Letter to the IMF

Mr Norbert Funke
IMF
11 September 2007

Dear Mr Funke,
Re: Stabilizing the non-monetary side of the economy in Zimbabwe.

Inflation has two components under the current 700 year old Historical Cost paradigm: a monetary component called Cash Inflation or Monetary Inflation and a non-monetary component called Historical Cost Accounting Inflation.

This is not yet a generally accepted fact in the world economy. The second component was first identified in the book RealValueAccounting.Com – The next step in our fundamental model of accounting which is available as a free download at the Social Science Research Network at http://papers.ssrn.com/sol3/papers.cfm?abstract_id=946775

The fact that the economy has a monetary side and a non-monetary side is also not yet generally accepted in the world economy except in the Brazilian economy and perhaps some other (South American?) economies where indexation was used during periods of high inflation and hyperinflation. The fact that you make no mention of the fact that Brazil stabilized the non-monetary side of their economy during both periods analysed in your Working Paper: Lessons from High Inflation Episodes for Stabilizing the economy in Zimbabwe is a very good example of the fact that it is not yet generally accepted. “A não-monetária lado da economia” or the non-monetary side of the economy is a term that regularly appears in the Brazilian literature regarding inflation and hyperinflation.

Brazilian central bankers, economists, accountants, bankers, governments and the population at large regularly used that term along the 30 years from 1964 to 1994 during which various governments applied various formulas to establish various non-monetary indices that were used to index non-monetary items on a daily basis in “the non-monetary side of the economy” as the Brazilian Central Bank recently informed me by email.

The use of a non-monetary index helped to stabilise “the non-monetary side of the economy” during those thirty years while the Brazilians still had high and hyperinflation in the monetary side of their economy. They had periods of positive economic growth under hyperinflation when they indexed the non-monetary side of their economy with a daily changing index.

Their thorough understanding of the fact that the economy has a monetary and a non-monetary side culminated in their development of the Unidade Real de Valor that they then transformed by law into their national currency, the Real. The monetizing of the index is not a general case – even though Dr Gustavo Franco, one of the creators of the Unidade Real de Valor, thinks it is – as he indicated to me. Monetizing the index was unique to the Brazilian Unidade Real de Valor. Monetization of the index would not be necessary in the case of Zimbabwe as will become amply clear to you in the paragraphs that follow.

The fact that the Brazilians were very well aware of the non-monetary side of the economy still did not lead them to identify the fact that inflation has two components. A thorough understanding of the very destructive role played by the stable measuring unit assumption – the cornerstone of the Historical Cost Accounting model – is the only way a person can understand the fact that inflation has two components – only under the current Historical Cost model. Revoke the stable measuring unit assumption as done under the Real Value Accounting model and as was unwittingly done under the Unidade Real de Valor and inflation only has one component: its monetary component - which has erroneously always been generally accepted as its only component.

The fact that the economy has a non-monetary side as well as a monetary side is thus not my invention or discovery. It is a well documented fact – mostly in the Brazilian literature. This is not yet a generally accepted fact in the world economy (outside Brazil) – as I have stated before.

What is generally accepted in the world economy is the fact that there are at least two distinct economic items in the economy: monetary items and non-monetary items. See the IASB´s International Accounting Standard 29 Financial Reporting in Hyperinflationary Economies. The fact that there are not only two but actually three distinct economic items in the economy is another not yet generally accepted economic fact. The three distinct economic items are monetary items, variable real value non-monetary items and constant real value non-monetary items. See RealValueAccounting.Com – The next step in our fundamental model of accounting.

The fact that you stabilise the non-monetary side of the economy by means of a non-monetary index - updated daily in a hyperinflationary economy - is also not my invention or discovery. It is also a well documented fact – mostly in the Brazilian literature. This is not yet a generally accepted fact in the world economy as I have stated before and as the lack of its appearance in your Working Paper clearly indicates.

