Back to economics basics

2017-07-10 14:10

The application of monetary policy by which the governments of many countries in the world intervene in the economy, using legislation in the form of central banks, is not as important and effective as generally accepted.

If there is a single development that has seriously gone wrong in the world economy, it would be the general acceptance that all other economic variables, such as specifically interest rates, but also exchange rates and even economic growth, are more important and have a greater role in the economy to play than the demand and supply of products and services. 

The producers, manufacturers and service providers on the supply side and the consumers on the demand side of the economy are in fact the largest and most important role players, as they are the creators of economic growth, prosperity and progress in the world. 

In the process, it is assumed that monetary policy can solve almost all problems at the expense of consumers who are accused and punished for price increases that result in a higher rate of inflation, but who are in most cases not at all responsible for it.

The level of inflation is actually determined by the functioning of the market forces of supply and demand in the economy, with in which governments and central banks intervene on a permanent basis and preventing these forces from functioning freely and independently. The prices generated by market forces must be allowed to perform its essential function in order to balance the supply and demand in the economy at an equilibrium price at which buyers are willing to buy products and services and sellers are willing to sell. The attempt to stabilise prices in the economy disregards this important function and is, therefore, the single biggest delusion in economic science. 

The fact that interest rates do not play such an important role in the economy and simply undermine these important market forces which can lead to serious consequences affecting the whole economy. No one can determine the levels of inflation better and more accurately than the market itself. This interference in the operation of the market forces causes prices to be distorted and that the correct price signals cannot be passed on to the market participants, which include the consumers, investors, producers, manufacturers and service providers. 

The generally accepted influence that interest rates have on inflation and that it can curbs price increases is in fact a myth, due to the fact that inflation is almost always determined by the interaction between supply and demand. If the demand in the economy is higher than the supply, prices will rise, while if the supply exceeds the demand, prices will fall again. 

There can be no better practical confirmation of this economic principle than the fact that the inflation rate reached its lowest level in 16 months of 5,3% in April, while the Reserve Bank held its interest rate at 7% since April 2016. This means that there can be no doubt about how strong and important market forces are, seeing that the demand in the economy has already been considerably lower than the demand for quite some time. According to the Reserve Bank's calculation, the quarterly real private consumption expenditure declined in the first quarter of 2017 for only the third time, but in this case also the most, since the second quarter of 2012. 

The abovementioned decline can mainly be attributed to rising living costs and wage increases that did not keep up with it, record unemployment rates and the high debt levels of consumers. The general acceptance that consumers reduce their spending because the Reserve Bank and the commercial banks raised their interest rates, is not correct, as consumers actually reduce their expenditure due to the increases in the prices of, for example, electricity, fuel and food, as well as minimum wages, which in turn increase the inflation rate and not because of the higher interest rates. 

Monetary policy can also not have an effect on inflation if the government regulates fuel prices and electricity tariffs. Increases in these prices will also increase the consumer price index even if consumers would significantly reduce their fuel and electricity consumption. 

Monetary policy, for example, cannot influence government-controlled prices, such as electricity tariffs, fuel prices and minimum wages. If these prices increase, it will increase the consumer price index even if consumers would significantly reduce their consumption. 

The consumer price index only measures consumer spending, while the government's unauthorised expenditure and corruption pump billions of rand in the economy, which is highly inflationary, but which are excluded from the index. As a result, consumers are also held responsible for the full increases in the inflation rate. 

The huge increase in the international crude oil price from $57 a barrel in January 2007 to $140 a barrel in June 2008 due to a much larger demand for crude oil by the Asian countries lead to, for example, a huge increase from $160 to $320 per ton in the international maize price. The American bioethanol manufacturers, who use maize as a feedstock, could continue manufacturing despite the much higher maize price as the bioethanol prices also increased as much as the crude oil price. 

The sharp increase in the international maize price on the Chicago agricultural futures market in the USA, also had the same effect on South Africa's agricultural futures exchange (SAFEX), where prices are, just as in the USA, only determined by the supply and demand for maize. The local maize price is in fact a derivative price of the international price of maize and the R/$ exchange rate. 

The local producers and consumers were in no way responsible for the resulting increases in the local rate of inflation, but the Reserve Bank increased its interest rate 6 times from March 2007 to November 2008, by a total of 3 percentage points (300 basis points) due to the much higher fuel and food prices being pointed out for several consecutive months as the biggest scapegoats and the main reasons for the rise in the inflation rate. The question that should be asked, is whether the globalisation that has already been taking place in the world for some time has ever reached the Reserve Bank? 

However, the Reserve Bank and most economists were delighted because, according to them, the higher interest rates have helped to reduce the inflation rate, while it actually declined just as fast for the same reasons why the inflation rate has risen so sharply. Mainly because the average monthly crude oil price again fell back to $46 a barrel in December 2008, while the international maize price declined to about $150 a ton over the same period. The local producers and consumers were in no way responsible for the increases in the local fuel and maize prices, but they were again unnecessarily punished with higher interest rates. 

Even as long ago as May 2008, some of the best central bankers of the Group7 countries, including policy makers from developing countries, came to the following conclusions about monetary policy: "Food price inflation may be one of the most serious problems facing the world, but it is one that monetary policy had little power to tackle,” and "Food price pressure is a global problem, …. but we cannot use monetary policy tools to manage this problem.It will consequently be correct to assume that these conclusions also apply to the price increases of virtually all other consumer goods and services that cause inflation. 

Despite of this acknowledgement by the central bankers, they still continue to try and curb inflation through monetary policy, thereby penalising consumers all over the world for price increases they cannot be held responsible for.

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