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Friday, 25 May 2012

CIPPA equals automatic zero erosion in the constant item economy

CIPPA equals automatic zero erosion in the constant item economy
We do not have stable – as in fixed real value – money. The real value of money is generally accepted by the public at large to be stable – as in fixed – in low inflation economies, but this is not true. The belief that we have stable – as in fixed real value – money is an illusion, namely the notorious money illusion.



Central banks and monetary authorities have monetary policies that often create the impression that money is stable in real economic value. They implement monetary policies that include the tolerance of low inflation limits of up to two per cent per annum. Then they assure everybody that ‘price stability’ is guaranteed and assured. The public at large mistakenly assume that this means stable – as in fixed – prices. We regularly read in inflation reports that low inflation targets have been met and that ‘price stability’ is assured.






South African Reserve Bank



In a low inflationary economy this appears to be true. But in reality it is not true. Yes, money illusion makes us believe that our depreciating money maintains its real value stable, while it actually halves in real value over 35 years with constant two per cent per annum inflation – the generally accepted level of ‘price stability.’ All currently existing bank notes and coins will eventually arrive at a point of being completely worthless in real value during indefinite inflation. How quickly depends on the level of inflation.



Table 2

                               Real Value Table



            Per cent of Today’s Real Value Eroded



                                                                   Hyperinflation*

Annual Inflation     2%        6%        10%        26%



                   Years       %         %          %           %



                     5           10          27          41          78

                    10          18          46          65          95

                    16          28          63          84          99

                    20          33          71          88

                    30          45          84          96

                    35          51          89          98

                    44          59          93          99

                    75          78          99

                  114          90

                  228          99



*Cumulative inflation over three years equals or is more than 100 per cent: for example, inflation at 26 per cent per annum for three years in a row.



In Zimbabwe hyperinflation reached such high levels that the real value of the country’s entire money supply was wiped out when the ZimDollar had no exchangeability with any foreign currency in November 2008.  Towards the end of the hyperinflationary spiral the real value of the ZimDollar halved every 24.7 hours according to Steve Hanke from Cato Institute. There is no money illusion in hyperinflationary economies. People know that hyperinflation erodes the real value of their money very quickly.



Central bank governors aid and abet money illusion by regularly stating in their monetary policy statements that they are ‘achieving and maintaining price stability.’



‘The MPC remains fully committed to its mandate of achieving and maintaining price stability.’



(Mboweni, 2009)



It is not regularly pointed out by governors of central banks that the ‘price stability’ they mention, refers to their particular definition of ‘price stability’. Jean–Claude Trichet, the ex-President of the European Central Bank, was a central bank governor who regularly mentioned that two per cent inflation was their definition of price stability. Absolute price stability is a year–on–year increase in the Consumer Price Index of zero per cent. The SARB´s definition of ‘price stability’ ‘is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis.’



The SARB would aid in reducing money illusion in the SA economy by stating:



The MPC remains fully committed to its mandate of achieving and maintaining the SARB´s chosen level of price stability which is for CPI inflation to be within the target range of 3 to 6 per cent per annum on a continuous basis. Absolute price stability is a year–on–year increase in the CPI of zero per cent. Current 6 per cent annual inflation eroded 6 per cent of the real value of every Rand and in total about R132 billion of the real value of the Rand money supply over the past 12 months to the end of March, 2012.



It has to be remembered that the stable measuring unit assumption (not inflation) as implemented as part of the traditional Historical Cost Accounting model used by South African companies unnecessarily eroded an additional about Rand 100 billion of the real value of constant items never maintained constant in SA companies at a rate equal to the 6 per cent (March, 2012) annual inflation rate.



A one per cent decrease in inflation (disinflation) would maintain about R22 billion per annum of real value only in the SA monetary economy as a result of the decrease in the level of inflation. At the same time, an additional R20 billion would be maintained in the SA constant item economy as a result of the reduction in the level of erosion by the traditional HCA model in the real value of constant items never maintained constant in consequence of the implementation of the stable measuring unit assumption; i.e. financial capital maintenance in nominal monetary units during low inflation in South Africa.

All that has to be done to completely stop this erosion of constant items by the stable measuring unit assumption is for all entities to freely change over to IFRS–approved financial capital maintenance in units of constant purchasing power during low inflation (CIPPA) in terms of a Daily CPI and the SA real economy would automatically be boosted by about R100 billion per annum for an indefinite period of time as long as the SARB maintains its chosen level of price stability at 6 per cent inflation per annum. This would require complete co-ordination although any individual company can start any time it wants since it was authorized in IFRS in 1989.

The SA economy would continue to suffer the erosion of R132 billion of the real value of the Rand money supply per annum – ceteris paribus – but would be boosted by the maintenance of about R100 billion per annum in the constant item economy for an indefinite period of time at continuous 6 per cent inflation when everybody is SA change over to financial capital maintenance in units of constant purchasing power (CIPPA).

The SA economy would be boosted by a further R132 billion per annum for an indefinite period of time at continuous 6 per cent inflation when SA inflation-adjusts the entire money supply.

As the Deutsche Bundesbank stated:

‘The benefits of price stability, on the other hand, can scarcely be overestimated, especially as these are, in principle, unlimited in duration and accrue year after year.’

(Deutsche Bundesbank, 1996)

All SA entities changing over to CIPPA would mean automatic zero erosion of constant items´ real values for an indefinite period of time in the SA economy in all entities that at least break even during inflation and deflation – ceteris paribus. The same principle applies to all other economies.

Gill Marcus, the current (2012) governor of the SARB, would have to bring inflation down to zero per cent per annum on a permanent basis to have the same effect in the constant item economy. Financial capital maintenance in units of constant purchasing power (CIPPA) in terms of a Daily CPI would do this automatically at any level of inflation or deflation. Zero per cent inflation is not currently advisable in the monetary economy because governments and central banks still do not know how to run an economy at sustainable zero per cent annual inflation. It is relatively easy to automatically run the constant item economy in any country or monetary union at sustainable zero per cent erosion in constant items for an indefinite period of time: just choose the other option: real value maintaining financial capital maintenance in units of constant purchasing power (CIPPA). It is compliant with IFRS and has been authorized by the IASB in 1989.

Financial capital maintenance in units of constant purchasing power (CIPPA) is a basic accounting model that results in the automatic maintenance – without additional capital contributions or extra retained profits – of the real value of constant real value non–monetary items in the constant item economy for an unlimited period of time in all companies that at least break even in real value during inflation and deflation – ceteris paribus. The principle applies when any economy changes over to financial capital maintenance in units of constant purchasing power (CIPPA).




Nicolaas Smith

Copyright (c) 2005-2012 Nicolaas J Smith. All rights reserved. No reproduction without permission.