SANE Views

Vol.5 No.5, 03 April 2005

Do Interest Rates Really Control Inflation?

By Margaret Legum

Has anyone else noticed that whether the rand is going up or down reasons are found not to reduce the rate of interest? A potentially inflationary effect can be found both from a weakening and from a strengthening rand. Who is going to question the arcane reasoning: all we know is that preventing inflation is top priority and that means high interest rates and lack of expansion.

Inflation is, very simply, too much money chasing too few goods and services. If there is more money than things to buy their prices go up, if less money than goods it goes down. The theory is that if you raise interest rates people will borrow less and there will be less money around to chase those goods.

It is an important function of government to keep the money supply in line with what can be bought. Inflation makes everyone insecure. But its opposite – too little money – is just as bad. It means we waste resources because there is no money to employ them. How silly.

Here are some interesting facts relevant to inflation and the supply of money. First, banks create 93% of new money - through giving loans; while government creates only that 7% that comprises new printed notes and coins. Banks do it for profit: hence government’s difficulty in controlling the flow.

Second, in two years world hedge fund assets rose from $400 billion to $1 trillion; they are expected to reach $5 trillion by 2008. Hedge funds are in effect pyramids of invented money based on speculative loans, having virtually no connection to goods and services. A small change in interest rates has no effect on money supply compared to the ballooning of hedge funds; and they make no equivalent goods on the ground.

Third, the number of billionaires is growing apace, having reached nearly 700 last year. The most unequal societies have most, of course: China, with only two, lags behind India with twelve. The US has the most. It also takes the prize, second only to Mexico, for the highest levels of child poverty in the developed world. UNICEF tells us that less than 5% of children in the Nordic States live in poverty; the figure in the US is nearly 22%. Billionaires lock up money, because they cannot spend it all.

Fourth, South African financial services companies have nearly R15 billion of reserves sloshing about unused. They probably include the financial sector salaries we have been reading about – R12 million a year for Sanlam’s senior staff for instance. Meanwhile, debt as a proportion of household income has risen steadily over the past few years to reach nearly 55% in the last quarter of 2004.

These last two facts are described by financial gurus as good news. Reserves are seen as poised for investment: they are in fact waiting for short-term speculative opportunities. Household debt is presented as the outcome of joyful shopping sprees based upon a calculation of current ‘low’ interest rates and expectations of stock market and property booms. Clearly these gurus have a narrow circle of acquaintance. Most people are unhappily, even desperately, in debt, because they cannot come out on their incomes, have lost jobs or encountered unexpected ill-fortune.

Considering that evidence of huge differences in access to buying power, how can the rate of interest seriously control the money supply and inflation? Do people with salary cheques in the millions contribute more or less to inflationary pressure than people with R500 a month? Do they, for example, consider small changes in the interest rate when buying something, or help to keep prices down by shopping around for groceries?

What we know is that they invest their surplus income in property and in stock market shares, which creates inflation in those sectors. It is bad for the rest of us who want to buy property to live in, and shares as a way of secure saving. It is also the reason why property loans and the bond market are not included in the CPIX (consumer inflation minus mortgages) figure: we would rather imagine that inflation is caused by spending at the lower end of incomes. That way we can blame the trade unions for inflation.

The truth is that there is a large and growing shortage of money in the middle to lower end of the economy where people are employed to make real goods and services. All of those goods are ‘over-supplied’, because people do not have the money to buy them. There would be little inflationary effect in getting money to poor people: their extra income will soak up the excess of goods and services. There is no shortage of supply in the market for consumer goods, only a shortage of demand.

At the same time there is an extremely dangerous and potentially inflationary over-supply of money at the upper end of all economies in the global market.