I am not dealing with the value of a business entity´s capital or stock as determined in the market.
As we all know, the term capital has many meanings. As far as it relates to a company it also refers to various different things.
The capital of a business entity has, amongst others, the following two meanings:
(1) The market capitalization of a company; i.e. the market value of one share times the number of shares issued. This "capital" or stock of a company is a variable real value non-monetary item. Its value is determined in the market at market price as per IFRS. I agree 100% with that.
(2) The shareholders´ equity which includes, issued share capital, share premium account, reported retained profits, retained losses, share discount account, capital reserves, revaluation reserve, etc. These items are all constant real value non-monetary items. Currently they are being valued in nominal monetary units by HC accountants world wide during low inflation with the exception of the accounting process of property revaluations via the revaluation reserve account. Only the real value of issued share capital and share premium account can be maintained via sufficient property revaluations via the revaluation reserve account. This real value maintenance can not be applied to other reported items in shareholders´equity, e.g. reported retained profits.
All items in shareholders´ equity are constant real value non-monetary items and - in order to maintain their real values constant during low and hyperinflation - their real values have to be valued in units of constant purchasing power during low inflation and hyperinflation by means of financial capital maintenance in units of constant purchasing power. When this is not done, i.e. when they are currently valued in nominal monetary units, their real values are being destroyed by HC accountants implementing their very destructive stable measuring unit assumption - with the exception of issued share capital and share premium account, the real values of which can be maintained indefinitely with sufficient unreported and hidden revaluable holding gains in fixed property.
I only deal with the valuation of constant real value non-monetary items in companies. I only deal with the "capital" of a company as defined in (2). As far as (1) is concerned, I agree 100% with its valuation in terms of IFRS; i.e., at market value.
Kindest regards,
Nicolaas Smith
Tuesday, 8 December 2009
Why low inflation is better than no inflation.
1. Low inflation is helpful to economic growth. See previous blog.
2. Maintaining a zero inflation monetary policy can lead to unpredictability and instability in the economy. An inflation targeting policy like the SARB´s 3 to 6 percent target range seeks to maintain a constant rate of inflation. Unfortunately inflation always moves to the top of the target range, thus doubling the cost of inflation in SA´s case. At continuous 3% annual inflation only R60 billion per annum will be destroyed in the real value of the Rand and SA accountants will only unknowingly destroy about R100 billion in the real value of existing constant items (e.g. reported Retained Profits) in the SA real economy with their very destructive stable measuring unit assumption instead of double these values as currently happens. Adherence to a constant low rate allows firms to make reasonable predictions in the future about price and wage levels, but, it causes structural or built-in inflation in the economy. A zero inflation policy would attempt to correct for past deviations. A past period of inflation would have to be corrected by a period of deflation. Past deviations cannot be let go as zero inflation (a set price level) has to be maintained. This need to correct past deviations means that the monetary authority might have to take drastic action to swing the economy in the other direction and so actually increase unpredictability and instability in the economy rather than decrease it.
3. Zero inflation increases the risk of the economy slipping into deflation. The decrease in prices causes nominal wages to fall while their real values increase and fewer goods to be produced, which in turn causes prices to fall further causing further decreases in nominal wages but increases in real wages under the current Historical Cost Paradigm. Production and employment normally decrease too. A low rate of inflation provides a safety barrier against this. Deflation is also very hard for a monetary authority to correct. See Japan’s “ten lost years”. Interest rates typically cannot be used at a negative rate.
4. Downwards stickiness in prices and wages. Wages in particular are very hard to negotiate downwards as workers and trade unions are naturally very reluctant to accept nominal cuts in wages in an inflationary environment. However, if downward adjustments were not possible the disequilibrium in the economy would cause instability and a decrease in economic growth. A low inflation rate allows real wage decreases, while avoiding nominal cuts simply by having no wage increase or a wage increase rate lower than that of inflation. It is in this sense that inflation has been called the grease on the wheels of the economy.
