Eskomflation and FIFAflation are a myth

falling-pricesWe’ve been banging this drum a lot in the past couple of weeks but it really does need to be re-bung (banged? bonged?).  So strong is the belief that Eskom tariff hikes and the FIFA World Cup will raise prices that we need to address the fallacy here, and we’ll keep doing so as 2010 plays out.

This is really a bit of Econ 101.  The first point to make is that the misunderstanding originates from a misconception of ‘inflation’ itself.  Inflation is not rising prices.  Rising prices are the result of inflation, which is the expansion of the money supply.

So, the first piece of this puzzle is the money supply.

In a stable-to-contracting money supply environment, which South Africa is experiencing right now, price hikes in one area of the economy cannot impact the general price level.

Secondly, we have a misconception about inflation arising from the demand for available money vs the amount goods and services available for consumption.  If, holding money supply constant, the demand for money rises, the price level of all goods and services denominated in money must fall.  If, on the other hand, the demand for money falls, causing people to hold more goods instead of money, the price level of all goods and services denominated in money must rise.

Now we have in place a basic but sound conceptual understanding of our two main puzzle pieces for prices - supply of money and demand for money/currency. 

On top of this you need to add the supply or stock of goods and services.  Remember, demand for goods and services always originates from the supply of goods and services, after all, we cannot demand anything unless we have first created something somebody else wants and can buy, in turn, with something they’ve supplied to the market.

Basically, at the margin, a relative scarcity of money in relation to goods and services will see the price of money expressed in terms of goods and services rise, or, in other words, the prices of goods and services as we commonly express them in terms of money, fall.  Conversely, at the margin, a relative scarcity of goods in relation to money will see the price of money expressed in terms of goods and services fall, or prices of goods and services expressed in money rise.  The former is commonly called price deflation, the latter price inflation.

There is no other systemic cause of rising or falling prices across the economy expressed in the monetary unit but the relative scarcity of money and goods in relation to one another, based on supply and demand of money and quantity of goods available to consume.

So, with this in mind, let’s gets back to 2010 and the Eskom and World Cup, and see why if anything they will cause falling, not rising, prices.

When Eskom prices increase it will suck household and business funds away from normal goods and services toward electricity.  With little or no credit growth, households will have no choice but to play this substitution game.  The pool of money available for non-electricity spending will shrink, causing prices in most of the rest of the economy to fall not rise.  On balance the overall price impact, holding other factors constant, should on average be unchanged, unless of course SA actually keeps experiencing falling money supply in 2010 in which case the pressure for deflation will start to make itself felt.  Only if credit and money supply ramp up again in 2010 will Eskom’s tariff hikes lead to a general increase in prices, but then that would be a monetary issue, not an electricity tariff issue.

As for the FIFA 2010 World Cup, 500,000 foreigners are expected to visit these shores for month from mid-June to mid-July.  They will be wanting rands in their wallets as by and large their dollars, Euros and pounds will be of little use to most local vendors.  Unless the government grows the monetary base at the same rate as the growth in new money demand arising from foreigners, there will necessarily arise a relative scarcity of currency in 2010.  This would be compounded if foreign investors keep buying up SA assets in 2010 at even a fraction of the fast pace they have been accumulating in 2009.  The relative scarcity of currency near to, during, and just after the World Cup will act to force goods and services prices down not up.

Yes, retail and tourist vendors will probably be able to charge higher prices to tourists, but this will be temporary, isolated, and reverse quickly after the World Cup.  In any case, general prices in the economy not related to tourist consumption spending will be unable to rise and will probably start to fall, leaving the overall impact on the general price level unchanged or probably lower.  Also, to the extent that producers make more goods and services available for the World Cup and SA productive growth increases during a relative scarcity of currency, this will create even more pressure for the general price level of goods and services expressed in money to fall not rise.

Government policy a wild card

Like the changing of the seasons, the coming in and going out of the tides, and the rising and setting of the sun, we can be sure that Keynes-infested governments do not like falling prices.  Strange as it may seem, since people like falling prices and governments generally like to please people, the state and its economist minions tend to think falling prices will condemn the economy to complete and utter ruin.

So as we head for a very soft inflation environment in 2010, and possibly widespread falling prices, will the SA policy makers start to crank up the printing press?  Little in our history leaves one optimistic that they will not start conjuring up freshly printed notes out of thin air to keep price increases within the 3-6% wealth destruction target.

If they do it will probably take the form of buying up foreign exchange on the open market faster than we’ve ever seen and lowering interest rates much further in the 1st half of the year.  This won’t help straight away, but if the govt does manage to engineer another rapid growth in money supply and credit in 2010…

…then watch out for the inflation firestorm in 2011/12.

3 Responses to “Eskomflation and FIFAflation are a myth”

  1. Shregger says:

    What about cost push inflation impact of the Eskom price Hike? With a 25% price hike in electricity surely the producers of goods (almost all of whom use electricity in production) will pass these higher electricity costs on to the consumer who will experience inflation even if they are buying less goods? Surely Money Supply dictates the overall spending in an economy (i.e. price x goods & services consumed) whereas inflation (as measured by CPI) measures the price side so if money supply is constant the price will rise but no. of good and services consumed decreased?

  2. freeman says:

    Short answer to all your questions is, No. Now for the long answer: The general price level of goods in the economy expressed in Rands (or dollars, pound etc) is determined by the amount of goods and services produced and the demand and supply of money. Goods and services production changes slowly but money demand and supply can change quickly and significantly so it is the key determinant for the general price level. Higher demand for money and stable money supply means the general price level cannot rise. In fact, in a stable money supply world where goods and services production is rising over time you would see a contstantly falling CPI. Your confusion here is with monetary and real value. Imagine there was no money in the system and we had a barter economy. Now imagine Eskom said that 1 KwH of power would cost 4 televisions instead of 2. We would have to devote more of our stock of televisions to paying for power. But because televisions are bartered for all other goods, in reality power costs twice as much of any good you plan to exchange for your power needs. Basically this means more resources are now used up in order to use electricity. This does represent a cost to producers, but how will they pass this cost on to consumers if the entire economy is devoting more resources to pay for electricity. Consumers cannot suddenly conjur up resources out of thin air. Producers will have to accept lower profit margins. This means marginal producers will go out of business. Therefore, Eskom tariff hikes will not impact CPI but will hurt wealth creation in other sectors of the economy.

  3. Shregger says:

    Thanks for your response Freeman. I think I understand the theory of what you are saying but do you have any practical examples of where this has happened in South Africa? ( I guess it would be fairly hard to track this in reality). With fixed resources I would think that the consumer would pay the higher prices on items such as food (inelastic demand) and cut back on luxuries so while an all inclusive price index might remain unchanged the average South African would still experience inflation in their basket of goods?