Has Monetary Policy Failed?*(1)

By D. W. GOEDHUYSTHE PRICES IN the shop windows seem to answer my question. With inflation so evident, how can the answer be other than yes?Yet the obvious answer is not always the correct one. It is worth looking a little more closely into the objectives and performance ofmonetary policy before pronouncing sentence.

Objectives of Monetary PolicyThe money economy, for all its efficiency, is subject to disturbances not encountered in a barter economy. Variations in the sizeand rate of circulation of the stock of money, owing to several causes, bring about variations in the demand for goods and servicesthat are not necessarily matched by current supply at current prices. Hence the need to regulate the supply of money, in order tomaintain stable prices while leaving enough elbow room for the economy to achieve rising levels of production and employment.That dual objective is hard to attain and is made all the more difficult by the need to co-ordinate measures in the monetary field withfiscal management and the demands of industrial and infra-structural development. Conflicts arise continually. A forceful attack oninflation may lead the economy into recession and unemployment. Heavy public spending on urgently needed infra-structure maycause prices to rise when productive capacity is already fully employed. The concern for stable prices may seem to conflict withthat for economic growth, which would appear to require an expansive monetary climate.Closer analysis shows that price stability in fact contributes to sound economic growth and derives its significance as an objectiveprecisely from that contribution. Stable prices facilitate accurate planning and a realistic calculation of depreciation, investmentoutlays and expected revenues. Inflation, in contrast, undermines the efficiency of the market economy. Relative price movementsserve as signals to producers and investors of the quantities of goods and services wanted by the community. Some prices andincomes adjust faster than others to inflationary pressure of demand. When prices thus rise unevenly they do not reflect genuinelychanging needs and, therefore, give the wrong signals to producers and investors. As a result, the composition of output departsfrom the optimum satisfaction of wants. There is no virtue in economic growth in the wrong direction under the impetus ofinflation. Feverish, inflationary growth has already produced, in more advanced economies than ours, the odious state of privateopulence amid public squalor.

1972 SAJE v40(1) p78

Some economists do not oppose moderate inflation at the rate of, say, two or three per cent a year, on the ground that its benefit toentrepreneurs is an incentive to expand, which helps the economy to retain its vigour. A measure of flexibility is also restored to a"sticky" price system since some prices, instead of falling, need merely rise slower than others to achieve the same relative effect asprice variation around a constant mean. One cannot be sure, however, that the goods and services whose prices rise faster thanaverage are necessarily those for which the social need has become more pressing. Those prices may simply be the more volatile.Nor is there any assurance that the prices that lag behind, such as bus fares, electricity rates and teaching salaries, for that reasonreflect a diminishing social need. It has also proved difficult to prevent moderate inflation from feeding upon itself and steadilygaining momentum.

Recent Monetary Experience in South AfricaLet us now see how we have fared on the score of prices, interest rates and the stock of money in recent years. I take the years1965 and 1970 as a basis for comparison. Over these five years, the consumer price index registered a rise of 18 per cent. If we wereto look at a slightly longer period the increase is much greater: between 1963 - the base year of the Reserve Bank's price index-andthis year, the index increased by 32 per cent. Even more worrying is that prices have risen at an annual rate accelerating fromaround three per cent in the early years to over six per cent in the current year.The trend of interest rates has been steadily upwards, but with some easing perceptible since May this year. The rising trendreflects the increasing return, in money terms, on real investment under inflationary conditions. The recent change reflects thehesitant business outlook, which lowers the prospective return on new investment.The stock of money, as measured by the total of money and near-money, has grown over the five years ending December 1970 fromR2 470 in. to R3 984 in., or by 65 percent.*(2) By way of comparison, it may be added that the gross domestic product in real termsincreased from R7 448 m. in 1965 to R9 797 m. in 1970, or by 32 percent. The money stock, therefore, grew twice as fast as the realGDP. In relative terms, it grew from 33 percent to 41 percent of the real GDP, a growth of 8 percent in the relative money stock.We may not be quantity theorists today (or we may be again?), but none, I believe, will dispute that the 8 percent growth in therelative money stock is not unrelated to the 18 percent rise in prices noted earlier, the difference between 8 and 18 being made upby a much greater velocity of circulation and some statistical discrepancies between the three series we are comparing. Whatever

52

may be the motor causes of our inflation, be they import prices, the greater propensity to spend, or the competition for skilledlabour, prices could not have risen so much if the money supply had not been so elastic.