5. Avoiding a possible liquidity trap. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the central bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy.This is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate. Some economists assert that even under an occurrence of a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of both the Bank of Japan in the 1990s, when it embarked upon quantitative easing and of the central banks of the United States and Europe in 2008-9, with their foray into quantitative easing. All these policy initiatives are attempts to stimulate the economy through methods other than the mere reduction of short-term interest rates.
6. The real interest rate is normally still positive at low levels of inflation; thus, inflation provides a savings and investment incentive as it is preferential to save or invest than just have your money on deposit at no return thus losing real value at the rate of inflation.
Kindest regards,
Nicolaas Smith
2. Maintaining a zero inflation monetary policy can lead to unpredictability and instability in the economy. An inflation targeting policy like the SARB´s 3 to 6 percent target range seeks to maintain a constant rate of inflation. Unfortunately inflation always moves to the top of the target range, thus doubling the cost of inflation in SA´s case. At continuous 3% annual inflation only R60 billion per annum will be destroyed in the real value of the Rand and SA accountants will only unknowingly destroy about R100 billion in the real value of existing constant items (e.g. reported Retained Profits) in the SA real economy with their very destructive stable measuring unit assumption instead of double these values as currently happens. Adherence to a constant low rate allows firms to make reasonable predictions in the future about price and wage levels, but, it causes structural or built-in inflation in the economy. A zero inflation policy would attempt to correct for past deviations. A past period of inflation would have to be corrected by a period of deflation. Past deviations cannot be let go as zero inflation (a set price level) has to be maintained. This need to correct past deviations means that the monetary authority might have to take drastic action to swing the economy in the other direction and so actually increase unpredictability and instability in the economy rather than decrease it.
3. Zero inflation increases the risk of the economy slipping into deflation. The decrease in prices causes nominal wages to fall while their real values increase and fewer goods to be produced, which in turn causes prices to fall further causing further decreases in nominal wages but increases in real wages under the current Historical Cost Paradigm. Production and employment normally decrease too. A low rate of inflation provides a safety barrier against this. Deflation is also very hard for a monetary authority to correct. See Japan’s “ten lost years”. Interest rates typically cannot be used at a negative rate.
4. Downwards stickiness in prices and wages. Wages in particular are very hard to negotiate downwards as workers and trade unions are naturally very reluctant to accept nominal cuts in wages in an inflationary environment. However, if downward adjustments were not possible the disequilibrium in the economy would cause instability and a decrease in economic growth. A low inflation rate allows real wage decreases, while avoiding nominal cuts simply by having no wage increase or a wage increase rate lower than that of inflation. It is in this sense that inflation has been called the grease on the wheels of the economy.
5. Avoiding a possible liquidity trap. If an economy finds itself in a recession with already low, or even zero, nominal interest rates, then the central bank cannot cut these rates further (since negative nominal interest rates are impossible) in order to stimulate the economy.This is known as a liquidity trap. A moderate level of inflation tends to ensure that nominal interest rates stay sufficiently above zero so that if the need arises the bank can cut the nominal interest rate. Some economists assert that even under an occurrence of a liquidity trap, expansive monetary policy could still stimulate the economy via the direct effects of increased money stocks on aggregate demand. This was essentially the hope of both the Bank of Japan in the 1990s, when it embarked upon quantitative easing and of the central banks of the United States and Europe in 2008-9, with their foray into quantitative easing. All these policy initiatives are attempts to stimulate the economy through methods other than the mere reduction of short-term interest rates.
6. The real interest rate is normally still positive at low levels of inflation; thus, inflation provides a savings and investment incentive as it is preferential to save or invest than just have your money on deposit at no return thus losing real value at the rate of inflation.
Kindest regards,
Nicolaas Smith
Monday, 7 December 2009
Inflation and Economic Growth
“The South African Reserve Bank (the SARB) is the central bank of the Republic of South Africa. It regards its primary goal in the South African economic system as "the achievement and maintenance of price stability.
The South African Reserve Bank conducts monetary policy within an inflation targeting framework. The current target is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis. The Bank has a floating exchange rate policy and there are no exchange rate targets.
