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Wednesday, 2 December 2009

Who gains from inflation?

Kalinka asked me on the previous blog in South Africa: Who gains from inflation?

Kalinka,

Inflation is always and everywhere the destruction of the real value of money and other monetary items, e.g. monetary loans, over time.

As at 31 Oct 2009 SA´s money supply was R 1 939 278 million. Let us assume it was the same for the 12 months to Oct, 2009. Inflation was 5.9% over that period.

That means inflation destroyed 5.9% or R114.4 billion of the real value of that R1.9 trillion over those 12 months.

SA thus lost R114.4 billion in economic real value during that period although all the money is still there in nominal value.

Kalinka, no-one gains from inflation in the Rand at the macro level. But, this is only half the story.

Everybody loses as being part of the SA monetary economy that is the same in nominal value but R114.4 billion smaller in real value over the last year to Oct, 2009.

Everyone in SA is supposedly happy with this destruction in the real value of the Rand because it is within the SARB´s inflation-targeting range of 3% to 6%. Apparently everyone in SA will also be happy when Gill Marcus brings down inflation to 3% and only R58.1 billion in real value is destroyed. SA will gain R56.3 billion per annum. What a nice annual present from Gill and her team at the SARB that would be.

It is very obvious that everyone will be happier at R58.1 billion real value destruction than at R114.4 billion real value destruction per annum. Both are in the target range. Why the lower much happier target is not chosen, I do not know.

Kalinka, now I have some shocking news for you! You think that there is only one economic enemy in SA, namely, inflation. Unfortunately, I must inform you that there is a second one. It is called the stable measuring unit assumption which the accountants at all the companies that your sister audits as well as all other accountants at all other SA companies implement.

Kalinka, as you know Cosatu and Numsa and all the other trade unions see to it that workers´ wages and salaries are valued in units of constant purchasing power, i.e. inflation-adjusted in SA´s low inflationary environment to compensate at least for the annual destruction in the real value of the Rand. SA workers´ salaries and wages are constant real value non-monetary items but they are accounted in the Rand, a depreciating nominal monetary unit of account. They have constant real values but are paid out in a continuously depreciating monetary unit, the SA Rand.

SA accountants agree that inflation of 5.9% destroys the real value of the Rand, which is the depreciating monetary unit of account they use to account all economic activity in SA companies and prepare all financial reports, at 5.9% per annum. They know that if they keep workers´ salaries and wages (which have constant real values over time) the same they would be destroying the constant real values of those salaries and wages because they use the depreciating Rand as depreciating monetary medium of exchange to pay out constant item salaries and wages. They just happily inflation-adjust them at the union agreed values per industry and company.

Where do their companies get the extra money from to pay the inflation-adjusted salaries? In general, they all inflation-adjust all their selling prices too. In fact, the ones who increase their selling prices at levels higher than inflation when there is no actual real increase in real value in the products they sell, actually create this 5.9% inflation that we all have to pay for in the destruction of the real value in the Rand.

Inflation-adjusting or valuing salaries and wages in units of constant purchasing power is of great importance in the SA economy since it maintains internal demand for goods and services and adds greatly to economic, social and political stability in SA. This was not done in Zimbabwe and we all know what happened there.

All those accountants know that inflation was 5.9%. However, when they value all their companies´ reported retained profits and other constant real value non-monetary items never maintained in the companies (which are constant non-monetary items exactly the same as salaries and wages), they suddenly change their collective minds and they all collectively assume that the 5.9% change in the real value of the Rand is not sufficiently important to measure these items in units of constant purchasing power, i.e. they refuse to inflation-adjust them like they did with the salaries and wages.

Kalinka, can you imagine that! Now we are in for big trouble! They collectively implement their very destructive stable measuring unit assumption, the second economic enemy operating only in the constant item part of the SA real economy.

As they would have destroyed the real values of the workers´ salaries and wages if they had not inflation-adjusted them, so they, in fact, unknowingly and unintentionally destroy the real values of all these reported constant items never maintained in their companies; e.g. the reported Retained Profits of all SA companies, including the ones your sister audits.

They unknowingly destroy about R200 billion per annum in SA companies´ like that – each and every year. I am going to calculate this value as accurately as I can.

No-one forces them to do that. They simply do it because it has always been done like that. But, they do not have to do it like that. The International Accounting Standards Board authorized them 20 years ago to stop this destruction in the Framework, Par. 104 (a) which states:

“Financial capital maintenance can be measured in either nominal monetary units or in units of constant purchasing power.”

This is in agreement with International Financial Reporting Standards.

They can thus freely choose to measure all those constant items in units of constant purchasing power and stop their unknowing destruction of the real value of those items. They do not understand that they are unknowingly doing it with their very destructive stable measuring unit assumption. Neither do  accounting lecturers at universities. They vaguely know that inflation has some effect on financial reports.

They implement their very destructive stable measuring unit assumption at annual inflation rates ranging from 0.1% per annum to 25.99% per annum for three years in a row. At these levels of inflation they assume that the change in the purchasing power of the Rand is not sufficiently important for them to measure financial capital maintenance in units of constant purchasing power.

However, when inflation increases just a little bit more by 0.1% to 26% per annum for 3 years in a row then they all happily would measure all constant items as well as all variable items in units of constant purchasing power. Why? Because 26% annual inflation for 3 years in a row will add up to 100% cumulative inflation over 3 years which is the IASB´s definition of hyperinflation. They have to inflation adjust all non-monetary items during hyperinflation as required by International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies.

But, at 25.99% annual inflation they assume it is not sufficiently important for them to inflation-adjust constant items. They refuse to measure financial capital maintenane in units of constant purchasing power. They insist on unknowingly destroying the real value of reported constant items never maintained in SA companies.

Strange is it not?

Accountants simply blame inflation, the ANC´s economic and growth policy and the SARB´s monetary policy for this at all levels of inflation from 0.1 to 25.99% per annum for 3 years in a row.

It is very clear that accountants and accounting lecturers at do not understand the effects of measuring finacial capital maintenance in units of contstant purchasing power during low inflation as authorized by the IASB in the Framework, Par. 104 (a) although it was published in 1989. If they did, they would have stopped the stable measuring unit assumption in SA by now and they would not make unbelievable statements like

"We do not concur with the suggestion that the standards should reject the stable unit measuring assumption." when the Standards reject it in IAS 29 and its rejection has been approved as an option by the IASB 20 years ago.

Kalinka, your sister audits their accounts and then she or the partner at her audit firm signs the financial reports off as fairly representing the business of the companies when this is in fact happening in all of them. Can you believe that?

Kalinka, as you can see, no-one gains from inflation at the macro level although it is seen as a way to get out of deflation like Japan is trying right this very moment. That is another macro aspect of inflation. As you can see, in SA´s case it is twice as bad as you thought.

But, don´t despair. As soon as SA accountants start measuring financial capital maintenance in units of constant purchasing power they will collectively and knowingly kill the stable measuring unit assumption in SA forever. Then there will only be one economic enemy: inflation and we know Gill Marcus is the enemy of inflation.

Kalinka, I will deal with inflation on a micro level for you in the next blog.

By the way, I am simply an accountant. I am not a macroeconomist or central banker or banker, but, I will try and help with the concepts I do understand. Inflation is a very complex subject especially at the macro level. I am not an expert in inflation at all.

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