1972 SAJE v40(1) p79

The Measures TakenCertainly the monetary authorities have made that deduction and a major aim of disinflationary policy has for some years now beento check the expansion of the stock of money. Only recently has some success in curbing the rate of monetary growth beendiscernible, but that may be due mainly to the decline in the gold and foreign exchange reserves.The control measures taken must be seen in relation to the sources of monetary expansion. Of those there are only two: bank credit,including credit extended by the central bank, and changes in the gold and foreign exchange reserves. Only the first, bank credit, isdirectly subject to monetary policy and, it must be emphasised, fiscal policy, for government borrowing from the banking systemalso adds to the stock of money. The growth of the money stock is to be attributed mainly to bank lending to, and investing in, theprivate sector, the total of which increased from R2 106 m. in 1965 to R3 614 m. in 1970, or by 71 percent. Bank credit to thegovernment sector showed only a 7 percent rise, from R649 m. to R694 m.The monetary controls were, accordingly, aimed at bank credit to the private sector. In each of the years 1965-71, measuresaffecting the quantity and the cost of credit were taken. They comprised, briefly, the following:In March 1965 a penalty discount rate over Bank rate was imposed on Reserve Bank accommodation, where granted, to banksextending excessive or non-essential credit, as well as on Reserve Bank purchases of prescribed assets from the banks. Later thesame month this was followed by deposit rate control on all types of banks and the building societies, in order to protect the latterfrom the keen competition by financial institutions which was continually pushing up interest rates. The second half of the yearsaw the introduction of tap Treasury bills to discount houses and commercial banks, as a means of absorbing excess funds in themoney market. Next, credit ceilings were imposed on all monetary banks, freezing the lending of each against an increase, or agreater than stipulated increase. The ceiling instructions were coupled with guidelines for the rationing of the permitted volume oflending, bearing more lightly on farmers and exporters but more harshly on importers, consumers, speculators, foreign-controlledcompanies and credit for inventories and leasing. While amended from time to time, the credit ceilings are still in force. Also in 1965,the Reserve Bank was empowered to sell, on behalf of the Treasury, unlimited amounts of government stock for the credit of theExternal Procurement Fund and the Stabilization Account.That deposit rate control prevented the rise in interest rates needed to contain inflation was conceded in July 1966, when thecontrol was withdrawn.A year later, in July 1967, the Reserve Bank commenced the sale, from its portfolio, of Land Bank bills to the discount houses undera repurchase agreement, again as an absorptive measure.In 1968, the ceiling on bank credit was extended to bank investment in the private sector, while a supplementary reserve balance,equal to a percentage of

1972 SAJE v40(1) p80

any increase in the short-term liabilities since a specified date, had to be maintained at the Reserve Bank. In addition, specialdeposits, similarly calculated, had to be placed with the National Finance Corporation. In the same year, the Reserve Bankconcluded so-called swop arrangements with the commercial banks, whereby the latter were allowed to make short-term foreigninvestments under forward cover from the Reserve Bank.When the housing finance situation again became critical, in 1969, rate control on time deposits of a year or longer wasre-introduced, and maintained for about a year.Finally, in 1971, additional cash reserves were required by the Reserve Bank from banks that exceeded their credit ceilings.The official interest rate policy throughout those years followed a much more timid line. Bank rate, which stood at 41/2 per cent atthe beginning of 1965, reached no higher level than 51/2 per cent at the end of 1970, after a period at 6 per cent in 1966 and 1968. (Itis now 61/2 per cent.) The rate on long-term government stock was raised in stages from 5 per cent at the beginning of 1965 to 73/4per cent at the end of 1970. It stands now at 81/2 per cent.