Dr Gustavo Franco described in an article on the internet: How Brazil beat Hyperinflation how they first stabilized the non-monetary side of the Brazilian economy by indexing non-monetary items on a daily basis. That gave them the chance to devise ways and means to stop their monetary hyperinflation. It took them 10 years to achieve that. (I am not proposing that Zimbabwe should take 10 years to do the same.)

I think you will now readily agree with me on the following points:

1. The economy has a monetary side and a non-monetary side.2. The non-monetary side of a hyperinflationary economy can be stabilised by indexing all non-monetary items on a daily basis as was done so successfully with the Brazilian Unidade Real de Valor. See Unidade Real de Valor in the English Wikipedia.

The fact that the Brazilians were always very aware of the social importance of maintaining the real value of salaries as well as their understanding of the fact that they could stabilise the non-monetary side of the economy by means of indexing non-monetary items, resulted in them automatically maintaining a significant part of their internal market. It fortunately prevented them from destroying that part of their internal market.

The exact opposite is the case in Zimbabwe.

Zimbabweans are – in line with the major part of the rest of the world economy (previously including the IMF) - generally unaware of points 1 and 2 above. (I have emailed the Zimbabwean Instituted of Chartered Accountants, the Big Four accounting firms in Harare, Dr Gono – the Governor of the Reserve Bank of Zimbabwe, Minister Mpofu as well as the other major accounting institutes in Zimbabwe regarding this matter. I do not know whether I was successful in my attempt to explain the importance of a non-monetary index to them.)

They update salaries now and then – in their hyperinflationary economy.

They have been in hyperinflation for 17 years – based on the IASB definition of cumulative inflation approaching 100% over three years. Most Zimbabwean companies only update their selling prices in terms of the parallel rate. The stable measuring unit assumption has thus destroyed their internal market over the last 17 years.

Part III of your Working Paper: Critical Reform Elements and Sequence

I understand that your suggestions a to f are the result of the terms of your analysis: “the stabilization experience of countries that experienced similar rates of inflation (above 1 000 percent) during 1980-2005” with specific reference to Critical Reform Elements and Sequence.

I suspect that the fact that only one country, Brazil, used indexation continuously during the whole period of your study led you to exclude indexation from your working paper. In fact this exclusion is not acceptable especially since indexation is the only way, excluding immediate low inflation, to stabilise the non-monetary side of any economy.

Perhaps you regarded it is a one-country process and considered it as outside the terms of your analysis.

I further suspect that the fact it is not yet generally accepted that inflation has a monetary and a non-monetary component and that the economy has a monetary and a non-monetary side aided this exclusion of indexation from your analysis.

Your macroeconomic approach to the problem of hyperinflation is in fact “the best case” approach; that is, implementing the correct macroeconomic measures to go straight from hyperinflation to low inflation with co-operative governments.

I fully agree that when it is possible to go straight from hyperinflation to low inflation – especially with dollarization of an economy – then, logically, indexation is not needed at all. The many benefits the low inflation achieved - compared to the destructive effects of hyperinflation - make indexation superfluous.

It is, however, a fact that the non-monetary side of the economy can be stabilised with indexation as shown above. It is a guaranteed way of stabilising the non-monetary side of the economy.

Your proposals for achieving macroeconomic stabilization in Zimbabwe. (Part IV of your working paper.)

On a macroeconomic basis I agree with your proposals.

I regard No 5: Establishing a strong money anchor to reduce inflation as perhaps not really necessary to mention since Zimbabwe does no have the foreign exchange reserves to implement it – as you stated. I accept that you included it simply for your proposals to be theoretically complete on a best case macroeconomic level.

Implementing an index to stabilize the non-monetary side of the economy in Zimbabwe.

1. With a Zimbabwean government accepting Numbers 1 to 4 of your proposals.The advantage of indexation is that it eliminates inflation completely from the non-monetary side of the economy. Obviously the index has to be formulated and calculated correctly and it has to be calculated on a daily basis in a hyperinflationary economy.

First of all non-monetary items have to be defined.

Non-monetary items are all items that are not monetary items.

