Yesterday, I talked about the Rand, and why the depreciation of the Rand is more of a global story than a domestic political blunder (see here).
Today, I want to talk about the other side of the saga: the deep-seated fear that somehow, South Africa is going to follow in Zimbabwe’s footsteps and hyperinflate.
Here’s an analogy:
- Hyperinflations are like severe hurricanes.
- Hurricanes have thunder and lightening and rain.
- So do plain old rainstorms.
- Saying that South Africa is going to hyperinflate is like calling “hurricane” each time we get a bit of rain.
But hyperinflation is so much more than a bit of inflation.
PS: for this next bit, I’m going to lift some sections out of some older posts.
The Difference Between Inflation and Hyperinflation
Inflation is just a rise in prices. But Hyperinflation happens when people lose faith in their money as a medium of exchange – and that loss of faith is expressed by extraordinarily high rates of inflation.
The question then: how does a people lose faith in their currency?
The Common Early Warning Signs
- A weak government, without the ability to make and enforce changes in policy. Either that, or a deeply ideological populist government with no intention of putting in the necessary policies.
- Limited ability of the government to raise money through debt issues (either due to poor credit ratings or lack of lenders’ capital or both).
- A tax system that is intractable, corrupt, or poorly policed.
- Large fiscal deficits (ie. the government spends more than it brings in)
What these factors essentially mean is that the government’s finances are stretched. Not that they are bankrupt or insolvent – just that they walk a financial tight line. In the same way that your Macdonald’s burger flipper has a budget plan down to the last cent, with a maxed-out credit card and a double mortgage on his mother’s apartment. No room for luxuries there.
This leaves the economy vulnerable to “fiscal shocks”.
The Steps Toward Hyperinflation
- A “fiscal shock” takes place. This is unplanned and unbudgeted-for expenditure. So, for example, an unplanned war. Or unexpected subsidies to compensate for a dramatic decline in production (for example: a widespread drought in a country that is very dependent on agriculture).
- This expenditure needs to be financed. But if the government is unable to borrow money to finance the expenditure, and if it can’t raise the money from taxes, then the government has to look elsewhere for the funds.
- The authorities then approach the Reserve Bank, and request that they, as the monetary authorities, lend them the money. They are, after all, the lender of last resort.
- The government authorities get their money, in the form of freshly-typed balances in their bank accounts (most people assume that money creation is a notes and coins thing – it isn’t: today, most money creation is electronic).
- The money enters the economy, and you have the standard story of more cash chasing the same amount of goods, demand and supply forces play out, and you have a rise in the general level of prices.
At this point, everything still seems manageable. It’s just one fiscal shock. The solution was only temporary. And if anything, the sudden flush of liquidity has caused some expansion, a nice ripple effect, and everyone feels a little prosperous.
But there are some issues still at play that may not have played out yet:
- Generally, taxes are based on the returns earned in the past year. If inflation has played its role, by the time tax season arrives, the taxes collected have had their real value eroded. So the economy at large has experienced a lessening in its tax burden – which turns out to be even more stimulative. But for the government, its tax revenues have worsened – so its fiscal deficit is growing (after all, its expenses are keeping line with inflation – where its tax revenues are falling behind).
- And at the same time, fiscal shocks financed by money creation are not generally looked upon with favour by lenders. It’s unlikely that there will be any more freedom with the debt.
So the conclusion of the fiscal shock episode is that the government is worse off than before. And they’re now even more vulnerable to fiscal shocks. And unfortunately, fiscal shocks are not always once-off anomalies – wars, for example, can’t be paid for as an upfront package. And droughts can be long-term – just look at California.
So let’s assume that another fiscal shock occurs shortly afterward. Only, the government finances have not changed, because the government is unable or unwilling to enact pre-emptive economic safeguards to change it. So the process repeats itself.
When Fiscal Shocks Happen Too Close Together
- The inflation rate begins to climb more than expected.
- The government’s finances are further strained with the rise of inflation: tax revenues are falling in real terms, and debt costs now have a premium for expected inflation, making borrowing more expensive.
- More frequently, the government starts taking trips to the Reserve Bank.
- People begin to suspect that the government is adopting money creation as a fiscal policy, and so they begin moving their cash out of their bank accounts and into real assets.
- That move from cash balances to real assets? That’d be the “loss of faith” pivot point.
- At the same time, traders start to increase their selling prices in an attempt to pre-empt the inflationary erosion on the cash received.
- So inflation rises even further.
- And worse: as the effect snow-balls, investors begin to take out bets against the currency (for example, by leveraging their positions in the inflating currency). This creates a growing vested interest in the inflation.
- At that point, the cycle starts to repeat itself, and the economy spirals into hyperinflation.
The Key Points
- Hyperinflation is more than just money creation. There are a whole array of bad situations that need to coincide before a government has no other option but money creation to finance itself.
- Hyperinflation becomes an inevitable outcome once the general population starts trying to reduce cash balances.
- But in order for any of this to happen, you need to have a Central Bank that is willing to lend money to the government.
Why This Is So Unlikely For South Africa
Three main reasons:
- The South African Reserve Bank is very independent. Despite many populist calls for it to make decisions around employment and stimulus (from COSATU and co), the SARB has stuck to its inflation-targeting guns.
- The South African Revenue Service (SARS) is very good at its job. It’s streamlined, powerful and efficient (as much as a government agency can be). And South Africans pay tax.
- Points 1 and 2 mean that the Rand is a much-traded currency, which makes South African debt an acceptable investment to global investors.
- If the South African government runs out of money, the SARB is unlikely to just hand them new notes.
- SARS can implement new tax collection policies as and when it needs to. So the South African government is unlikely to run out of money.
- And in any case, South Africa has the ability to borrow money on global markets (as a result of the strength of its financial institutions, and its position in the emerging market spectrum).
If those things change, then yes – we can worry about the possibility of hyperinflation. But they haven’t changed yet.
And even countries without those institutions somehow manage to avoid hyperinflation.
So worry not.