Financial stability is not an end in itself, but, like price stability, is generally regarded as an important precondition for sustainable economic growth and employment creation.”
SARB
The average annual inflation rate in SA has been 6% over the last 10 years while Tito Mboweni was the Governor of the SARB. This is half the 12% average annual inflation rate during the 18 years before Mboweni took over the helm at SA´s central bank.
SA is thus committed to low inflation. This is the correct policy.
“Real economic gain can be achieved by reducing the trend growth of money.”
Money, Inflation and Economic Growth. Keith Carlson, Federal Reserve Bank of St. Luis. 1980
“Monetary policymakers have assumed that faster sustainable growth can only occur in a climate where the inflation monster is tamed.
A reduction in inflation of even a single percentage point leads to an increase in per capita income of 0.5 percent to 2 percent.
As the authors point out, their analysis leaves little room for interpretation. Inflation is not neutral, and in no case does it favor rapid economic growth. Higher inflation never leads to higher levels of income in the medium and long run, which is the time period they analyze. This negative correlation persists even when other factors are added to the analysis, including the investment rate, population growth, schooling rates, and the constant advances in technology. Even when the authors factor in the effects of supply shocks characteristic of a part of the analyzed period, there is still a significant negative correlation between inflation and growth.
Inflation not only reduces the level of business investment, but also the efficiency with which productive factors are put to use. The benefits of lowering inflation are great, according to the authors, but also dependent on the rate of inflation. The lower the inflation rate, the greater are the productive effects of a reduction. For example, reducing inflation by one percentage point when the rate is 20 percent may increase growth by 0.5 percent. But, at a 5 percent inflation rate, output increases may be 1 percent or higher. It is therefore more costly for a low inflation country to concede an additional point of inflation than it is for a country with a higher starting rate. Given their detailed analysis, the authors conclude that "efforts to keep inflation under control will sooner or later pay off in terms of better long-run performance and higher per capita income.”
Does Inflation Harm Economic Growth? Evidence for the OECD: Javier Andres, Ignacio Hernando, The US National Bureau of Economic Research, 1997
“The tests revealed that a weak negative correlation exists between inflation and growth, while the change in output gap bears significant bearing. The causality between the two variables ran one-way from GDP growth to inflation.
Correlation coefficients showed only a weak negative link, while causality was shown to run from economic growth to inflation. With the majority of Fiji’s inflation being imported, the influence of domestic factors (being unit labour costs and to a lesser extent the output gap) is limited. The findings of other empirical studies, however, provide some guidance for Fiji policymakers on the importance of maintaining low inflation, in order to foster higher economic growth. For its part, the Reserve Bank of Fiji will need to maintain monetary policy consistent with low inflation and inflation expectations.”
Relationship between Inflation and Economic Growth: Gokal and Hanif, Reserve Bank of Fiji, 2004
“ There are also significant feedbacks between inflation and economic growth. These results have important policy implications. Moderate inflation is helpful to growth, but faster economic growth feeds back into inflation.
Attempts to achieve faster economic growth may overheat the economy to the extent that the inflation rate becomes unstable. Thus, these economies are on a knife-edge. The challenge for them is to find a growth rate which is consistent with a stable inflation rate. They need inflation for growth, but too fast a growth rate may accelerate the inflation rate and take them downhill as found by Bruno and Easterly (1998).”
INFLATION AND ECONOMIC GROWTH: EVIDENCE FROM FOUR SOUTH ASIAN COUNTRIES, Asia-Pacific Development Journal Vol. 8, No. 1, June 2001, Girijasankar Mallik and Anis Chowdhury
Kindest regards,
Nicolaas Smith
The South African Reserve Bank conducts monetary policy within an inflation targeting framework. The current target is for CPI inflation to be within the target range of 3 to 6 per cent on a continuous basis. The Bank has a floating exchange rate policy and there are no exchange rate targets.
Financial stability is not an end in itself, but, like price stability, is generally regarded as an important precondition for sustainable economic growth and employment creation.”
