatively, the SARB’s mandate should be amended to explicitly target unemployment as well or the upper limit of the target range be increased.

The reduction of unemployment, and not a low rate of inflation, should be the key objective of macroeconomic policy in the short to medium-term. This would have a positive impact on the budget deficit through reduced social spending while revenue collections increase. This would allow the government space to increase spending on growth enhancing items like education, crime prevention, etc. creating a ‘virtuous circle.’

Clearly, this monetary policy would have to be complemented by strategies implemented by government and the private sector to ensure that growth is in sectors with the greatest employment creation potential. In other words, avoid the curse of jobless growth. The proposals address this issue.

It is interesting to note that the wage increases typically demanded by unions, particularly public-sector unions, clearly indicate that their inflationary expectations are consistently higher than the actual rate of inflation. This is puzzling as the SARB has maintained consistently low and relatively stable rates for a long time. This, in fact, seems to reflect the strong power that unions have in South Africa. This may reflect general historical union development, but it may also be due to the existence of an alliance between unions and the governing party.

3     Bibliography

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[1] Some economists have argued that as the rate of inflation becomes very low and stable, the economy will gradually absorb the unemployed, leaving only people and resources who are unemployed for structural and other reasons (e.g. “frictional” unemployment).

[2] It has been shown in some developed economies, most notably the United States and Japan, that it is possible to tame inflation while at the same time attaining a level of ‘full’ employment.

[3] The Bank of England and the SARB, in particular, have gone through such experiences