Monetary items are money held and accounted monetary values only of money where money is the functional currency. Simply: only money and accounted values ONLY of money.

The functional currency is the monetary unit of account of the principal economic environment in which an economic entity operates.

Money has three functions: 1. Medium of exchange. 2. Store of value. 3. Unit of account.

The US Dollar is only money in the USA, El Salvador, Ecuador and Panama – the last three countries having dollarized their economies. In all other countries the US Dollar and all other foreign exchange are variable real value non-monetary items. In these countries the USD or any other foreign currency does not fulfil all three functions of money; namely, it is not the unit of account in those countries.

To define the index correctly the correct data have to be available on a daily basis in a hyperinflationary economy. The Brazilians based the Unidade Real de Valor on three Brazilian non-monetary indices and it also had a 1-to-1 relationship with the US Dollar. The Brazilian government updated the URV on a daily basis for the Brazilian population.

When I recently asked the Central Bank of Brazil to send me the formula that was used to calculate the URV they responded and said that various different governments used various different formulas over the 30 years from 1964 to 1994 and that I have to request the data from another government department.

My suggestion for Zimbabwe is that the USD should be used as the non-monetary index. It is generally accepted as a “stable” value. In Zimbabwe it is already a non-monetary item as indicated above. It is, in fact, more or less 2% away from being a 100% stable non-monetary item in Zimbabwe. Its instantaneous acceptance as a “stable” real value makes it the perfect substitute for a non-monetary index in Zimbabwe. Most non-monetary items in Zimbabwe already have USD values.

With a co-operative government in Zimbabwe the ZimDollar will be floated which will result in the unification of the official and parallel rates at the parallel rate resulting in the disappearance of the parallel market when a single rate is established.

All non-monetary items will be valued at their current USD prices and will be updated daily at the official USD rate supplied by the Zim government on a daily basis. Salaries, capital, taxes, prices and all non-monetary items in Zimbabwe will be updated on a daily basis at the single official USD rate.

This will stabilise the non-monetary side of the Zim economy in exactly the same way as the URV stabilised the non-monetary side of the Brazilian economy. Nothing new. All old news.

The Zim government and RBZ can then implement your macroeconomic proposals to stabilise the monetary side of the Zim economy, namely, the ZimDollar, over time.

2. With a Zimbabwean government not accepting Numbers 1 to 4 of your proposals.

The IMF can explain the advantages of indexation to the Zim government – perhaps through a working paper on the subject of Indexation for Zimbabwe.

That would be acceptable as from a credible source: the IMF. Nicolaas Smith is simply a South African accountant living in Portugal described by some Zimbabweans as living in cuckoo land with his funny ideas about Real Value Accounting.

You can even suggest to the Zim government that they can implement indexation using the USD as the index and the Old Mutual Implied Rate as the daily rate for the index.

The Old Mutual Implied Rate is already in use in Zimbabwe as an approximation of the parallel rate for the USD. It is calculated as follows: The ZimDollar price of the Old Mutual share traded on the Zimbabwe Stock Exchange is divided by the UK Pound price of the same share traded on the London Stock Exchange. That supplies an implied rate for the UK Pound in ZimDollars. A cross rate calculation is then done with the Pound/USD rate to arrive at the Old Mutual Implied Rate for the USD.

The OMIR is available to everyone in Zimbabwe on a daily basis. When closing prices are used the OMIR is a single, unambiguous rate available daily to everyone.

Obviously indexation in whatever form has to be implemented by law in Zimbabwe.

To summarise: Indexation is the only way to stabilise the non-monetary side of an economy in the absence of low inflation as was very well demonstrated by Brazil during 30 years from 1964 to 1994. This is not yet a generally accepted fact outside the Brazilian economy. Indexation can be used to stabilise the non-monetary side of the Zimbabwean economy. The IMF promoting indexation will give it credibility – for those who do not regard the very successful Brazilian URV as sufficient credibility.

Yours sincerely

Nicolaas Smith

http://realvalueaccounting.blogspot.com/

Lisbon, PortugalTel +351 911 000 311