SARB
The average annual inflation rate in SA has been 6% over the last 10 years while Tito Mboweni was the Governor of the SARB. This is half the 12% average annual inflation rate during the 18 years before Mboweni took over the helm at SA´s central bank.
SA is thus committed to low inflation. This is the correct policy.
“Real economic gain can be achieved by reducing the trend growth of money.”
Money, Inflation and Economic Growth. Keith Carlson, Federal Reserve Bank of St. Luis. 1980
“Monetary policymakers have assumed that faster sustainable growth can only occur in a climate where the inflation monster is tamed.
A reduction in inflation of even a single percentage point leads to an increase in per capita income of 0.5 percent to 2 percent.
As the authors point out, their analysis leaves little room for interpretation. Inflation is not neutral, and in no case does it favor rapid economic growth. Higher inflation never leads to higher levels of income in the medium and long run, which is the time period they analyze. This negative correlation persists even when other factors are added to the analysis, including the investment rate, population growth, schooling rates, and the constant advances in technology. Even when the authors factor in the effects of supply shocks characteristic of a part of the analyzed period, there is still a significant negative correlation between inflation and growth.
Inflation not only reduces the level of business investment, but also the efficiency with which productive factors are put to use. The benefits of lowering inflation are great, according to the authors, but also dependent on the rate of inflation. The lower the inflation rate, the greater are the productive effects of a reduction. For example, reducing inflation by one percentage point when the rate is 20 percent may increase growth by 0.5 percent. But, at a 5 percent inflation rate, output increases may be 1 percent or higher. It is therefore more costly for a low inflation country to concede an additional point of inflation than it is for a country with a higher starting rate. Given their detailed analysis, the authors conclude that "efforts to keep inflation under control will sooner or later pay off in terms of better long-run performance and higher per capita income.”
Does Inflation Harm Economic Growth? Evidence for the OECD: Javier Andres, Ignacio Hernando, The US National Bureau of Economic Research, 1997
“The tests revealed that a weak negative correlation exists between inflation and growth, while the change in output gap bears significant bearing. The causality between the two variables ran one-way from GDP growth to inflation.
Correlation coefficients showed only a weak negative link, while causality was shown to run from economic growth to inflation. With the majority of Fiji’s inflation being imported, the influence of domestic factors (being unit labour costs and to a lesser extent the output gap) is limited. The findings of other empirical studies, however, provide some guidance for Fiji policymakers on the importance of maintaining low inflation, in order to foster higher economic growth. For its part, the Reserve Bank of Fiji will need to maintain monetary policy consistent with low inflation and inflation expectations.”
Relationship between Inflation and Economic Growth: Gokal and Hanif, Reserve Bank of Fiji, 2004
“ There are also significant feedbacks between inflation and economic growth. These results have important policy implications. Moderate inflation is helpful to growth, but faster economic growth feeds back into inflation.
Attempts to achieve faster economic growth may overheat the economy to the extent that the inflation rate becomes unstable. Thus, these economies are on a knife-edge. The challenge for them is to find a growth rate which is consistent with a stable inflation rate. They need inflation for growth, but too fast a growth rate may accelerate the inflation rate and take them downhill as found by Bruno and Easterly (1998).”
INFLATION AND ECONOMIC GROWTH: EVIDENCE FROM FOUR SOUTH ASIAN COUNTRIES, Asia-Pacific Development Journal Vol. 8, No. 1, June 2001, Girijasankar Mallik and Anis Chowdhury
Kindest regards,
Nicolaas Smith
Saturday, 5 December 2009
Who drives inflation - Part 1
Who drives inflation, Kalinka asked a day or two ago.
Inflation is always and everywhere the destruction of the real value of money.
Mainstream economists state that inflation is a rise in the general level of prices of goods and services in the economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation destroys the purchasing power of money – the destruction of the real value of the internal medium of exchange and unit of account in the economy. Monetarists believe the most significant factor influencing inflation is the management of money supply through the easing or tightening of credit via the central bank’s interest rate policy.
