The Inflation Imperative

 

A factor has arisen that is starting to raise warning signals in the minds of those who understand the theory of economics, and particularly in those minds that experienced the world immediately post World War II.  It seems that the view has come to be accepted that inflation is not only necessary, but also desirable.  There can be no more deadly belief than this.

Inflation is sought by the CEO of the large corporations, whose inflated salaries are padded by the big bonuses based on the (monetary) value per share, and whose welfare, in the short term, depends on the (monetary) earnings of the companies they steer.

Inflation is loved by those who speculate on the Stock Exchange, because it permits the belief of never-ending share price increases.  It is a fundamental of the brokers on the Stock Exchange, who give learned statements on the investment value of companies, while their brokerage fees are based on the monetary value of the shares in those companies.  The recent boom on the Stock Exchanges of the world were partly the result of too much easy money chasing a short-term fixed supply of shares, caused to a large extent by the misguided boost in the supply of cheap money by the central banks, in the belief (hope?) that the funds being created would be channelled to assist cash-starved businesses to keep alive, to grow and to create more employment.  In fact, those funds were diverted to a very great extent into speculative activities on Stock Exchanges, leading to a widespread perception that stock exchange activity could be seen as a proxy for economic activity!  The cause of the boom in share prices is the very definition of inflation:  too much money chasing too few goods.  The sales of the companies being chased were increasing, the costs were being held down, and the profits mushroomed, leading the worldly-unwise mid-twenties traders to buy the shares.  After all, the share price was increasing.  Right?  It is true that the share price was increasing, but was the company’s intrinsic value increasing?  In many cases, the answer would have to be no.  Sales were galloping forward at ten or fifteen per cent per year, in money terms, but the number of loaves of bread being produced, the litres of milk sold, were stagnant.  The number of man-hours expended in production were not increasing, and may even have fallen.  The growth in sales represented nothing more than the increase in prices.  Consider this:  in 1967, a three bedroom house in a good middle class suburb of Sandton sold for R16 000.  In 2012, that same house, now nearly fifty years older, sold for R1 870 000.  A top-of the-range BMW cost R10 831 in 1974.  The top-of-the-range BMW today would cost in excess of R1 800 000.  Admittedly, it has better gadgets, fancier trim, but 16 000% more value?  A two-litre bottle of milk cost R16 two years ago, today R24.  The cost of a driver’s licence renewal rose from R150 five years ago to R224 now.  The financial world is fond of the Government official rate of inflation, which, today, is stated at about 6,5% p.a., but ask the man in the street what his experience of inflation is.  The answer is likely to come back at between 15% and 20%.  The official rate of inflation has very little to do with what the people actually experience in their daily shopping.

What does this mean for investment (not the JSE variant, which is no more than an institutionalised form of slot machine)?  Investment means the purchase of productive assets by the use of saved funds.  The saved funds may be the money presently available, or it may be the funds that will be saved in the future from earnings in order to repay the loans taken today.  Investment happens when businessmen and –women see an opportunity to earn a profit by taking a risk now in the expectation that the investment made today will generate an increase in their earnings in the future.  They will not take that risk unless they are confident that the investment will continue to generate an excess of income over costs in the future.  That will not be the expectation when they believe, usually on the basis of experience, that the costs will gallop ahead faster than the increase in value of the production of the investment.  And that happens, of course, when the cost of staying alive is increasing more rapidly than the earnings of the people doing the buying.  That is what inflation does.  In the short term, people compensate for their shortfall in earnings by maintaining their desired level of expenditure by using credit wherever possible, but the day of reckoning will come, when the credit has to be repaid, and the asset has been consumed.  Credit is an inflation-generator of note.  The banks give out a multiple of the savings flowing into them, and the difference between the two represents an increase in the supply of money.  The classical definition of ‘inflation’ is ‘too much money chasing too few goods’.  The cycle is apparently endless.  The increased sales (or the maintenance of a level of sales not warranted by the earnings of the buyers) goes into the banks, to be re-lent at a multiple of the amount notionally saved, to finance the consumption expenditure.  More money is chasing the same amount of goods.  Unfortunately, the cycle is not endless.  It comes to an end, when manufacturers recognise that the end is in sight, or when the fiscus decides to step in and soak up some of the excess profits generated, or when Janet Yelland decides to warn the ‘investing’ public that stocks are over-valued.  Whatever the reason, the cycle stops, usually abruptly and often catastrophically, and the resultant cutback in consumer spending progresses speedily to retrenchments of bottom-level employees (any management consultant will tell you how management can never believe that the true source of cost increases is the incompetence and surfeit of management staff, usually at the top.  You need only look at the expenditure of Government on salaries and wages to see this!).  That results in an avalanche of spending reductions and job losses – the Negative Multiplier Effect, in which the loss of one job leads to the resultant loss of between eight and twelve other jobs, in a repeating cycle.  It does not require many months for the loss of one hundred jobs to result in the loss of ten thousand jobs, as the unemployed stop buying shoes, going to a restaurant for a pleasant meal or skip a haircut for another month, to stretch the available funds to buy another loaf of bread for the family, instead of the mince they would have bought last year.

