Inflation Targeting Retards Economic Growth

by Sep 30, 2010All Articles

By Dick Forslund and Mazibuko Jara

20 September 2010

At any rise in aggregate demand, the Bank increases interest rates.

Last week, the Reserve Bank waded into the battles between workers and employers over wage demands. Its monetary policy statement expressed concern about what it saw as high recent wage settlements that ignore the inflation-targeting goals of policy.

It also suggested that higher wages for workers negatively affect the number of available jobs for the unemployed. These arguments sound reasonable as they are standard. The government has used them in response to the wage demands from public sector workers. However, these arguments are flawed and without an empirical basis. If the objectives of economic policy are to reduce poverty, create decent employment, and reduce economic inequality, then questions must be asked about the role of monetary policy in achieving these objectives and whether the policy stances of the Bank contribute to meeting the challenges.

The Bank’s objection to higher wages is not only an argument for keeping inequality as it is, but for actually deepening inequality. In most sectors, we have seen rises in productivity in most of the past 16 years.

If workers do not demand “wage increases well in excess of inflation”, employers will get a larger and larger share of the value produced. This is precisely what has happened for the past 15 years. As last month’s GDP Statistical Release by Statistics SA shows, in 2000, the wage share of new value added was 52,8%. Last year, it had dropped to 49,9%. Due to this falling wage share of value added, employers enjoyed R410bn in additional profits than would have been the case had the trade unions been able to keep the wage share of new value added at the level it was 10 years ago. In this situation, it is completely legitimate for workers to fight for “wage increases in excess of inflation”. The Stats SA figures still include salaries for senior managers when accounting for how new produced value in the economy is shared between labour and capital. If these were excluded, the evidence is further weighed against the stance of the Reserve Bank.

It is interesting to note that in North America and Western Europe, the income share going to workers has varied between 65% and 68%, and the unemployment rate between 3% and 11%, since 1960. In other words, wage increases at or below inflation worsen income distribution as workers take a lesser share of national income and employers take a higher share. Given the capital intensity of the economy, the fall in the income share of workers boosts the rate of profit. This relationship is a challenge to the policy objectives outlined above.

As levels of investment as a ratio of GDP are still too low, clearly these additional profits are not invested in job creation as the monetary policy statement would have us believe. Instead, a significant portion of these profits is leaving SA. As heterodox economists and researchers from the University of the Witwatersrand report in the coming issue of Amandla!, legal and illegal capital flight in 2007 alone can be estimated at a staggering R450bn. The government has no intention of stopping this.

All this takes us back to the problematic assumptions of monetary policy. In the long run, the effects of monetary policy are expected by mainstream economic theory and practice to show only in the inflation rate. The current understanding among inflation- targeting central banks is that Reserve Bank actions do not have long-run effects. In this view, monetary policy actions are seen to affect unemployment and growth rates temporarily. As Prof Chris Malikane has argued in papers to the Congress of South African Trade Unions, this view uses empirical studies to show that if there is an effect of monetary policy on the unemployment and growth rates, the mechanism does not support expansionary monetary policy. The empirical evidence is used to show that in the long run, restrictive monetary policy generates higher economic growth even if it may temporarily depress growth rates. All this implies that a low inflation environment is conducive to faster economic growth.

By contrast, Malikane suggests that monetary policy has long-run effects on unemployment and growth rates. In his view, sustained demand expansions are indeed inflationary, but the basis of investment in long- term productive assets is the existence of sustained higher demand. In addition, if these demand levels are stable, this guarantees stable cash flow to businesses, and hence stable growth rates of investment. In the long run, demand-induced capacity expansion leads to a fall in the inflation rate, since capacity expansion would ultimately outstrip demand expansion. Therefore, in agreement with Malikane, this is to argue that the role of monetary policy must be to ensure there is sufficient demand to maintain a non-accelerating inflation rate of capacity utilisation.

It does not make sense to have an inflation target in the form of either a band or a specific number. As Malikane argues, a much more logical contributor to sustained fixed capital investment and job creation than an inflation target is sustained and stable aggregate demand. Large fluctuations in aggregate demand destabilise aggregate incomes (wages, profits and tax revenue) and discourage long-term investment. Therefore, the stability of aggregate demand should be one of the key macro strategies. A living wage would create higher demand for basic goods and services. If public sector workers indeed win the 8,6% wage increase and the R1000 housing allowance, then public sector workers would earn what they did in 2007 because of erosion through inflation. This will not do much to boost aggregate demand as a higher settlement would.

The monetary policy implication of the alternative view is that inflation targeting is simply the wrong tool to drive employment growth. Inflation targeting in fact works against expansionary measures such as the public infrastructure investment programme. This programme can stimulate aggregate demand. The obsession of the Reserve Bank with reaching its inflation target means that at any sign of a rise in aggregate demand the Bank is likely to increase interest rates in order to contain inflationary pressures. Higher interest rates increase the cost of credit and discourage investment by companies. Inflation targeting and high real interest rates constrain fiscal policy and keep it conservative. It is time to debunk the myths the Reserve Bank believes in. It is time for a coherent and technically sound overarching mix between fiscal, monetary, industrial and social policy.

Forslund is an economist and researcher at the Alternative Information and Development Centre. Jara is editor-at-large of Amandla!.


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