The Austrian School states that inflation is an excessive increase in the money supply by central banks. They want to ban them and go back to the gold standard.
Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied.
Rational expectations result in the outcome depending partly on what people expect to happen.
Adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past. For example, if inflation has been higher than expected in the past, people would expect the same to happen in the future.
Structural inflation (built-in inflation) is an economic term referring to inflation that results from past events and persists in the present. It then becomes a normal aspect of the economy, via inflationary expectations and the price/wage spiral.
Inflationary expectations play a role because if workers and employers expect inflation to persist in the future, they will increase their (nominal) wages and prices now. This means that inflation happens now simply because of subjective views about what may happen in the future. Of course, following the generally accepted theory of adaptive expectations, such inflationary expectations arise because of persistent past experience with inflation.
The price/wage spiral refers to the adversarial nature of the wage bargain in modern capitalism. Workers and employers usually do not get together to agree on the value of real wages. Instead, workers attempt to protect their real wages (or to attain a target real wage) by pushing for higher money (or nominal) wages. Thus, if they expect price inflation - or have experienced price inflation in the past - they push for higher money wages. If they are successful, this would raise the costs faced by their employers – if they do not inflation-adjust their selling prices – which they do. To protect the real value of their profits (or to attain a target profit rate or rate of return on investment), employers then pass the higher costs on to consumers in the form of higher prices. This encourages workers to push for higher money wages again as the cycle starts all over.
In the end, built-in inflation involves a vicious circle of both subjective and objective elements, so that inflation encourages inflation to persist.
Inertial inflation is a concept coined by structuralist inflation theorists. It refers to a situation where all prices of non-monetary items in an economy are continuously adjusted with relation to a price index by force of contracts as Brazil did for 30 years from 1964 to 1994 and as required by International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies
Changes in price indices trigger changes in prices of all non-monetary items. Contracts are made to accommodate this price-changing scenario by means of indexation. Indexation in a hyperinflationary economy is evident when, for instance, a given price must be recalculated at a later date, incorporating inflation accumulated over the period to correct the nominal price.
In other cases, local currency prices can be expressed in terms of a foreign currency: normally the US Dollar like in Zimbabwe. In some point in the future, prices are converted back from the foreign currency equivalent into local currency. This conversion from a stronger currency equivalent value (ie, the foreign currency) is intended to protect the real value of goods, as the nominal value depreciates.
In the medium-to-long term, economic agents begin to forecast inflation and to use those forecasts as de facto price indexes that can trigger price adjustments before the actual price indices are made known to the public. This cycle of forecast-price adjustment-forecast closes itself in the form of a feedback loop and inflation indices get beyond control since current inflation becomes the basis for future inflation (more formally, economic agents start to adjust prices solely based on their expectations of future inflation).
South Africa does not have inertial inflation. There is no indexation of all non-monetary items by contract.
So, Kalinka who drives inflation in SA?
We will have a look next time.
Kindest regards,
Nicolaas Smith
Inflation is always and everywhere the destruction of the real value of money.
Mainstream economists state that inflation is a rise in the general level of prices of goods and services in the economy over a period of time. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation destroys the purchasing power of money – the destruction of the real value of the internal medium of exchange and unit of account in the economy. Monetarists believe the most significant factor influencing inflation is the management of money supply through the easing or tightening of credit via the central bank’s interest rate policy.
The Austrian School states that inflation is an excessive increase in the money supply by central banks. They want to ban them and go back to the gold standard.
Economists generally agree that high rates of inflation and hyperinflation are caused by an excessive growth of the money supply. Views on which factors determine low to moderate rates of inflation are more varied.
Rational expectations result in the outcome depending partly on what people expect to happen.
Adaptive expectations means that people form their expectations about what will happen in the future based on what has happened in the past. For example, if inflation has been higher than expected in the past, people would expect the same to happen in the future.