What Went Wrong?This array of monetary controls, applied over a period of six years, has evidently not succeeded in halting inflation, which hasindeed accelerated throughout, nor even a significant impact on the stock of money. The question must be asked, what wentwrong? I shall attempt to diagnose the poor results of recent monetary policy by pointing to three causes:(1) Defects of some of the measures taken;(2) Some policy instruments were not, or not fully, applied; and

53

(3) An expansionary fiscal policy bedevilled the work of the monetary authorities.(1) Defects of some of the measures takenThe experiment with deposit rate control from March 1965 to July 1966 was singularly inappropriate to the inflationary conditionsthen emerging. Such control keeps money artificially cheap, sustains the demand for money and so stimulates the further creationof money. Rates pegged at lower-than-market level hamstring the monetary authorities in employing the weapon of interest rates tocurb investment activity that outruns the country's capacity to supply or import capital goods.Rising interest rates are the natural consequence of inflation and, if supported by other measures, its natural corrective. They raisethe cost, and hence the price, of capital-intensive products relative to that of other goods and enforce economy in the demandsmade on over-strained resources. To argue, as some do, that high interest changes are themselves inflationary, one mustpresuppose an

1972 SAJE v40(1) p81

expanding stock of money, because only on that assumption can a general price rise occur at a constant or growing output. Thefault, then, is with the expansion of the stock of money and not with interest rates, whose rise, indeed, is essential to any attempt tocontrol monetary expansion.If deposit rate control is wrong in theory, in practice it runs up against the problem that it can be applied only to deposit-receivinginstitutions. Funds from sources other than deposits by the public, such as debenture issues and internal sources, escape control,which causes distortions in financial flows and a below-optimum allocation of investible funds.One acknowledges the problems of house-owners and farmers, but there are other ways of assisting them, if desired, that do notinvolve interference with interest determination by the market.From the point of view of policy, a rise in the level of interest rates is an integral part of anti-inflation strategy and is implicit inopen-market selling, more restrictive discounting and higher liquid asset requirements for the banks.The major instrument of monetary policy employed at present is the ceiling method of credit control. The authorities introduced itreluctantly. They recognised that under the politically imposed restraints on interest policy and in the face of a continual increasein bank liquidity, fed by high government spending and foreign capital inflow, they had little choice. Credit ceilings at least havethe merit of restraining monetary expansion at one of its sources, but have the grave demerit of abridging the market mechanismand thereby becoming actually less effective than they appear to be. Forms of credit other than bank credit expand rapidly whenthe latter is rationed, particularly when capital inflow and govern-ment deficit spending inflate the amount of mo ney in the privatesector. The velocity of circulation will also tend to compensate when credit is rationed. Even bank credit cannot be fully controlledby it, because the observance of credit limits by the banks can be checked only as at the reporting dates (usually monthly; at mostfortnightly). Between dates, the limit may be exceeded and additional credit extended that is briefly hidden over the reporting dateby such expedients as the temporary sale of loan claims to depositors or the manipulation of remittances in transit. The officialstatistics, being based on the month-end bank returns, cannot tell us how much bank credit is in reality being granted.A more far-reaching effect of prolonged control by credit ceiling is that it strongly stimulates the diversification of the bankingindustry. Through holding companies, depositors' funds are channelled into property, industrial investment, insurance, leasing,factoring and a variety of other financial activities. About the desirability of this trend from the point of view of depositors and thecentral bank there may be different opinions, but no one can doubt that the effect on the velocity of circulation is inflationary.Credit ceilings are justifiable only as a strictly short-term holding operation until either the causes of the excess bank liquidity havebeen removed or the traditional methods, which should be applied simultaneously, begin to take effect.

