Booby-trapped playing fields

FERRIER INTERNATIONAL keeping you updated and thank Cess Bruggemans ; Chief Economist FNB for this article.

****************************************

Booby-trapped playing fields

By Cees Bruggemans, Chief Economist FNB
24 June 2008

As inflation rises steeply, central banks everywhere are rallying to give battle with higher interest rates.

But is that the right approach? Is monetary policy the right tool to address what in origin are structural rigidities preventing efficient market functioning created through policy mistakes the world over?

As a blunt copout, perhaps, but as a first option?

Does one correct one mistake by making another?

Does one address the inflation resulting from policy mistakes far and near by incurring growth sacrifice to the point of recession, falling income, wealth and employment?

If this sounds like a leading question to which the answer is so patently obvious it requires no further response, by all means.

But hardly anyone at present apparently thinks along these lines, as much locally as abroad. Many simply don’t see the main problem in these terms.

Instead, people act as if we are engaged in a war, more specifically a monetary policy war. It is a conflict in which most combatants are trying to decide whether they want to intensify the war or scale it down.

Few, if any, are saying perhaps the wrong war is being fought entirely.

That is similar to saying the Americans were wrong to enter Iraq and Afghanistan in response to 911. Instead, a global police effort should have been set in motion aimed at eradicating terrorism.

The combatants also remind of the Boer War (1899-1902). As the small Afrikaans nation took on the mighty British Empire, its people increasingly fell into two camps, bitterly divided over the right course of action.

There were bittereinders, who wished to fight on to the bitter end, no matter the cost. And there were handsuppers (hensoppers), who preferred to surrender and disengage or even collaborate with the enemy (joiners).

In the case of the Boer War, there wasn’t the luxury of deciding that perhaps the wrong war was being fought, and that the British should try to discover Transvaal-sized gold deposits in Antarctica (or whatever).

But before we make that jump by shifting the focus, perhaps first the usefulness of the Boer War analogy as it applied to increasingly divided camps.

At present South Africa has been an early leader to raise interest rates in response to steeply rising inflation outside the SARB target range, primarily caused by shock developments externally (oil, food, Rand).

But as external first-round shocks deepen further, now also reinforced by local first-round shocks (Eskom), these relative price changes boosting reported inflation are starting to lead to second-round price shocks (wage demands and business cost pass-throughs) as changing inflation psychology starts to affect longer term expectations.

The SARB’s classic response of raising interest rates isn’t as yet succeeding in arresting these second-round developments, but it is progressively succeeding in imposing growth sacrifice (slowing the economy down even to the point of entering recession).

The ‘bittereinders’ of the moment are fully committed in terms of monetary policy credibility to keep pushing interest rates higher until such second-round effects are defeated.

They are not dissimilar to Candide’s Pangloss whose every action is always undertaken for the best, no matter how horrific some of the consequences.

It reminds of olden times, when medical techniques were still pitiful. Doctors then, too, often thought nothing of killing the patient in the process of administering the ‘right’ treatments. Sounds familiar?

Unfortunately, given the nature of the inflation shocks and the structure of the economy receiving these shocks, there may well be little initial success in containing inflation by steadily raising interest rate. Not even the second-round effects may be successfully contained.

Instead, we are merely liquidating growth, private fixed investment momentum, formal employment and too many middle class elements, especially newly created ones, by these actions.

The ‘handsuppers’ lose appetite for conflict quickly whenever its rising cost comes into focus. Nobody wants higher inflation, for the costs it imposes on society longer term. But incurring deep prolonged growth sacrifice doesn’t seem to be the sensible way to go about things either. Indeed, it may be a too costly solution, given the nature of what we face here.

Whereas the bittereinders are prepared to keep pushing interest rates higher until the deepening growth sacrifice breaks the back of the second-round inflation forces (the first-round causes by definition can’t be addressed), the handsuppers feel one needs at some point to be pragmatic.

Thus the handsuppers are prepared at some point to stop raising interest rates, acknowledge that inflation is abruptly rising back to a high level for structural reasons, and await the end of the external inflation shocks feeding this process.

Once the commodity-driven price inflation, with second-round effects following in its wake, has peaked out, the long and costly process can resume of gradually converging back to a low inflation norm through limited growth underperformance and global anchoring.

Assisting in this process will be the eventual inevitable unwinding of the commodity price shocks, with its subsidence ultimately also creating a downward pull on second-round effects.

What neither party is really saying too loudly is that perhaps their energies should be focused elsewhere. They should try to obtain social and economic reforms, whose outcome will reduce cost-enhancing inflation shocks, globally as much as locally.

In nearly every instance, this would shift attention back to other sectors of the economy where policy mistakes have been made and continue to be made, feeding the long-term inflation process.

