SANE Views

Vol.7 No.17, 25 June 2007

INFLATIONARY PRESSURE FROM THE TOP

Margaret Legum

The dangers of inflation have been cited by government and financial experts as reason for government to limit their response to strikers’ wage demands. You may not be the only person confused about what causes inflation and how it is contained. Actually the essence is simple.

When there is more money about than goods and services to spend it on, prices go up: that’s inflation. But it needs unpacking: if the diagnosis is wrong, the remedies will be wrong.

Reserve Bank Governor Tito Mboweni blames consumers for creating inflation by borrowing too much, and workers for demanding ‘high wages’. If they carry on that way, he says, it will ‘result in rising interest rates’.

Two questions arise. First, how does an increase in money supply happen - who creates it? Second, who gets to spend it, with what effect on prices?

The answer to the first question is that banks make new money. When they give loans they are not lending out savers’ money, but creating new money. They respond to requests for loans on commercial criteria. Will they get the money, or the collateral, back with interest or not? If not, the loan is refused; if so, it is granted. They are not interested in the effect on inflation. That is not their job: their job is to maximise shareholders’ profits.

It is the job of the Governor of the Reserve Bank to keep inflation down. He could do so directly: he could decide how much money commercial banks can create in the form of loans. He has the power to limit what banks can lend as a proportion of their liquid reserves. He can simply raise that ratio, and it would be illegal for banks to go over it. He could stop over-borrowing at a stroke.

Instead he keeps the banks and other lenders happy by simply raising the rate of interest – on the theory that a higher rate will discourage people from seeking loans. That is a blunt instrument – a scattergun that affects existing borrowers as much as new ones, and has no effect on borrowers for whom the rate of interest is irrelevant. Among those are that 18% of people who, according to a recent survey, borrow simply to buy food. A higher but undefined proportion of debt goes on other survival needs.

By using that ineffective process the Governor also contributes to another cause of inflation – the effect on prices of the cost of production – because the cost of borrowing goes into practically everything. He also adds to inflation in property. House prices rise because banks compete for customers by making more money available over longer periods.

Who benefits by this financial system – who gets to spend the new money? It is, of course lenders and the financial sector that manages their money. The scale is almost unimaginable. How do Blackstone Group’s Schwarzman and Petersen spend the $2.6 billion they scooped for themselves personally when the company listed? Cast your eye down any list of the fabulously rich, the buyers of astonishing new levels of luxury, and you will source their income from lending their own or others’ money.

It is not only about fairness – the coexistence of such gross incomes with grinding physical deprivation. It is about the creation and multiplication of new money without an equivalent creation of new production – hence about inflation.

The current global wave of private equity deals is essentially about using existing assets to borrow money on. It is people who have money – or can borrow it - buying companies, and then using them to access more loans. It is called ‘leveraging’. The new owners sell off some of the assets, and take out new loans on the rest. Those new loans are new money. They are not matched by new goods, so they simply put more money into circulation in an inflationary manner.

Global mergers and acquisitions are a slightly less brazen version of the same process. In the first three months of this year over $3 trillion was used by investment bankers in global deals buying, selling and merging companies. All of them involve borrowing from banks – for whom such deals, and the resulting interest payments – are a huge source of profit. They do not result in new production, and usually reduce employment.

No one denies investment bankers have expertise in assessing profitability and facilitating financial arrangements. But their role in creating new wealth on the ground is relatively small. Last year only about 5% of private equity investment was in new ventures.

The millions daily created and spent in that virtual economy around the financial sector is not considered a source of inflation. Why? Its beneficiaries stint themselves nothing in the spending of it; incidentally also straining the balance of payments by buying imports. But a 10% increase in the salary of a nurse is deemed inflationary, though s/he will certainly contribute to the expansion of production, because s/he will buy locally.

That is very clear. But government and Mboweni avoid addressing the real problem, which is bank loans for purposes that do not increase equivalent production. That is because the global beneficiaries of the current system are strong enough to resist policies that, having correctly diagnosed, address the real issues.