Eustace Davie gets it

If you listen to the average talking head out there that appears on financial TV, the rand is supposedly strong right now.  However, as any person with half a brain knows, when you travel overseas the rand buys you a withering fraction of what it once did.  Ivo Vegter Tweeted this week during his US trip that he could buy a 50 litre keg of his local Knysna beer for the price of 5 pints of ale in Texas.

Now, adjusting for possible exaggeration, the bulk discount you’d get on the Knysna keg, and the premium you might pay for the fancy US beer brand at a fine establishment, that’s still a measly purchasing power of our beloved rond.

Try putting together a 2 week European holiday without sinking your financial ship and you’ve done well.  Walk into a Starbucks in London and try ordering a tall skinny cafe latte with extra foam without spluttering in astonishment when you convert the Sterling price into rands.

South African’s know the purchasing power of the rand is terrible overseas and it stands to reason too.  Since 1990 the central bank has happily presided over a 90% depreciation of the rand vs goods and services.  Why should we be surprised that we’re dirt poor in London when we’ve debauched the currency in absolute terms.

And yet day in day out on our local financial channels we have economists and currency strategists telling us that the rand is too strong because “purchasing power parity” studies say so.  But surely by any reasonably objective measure of purchasing power the rand is still quite weak?  Now don’t get me wrong, the rand has deserved a lot of its weakness in the past 25 years as South Africa’s central bankers have turned on the monetary taps, but if you’re going to argue the rand is fundamentally overvalued currently, surely PPP analysis is not the best way to show it?

Purchasing power parity analysis is subjective to start with, for it picks an arbitrary point in the past, looks at exchange rates and price indices then and now, and spits out a relative over or under-valuation of your currency.  Listen to three different analysts and you’ll get three different estimates of over or under-valuation of the rand based on PPP.  Some believe the rand is 30% overvalued at R7.30/$, while some believe its still 30% undervalued.

With all this confusion among our supposed top economists and analysts it is no wonder so few ever really seem to understand why the rand does what it does.

Thankfully there are still some islands of sanity in this world, and Eustace Davie of the Free Market Foundation is one of them.  Last week Davie put out a piece on rand strength that everyone should read called, The “Mystery” of the Rocketing Rand.

Davie is not a particularly well known economist among the wider public, but he should be, and his analysis of the current dynamics is spot on.

A few months ago we gave readers a sound framework for analysing the currency, based on quality and quantity.  It is odd that money supply growth, so clearly the systemic factor in determining currency value, is ignored by mainstream economists.

Davie makes no such mistake, striking at the heart of the matter when he says,

“The base money supply (quantity of notes and coins in circulation) in SA does not provide a total answer to the question of exchange rate fluctuations and the depreciation or appreciation of the currency but it is an important fundamental factor. Exchange rates are the result of many complex long-run and short-run factors, including the rate at which central banks print money. Current dollar weakness and rand strength is, without doubt, largely attributable to the fact that the US Federal Reserve is printing excessive quantities of dollars while the SA Reserve Bank is not doing the same with the rand.”

Davie then briefly takes us through the recent growth stats in the various monetary aggregates in South Africa and correctly points out that y/y growth in both narrow and broad money supply is in the low single digits.

“The value of notes and coins in circulation at the end of February 2009 was R68.3bn and at end February 2010 R72.3bn, an increase of R4.0bn (5.86%), which was slightly less than the increase in M0. This is a highly creditable performance and a great improvement on June 2007 when M0 increased y-on-y at 22.65%, a rate of increase responsible for the rapid increase in prices we subsequently experienced. The strengthening of the rand is no mystery; it is largely due to sound monetary management just as, in 2001, the plummeting rand was due to unwise management.”

Remember 2001 and 2002?  The rand got obliterated and as usual economists and politicians were left chasing their tales and twisting themselves into pretzels trying to explain the sharp and intense weakness in the exchange rate.  There were even government-led inquiries and interrogation of some analysts and traders who were suspected of being responsible for ”manipulating and taking down the rand”.  Of course, as usual, all this was a ruse to distract attention from the real culprit for the weak and volatile rand which was excessive money and credit creation by the commercial banks, fully aided and abetted by the central bank’s printing press.

Not all were fooled back then.  Eustace Davie sensibly saw in 2001 and 2002 that excessive money creation by the central bank was the chief cause of inflation and currency weakness.  Indeed, price inflation and currency weakness are two sides of the same coin.

The core reason for the lack of clear insight on the currency such as Mr. Davie can offer us is the total lack of understanding of inflation.  Economic ‘experts’ still tell us that inflation last month was caused by this commodity price spike or that tariff increase.

They’re doubly wrong.

Firstly inflation isn’t rising prices but rather the cause of them, for true inflation is not rising prices but an inflating money supply.  Rising prices are just one very clear evidence of monetary inflation.

This misunderstanding leads to the second error which is that supply side price ’shocks’ or strong economic growth causes inflation.  Nonsense.  If anything, strong economic production should cause prices expressed in monetary units to fall.  This is exactly what happened in the US and the major industrialising nations of Europe during the 1800s.

Unfortunately this blindness on what causes price increases is the same blindness that obscures clarity on understanding the currency, for monetary inflation and the price increases it creates is really just currency debasement.

Looking back on those frenetic days back in 2001 and 2002, Davie discards all the baloney explanations and offers this crucial analysis,

“A much more credible explanation was contained in a speech given by Reserve Bank Governor Tito Mboweni on 30 November 2001, in which he said: “When the Reserve Bank opened its doors for business 80 years ago, the total value of notes and coin in South Africa was less than R30 million. It is now R31 billion. For wider monetary aggregates, roughly the same order of magnitude for growth as for notes and coin applies over the period. This thousandfold increase in the money supply could not be absorbed by the twentyfold increase in the quantity of goods and services produced over the same period, but largely fed inflation.” Mr Mboweni should rather have said that the increase in the base money supply was totally responsible for the general price increases (inflation). The consequence (general price increases) has assumed the name of the cause (money supply inflation) and it is no wonder that few people now understand why prices keep increasing.”

And therefore it is no wonder why so few understand the current appreciation of the rand or why general price increases as measured by the CPI will get smaller and smaller as 2010 progresses.

The next time you hear someone talking about why the rand is strong or where its going, if they don’t mention money supply, they’re nothing more than babblers.