Monetary policy was never designed to fight such insidious structural forces with any hope, other than of incurring massive growth sacrifice. Instead, one should address the underlying, structural, institutional causes of the higher inflation.

There are unfortunately many areas of government failure whose cumulative effect is at the core of the global inflation storm and its local offshoot.

A few examples suffice to illustrate the analysis.

Globally, the tight oil demand/supply balance within a wider energy context has been exacerbated by many policy actions in many countries, such as European and American constraints on new nuclear facilities, environmental restrictions on building new US oil refineries for three decades, low US fuel taxes, unwillingness of Saudi Arabia and other OPEC members to invest in new oil supply (in part reflective of resource nationalism), and the willingness of many Asian countries to subsidise their domestic oil consumption and keep their currencies artificially undervalued.

But it goes much wider than this. When the Dutch Minister of Finance in desperation turns to the unions to do a deal, limiting second-round wage demands, other market rigidities come into focus.

Education, training, immigration, and labour regulations all have elements that contribute to market inefficiency, regarding trade competitiveness and the ability to absorb external price shocks efficiently.

Also, there is global agriculture, food subsidies, land use and regulations, including the unwillingness to accept genetically modified foods and the misplaced enthusiasm for supporting biofuels, including especially US subsidies for the farm lobby, all of which interferes with efficient food production for human consumption.

It is ultimately a very long list of policy failures in many countries that comes into focus, explaining the current global rise in inflation and its perpetuation.

Given the nature and very size of the inflation shocks, this is now even in the process of upsetting monetary policy as a major macro-economic tool, requiring actions from central banks that aren’t suitable at all.

Don’t think that a finely tuned monetary policy can compensate for deep global and domestic institutional and policy flaws, except by ultimately imposing monstrous growth sacrifice.

Isn’t it better to become an interim monetary handsuppper and shift attention and energies to addressing these other policy shortcomings?

This applies as much collectively as individually, and ultimately mobilizes the political process. In the 1970s and 1980s, Den Uyl fell from power in Holland, Callaghan made way for Thatcher in England and Carter made way for Reagan in the US.

The US Congress today should be raising fuel levies and ease environmental and ‘other’ restrictions on new energy supply discoveries, new oil refinery and nuclear power investments.

Instead, we also have Fed chairman Bernanke becoming drawn into fighting fire with fire even as the US economy is hardly in any condition to withstand any policy heat.

At home, the 9% current account deficit creates Rand risk. Too much emigration and too little immigration of skilled labour worsens shortages, adding to salary premiums. Too little training and poor education efforts undersupply the labour market. All this, together with existing labour market regulations, strengthen second-round inflation effects. Just so the political willingness to accommodate public sector unions and the indiscipline with which public sector administrated prices generally are imposed. Also trade protection insulating domestic producers unduly.

This must sound awfully difficult and complicated, especially to politicians seeking easy answers rather than undoing their own mistakes or tackling powerful political interests which won’t easily give way.

Rather bludgeon the economy into recession via indebted households and businesses, in this way getting producers to capitulate and adjust their pricing behaviour?

This suggests the overall policy focus may be all wrong. We are now in the process of superimposing a big new mistake on top of a whole series of big old mistakes.

That’s not even half right. We surely can do better, preventing undue growth sacrifice in response to present challenges, but also meaningfully starting to address a whole legacy of old mistakes we thought we had the luxury of quietly accepting as fait accompli.

What is required is a thorough, fundamental overhaul of government policy and its rules and regulations as it affects the economy in cost-inflation enhancing ways.

Perhaps this sounds ambitious but since when does that make incurring an even more horrendous mistake more acceptable? Those that are financially being duped and are losing their livelihoods or can’t obtain employment because of the deepening growth sacrifice have reason to complain.

Besides other countries and other governments over whom we have no control, we should at least ensure that we have our own house in order. Going by the Rand, Eskom, other administrated prices and second-round effects throughout the economy, especially the labour market, that is hardly the case.

In comparison, especially rich countries such as the US and the UK feel their labour, goods and service markets remain highly efficient, absorbing such relative price changes without creating (much) extra wage demands and core inflation pass-through.

Even so, the Dutch example, and German instances are indicative that wage demands on the European Continent are rising. Not all these industrial country markets are immune to changing inflation psychology, probably one reason why the ECB is so vigilant.

South Africans aren’t the only ones facing the demons of past policy mistakes and consequent market rigidities coming to haunt them via higher inflation and possibly draconian monetary policy responses.

But there should at least be debate about these issues rather than blind acceptance of specific offerings as being all for the best.

Reference:

Professor PDF Strydom, various private communications.

Cees Bruggemans is Chief Economist of First National Bank. Register for his free e-mail articles on www.fnb.co.za/economics

FERRIER INTERNATIONAL keeping you informed. Register with us today.

ferrier-international-web-logo-green.jpg