The guts of SA monetary policy (Part 2)

In part 1 we broke down how the SARB actually conducts monetary policy and showed that new credit is funded not predominantly by new savings but by new money creation.  This type of policy will fail to achieve its stated aims.

There are a few problems with the the policy in general.  The first is that new credit growth does not depend directly on the supply of loanable capital from saved funds in the private sector, but rather from newly created money from the SARB. This means that borrowing, for consumption and investment, can far exceed real private savings. The problem here is that the adequate price of capital is only efficiently determined by the supply of real savings and the demand for borrowed capital. If an interest rate happened to be too low, the supply of saved capital would diminish and the demand for borrowed capital would jump, and the mismatch would see the interest rate rise until the quantity of savings matched the quantity of demand for capital. By the SARB allowing this demand-supply gap to artificially continue by creating new money to fund new credit growth, the private sector will over-borrow and over-invest, often far beyond the economy’s normal capacity to support these activities.

This creates bubble conditions in which the only eventual result must be a spike in asset and goods inflation, sharply rising debt defaults, and eventually an implosion in returns on investment. All of these symptoms have been evident in each stage of the current recession in South Africa.

Another problem is that when policy makers lower the repo rate to fix the problems created by a low repo rate, they prolong the recovery from happening quickly and can perpetuate unsustainable business ventures and investments by perpetuating a gap between the supply of real savings and the demand for loanable funds. In a recession, capital is trying to allocate to its most productive use while at the same time there is a rational demand for liquidity. Both these dynamics should drive interest rates higher, but by forcing interest rates down, the central bank actually makes it more difficult for capital to reallocate because the hurdle rate for returns is lower, and many more companies and individuals can afford funds at these lower rates.

This means that the companies and individuals that need capital the most, and could show the best returns on that capital, do not necessarily get that capital ahead of someone who doesn’t need it as much and whose return on that capital is mediocre.

Because banks are coerced to price the prime lending rate at a fixed margin above repo, so the risk pricing mechanism can also be distorted. Banks obviously do still engage in perfectly legitimate discriminatory pricing of debt risk to different customers, but this is nevertheless greatly constrained by the rate setting policies of the central bank. Ultimately the new money pumped into the system, if it is pumped in faster than the growth in real activity, will become inflationary and undermine savings further as well as wiping away what participants in the economy thought were real gains in wealth.

This burden falls disproportionately on the poor.

Not only do the poor get hurt by monetary inflation because they hold few fixed assets and spend a disproportionate percentage of their income on basic commodities which tend to be subject to steep inflationary increases, but also because they are the least likely to qualify for new loans created from new money. The further away they are from the creation of new credit and money, the longer that new money takes to filter through the economy to them, and the more likely that it has already become inflationary by the time it reaches them, often making the poor poorer in real income terms.

One wonders if the policy makers have considered these possibilities and whether Cosatu and the SACP know they are really acting in the worst interests of their members by arguing for more rate cuts.