1972 SAJE v40(1) p82

(2) Instruments not, or not fully, appliedA powerful and accurate method of regulating the supply of money is open market operations by the central bank. By anappropriate choice of the maturities of the government stock bought or sold, bank reserves and private-sector money holdings maybe augmented or withdrawn.The Reserve Bank has undertaken such operations only rarely and on a small scale. The main reason, apart from certaininstitutional problems, is the inflexible interest policy. When selling, one must accept the yield levels ruling in the market. Thisimplies that sometimes a loss will be suffered on stock sold. It also implies that new stock issues by the Treasury must offer thepossibly high return that the market may at times demand, with a consequently heavier interest burden on the State. The same goesfor all other borrowers. It is those implications that the authorities have not been prepared to accept and their attitude, whileunderstandable in all the circumstances, has vitiated much of the anti-inflation effort.The increases made in Bank rate and, until quite recently, in the rates for long-term government stock have been too small and,moreover, too late. They have remained well behind the increases that European central banks, in similar circumstances, have beenwilling to countenance. The official rate changes have not kept pace, both as to size and timing, with the rates being quoted in the

54

market for non-government securities. It is well to remember that, for the same ultimate effect, a belated rate increase has to belarger than a timely one.Here is not the place to enlarge on the function of the rate of interest in regulating the course of the market economy, beyondindicating briefly the relation of interest to the stock of money. It might be thought that enlargement of the money stock must lowerits price, that is, the rate of interest. So it does, initially. But when maximum output has been reached and rising prices set in, therate of interest reacts upwards. That is because the supply of investible funds, large at first when real balances were supplementedby new money, next declines when real balances are eroded by rising prices. At the same time, the demand for investible funds isstimulated by the prospect of increased returns on new invest-ment held out by rising prices. At every stage the cost of a new realasset is given, but the returns, extending into the future, can be expected to rise year by year. A high level of interest rates,therefore, is the natural accompaniment of inflation.Now if the growth of the stock of money is successfully curbed, the immediate result is a further sharp rise in interest rates becauseprices continue to rise for a while under the impetus of the past monetary expansion. Only in the next stage, when the price riseitself slows down, can interest rates be expected to return to the pre-inflation level. The period of high interest rates is part of theanti-inflation medicine. If it is refused, the illness worsens and much stronger medicine has to be administered later.(3) Expansionary fiscal policyThe third cause of the failure to halt inflation to date is the expansionary

1972 SAJE v40(1) p83

fiscal policy, both as regards government spending and its financing. The trend of government spending is illustrated by thestatistics of consumption (current) expenditure, which for the years 1965-1970 recorded an increase of 67 per cent, for thegovernment as against 57 per cent for the private sector. If inflation indicates overspending then fiscal policy has been acontributory cause.On the revenue side, taxation can help to counter over-spending provided the additional revenue is not concurrently spent. In fact,out of the increase in government revenue of roughly R1 000 m. between 1965 and 1967, only R400 m. was retained in governmentdeposits. Insofar as higher taxation is at the expense of private-sector saving, it achieves even less in restraining consumerspending.We saw earlier that government borrowing from the banking system increased by seven per cent. While that is not a large increase,in the inflationary conditions prevailing there should have been none. Borrowing abroad also adds to the stock of money. Over theperiod 1965-70 such borrowing by the government increased by 49 per cent, or R75 m., to which must be added the considerableforeign borrowing by public utilities and public corporations.The over-all picture of fiscal policy, therefore, has been one of stimulation and expansion. Instead of strengthening the discipline ofmonetary policy it has placed a heavy burden on the authorities. The traditional role of monetary policy is to lean against the wind;in the event it has been quite blown over.

Verdict on Monetary PolicyI now turn to the title question of this talk: Has monetary policy failed? I have tried to show that some of the most powerful guns inthe arsenal of monetary policy - open market operations and interest policy - have hardly been fired, at least during the periodstudied (1965-70). One of them - interest policy - was once actually fired in the wrong direction, at the time when deposit ratecontrol was in force. The remaining artillery, while courageously deployed, was unequal to the task of subduing the enemy - thevolume of spending - which had fiscal policy on its side.Monetary policy has not, I submit, failed; it has not had a fair run. The political facts of life, which pressed government spendingup and prevented an appropriate interest policy, left the captains in the field little freedom of action, as has been known to happenin real battles. Monetary policy must not for that reason be written off; the task for the future is so to arrange fiscal, and generaleconomic policy that the monetary authorities are enabled successfully to fight inflation.University of South Africa,Pretoria.

55

Endnotes1 Talk given at the University of Natal, on 24th August, 1971.

2 All statistics from the Reserve Bank's Quarterly Bulletin.

56