Inflation is also dearly beloved by the fiscus.  Ever-increasing prices mean more VAT revenue, increasing wages mean more PAYE revenue, increasing profits mean more company taxation, increasing dividends mean more Company Tax revenue, increasing nominal prices mean more Property Taxes and Estate Duty.  All of this adds fuel to the fires of the Government, who are more than delighted to spend this increased tax revenue on things that buy votes and that add to their Swiss bank accounts.  Remember how smug Pravin Gordhan was when he begged for applause at his announcement that the annual budget was now more than one trillion Rands?  Of course, the increasing revenue flow makes the economy look stronger, particularly when compared with the artificially low stated rate of inflation, and that calls in more trillions of loans, often denominated in US Dollars or Euros, paying a rate of interest double or more of that for US bonds.  When the crash comes, as it surely will, those loans will attract interest at a much higher real rate, because of the crash of the SA Rand, and the repayment will cost fifty per cent more in Rand terms.  Does this scenario start making sense to you in the light of what is happening now?  The Government, unwilling to cut back on its wasteful pork-barrel expenditure, will continue to borrow, at ever-increasing rates in the face of declining security ratings.  The end result will be that our children and grandchildren will be repaying the debt that we allowed our Government to heap up on the hope that the cycle will go on forever.

What inflation does is debase the value of our real investments in the past.  It wipes away the benefits of frugality in our early years, making all of us poorer in later years.  It disincentivises saving, because we all know that R100 put away today will have the spending power of R1 when we reach retirement.  That knowledge says to us ‘Spend today on a high life, because there is no hope that you will be able to afford the little luxuries you forego today when you reach retirement.’  A current Liberty Life ad tells us of how the father of the founder had to live on a pension of R28 per month in 1965.  What it does not say is that the Legal Advisor of a major corporation started work in that year, with two university degrees, at a salary of R130 per month.  If that person were to start the same job today at a salary of R50 000 per month, the pension of Mr Gordon senior, on the same scale, would be R10 769 per month.  Not an exciting pension, but it demonstrates clearly the effect of inflation!  In order to earn that pension, at an assumed rate of earnings (by no means guaranteed!) of 8% p.a., his pension investment fund would have to stand at a current value of R1 615 000, or 103 500% of our young graduate’s annual salary in that year.  And don’t forget, two degrees is somewhat more than the start capital of most 22-year olds!

What inflation does is force us to pay more for the same value, more for our milk, more for our houses.  If you doubt the real meaning of that, look at the price of a Cadbury chocolate bar.  A year ago, a 200 gram slab cost R15, now a slab costs R22, and the mass is only 150 grams.  The cost has increased by 46% for a slab, and the value has decreased by 25% - our inflation rate of ‘6,5%’ has generated an increase of nearly 100% in the cost per unit of value in only one year!

Industrialists recognise the cycle of slowdown, far in advance of the Stock Exchange pundits and the Reserve Bank experts, none of whom seem to understand basic economics.  They understand that things are not likely to continue in the same blind, bling way.  They hold back on buying new productive equipment, believing that it is likely to stand at least semi-idle in the near future, while the cost of the capital invested continues to drain their resources, the reserves that they will need to survive the bleak years after the economic collapse.  They prefer to maximise profits now and hold onto the cash.  That, of course, aggravates the situation, but it is the prudent thing to do.  When the time comes, the cash will be available to acquire assets or even whole companies at knockdown values, while the less prudent, or less-experienced, will be banging on the doors of the banks for the funds they desperately need to keep in business.  The banks, in turn, will be banging on the doors of Government, demanding bail-out money, threatening the collapse of the economy, a situation that they were instrumental in creating, if public funds, in the form of investment are not made available (remember African Bank?) or lower interest rates or quantitative easing (read the inflationary creation of unbacked, fiat money), or preferably all three.  All of that, of course, will come from the wallet of the taxpayer, from you and me.

And the person at the end of the chain is the blue-eyed, rosy spectacle-wearing man in the street, who allowed it all to happen.