Structural inflation (built-in inflation) is an economic term referring to inflation that results from past events and persists in the present. It then becomes a normal aspect of the economy, via inflationary expectations and the price/wage spiral.
Inflationary expectations play a role because if workers and employers expect inflation to persist in the future, they will increase their (nominal) wages and prices now. This means that inflation happens now simply because of subjective views about what may happen in the future. Of course, following the generally accepted theory of adaptive expectations, such inflationary expectations arise because of persistent past experience with inflation.
The price/wage spiral refers to the adversarial nature of the wage bargain in modern capitalism. Workers and employers usually do not get together to agree on the value of real wages. Instead, workers attempt to protect their real wages (or to attain a target real wage) by pushing for higher money (or nominal) wages. Thus, if they expect price inflation - or have experienced price inflation in the past - they push for higher money wages. If they are successful, this would raise the costs faced by their employers – if they do not inflation-adjust their selling prices – which they do. To protect the real value of their profits (or to attain a target profit rate or rate of return on investment), employers then pass the higher costs on to consumers in the form of higher prices. This encourages workers to push for higher money wages again as the cycle starts all over.
In the end, built-in inflation involves a vicious circle of both subjective and objective elements, so that inflation encourages inflation to persist.
Inertial inflation is a concept coined by structuralist inflation theorists. It refers to a situation where all prices of non-monetary items in an economy are continuously adjusted with relation to a price index by force of contracts as Brazil did for 30 years from 1964 to 1994 and as required by International Accounting Standard IAS 29 Financial Reporting in Hyperinflationary Economies
Changes in price indices trigger changes in prices of all non-monetary items. Contracts are made to accommodate this price-changing scenario by means of indexation. Indexation in a hyperinflationary economy is evident when, for instance, a given price must be recalculated at a later date, incorporating inflation accumulated over the period to correct the nominal price.
In other cases, local currency prices can be expressed in terms of a foreign currency: normally the US Dollar like in Zimbabwe. In some point in the future, prices are converted back from the foreign currency equivalent into local currency. This conversion from a stronger currency equivalent value (ie, the foreign currency) is intended to protect the real value of goods, as the nominal value depreciates.
In the medium-to-long term, economic agents begin to forecast inflation and to use those forecasts as de facto price indexes that can trigger price adjustments before the actual price indices are made known to the public. This cycle of forecast-price adjustment-forecast closes itself in the form of a feedback loop and inflation indices get beyond control since current inflation becomes the basis for future inflation (more formally, economic agents start to adjust prices solely based on their expectations of future inflation).
South Africa does not have inertial inflation. There is no indexation of all non-monetary items by contract.
So, Kalinka who drives inflation in SA?
We will have a look next time.
Kindest regards,
Nicolaas Smith
Friday, 4 December 2009
Inflation - a nebulous subject
Who drives inflation, Kalinka asked a day or two ago. As I said: that is a very sensitive question – especially in South Africa.
Inflation is a huge, hazy, vague, indistinct and confusing subject because of the monetary nature of money and the human nature of consumers and business people. We could have solved the problem very quickly if money was not a store of value (and only a medium of exchange and unit of account) and consumers and business people were not human beings. Remember, central bankers have to guess the collective effects of hundreds of millions of consumers and business people (greedy wall street bankers) exercising their individual self-interests.
I do not like discussing inflation because I question everything, I have already seen many theories disproved, I am not a macroeconomist, nor a central banker, every Tom, Dick and Harrry are experts in inflation and how it comes about is not that important to me.
It’s correct measurement is. Thank heavens for the people in the past who developed the Consumer Price Index. I could not believe it when I saw that Statistics SA had the calculation wrong in the past. That should never, ever happen.
We know exactly what the problem is in accounting: the stable measuring unit assumption and we know exactly how to get rid of it: financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) twenty years ago. When our accountants stop assuming there is no such thing as inflation and never has been in the past as far as the valuation of the reported Retained Profits and other constant items in the SA economy are concerned, there will be zero real value destruction in the constant item economy.
We will be left with the final problem in real value destruction in the three economic items. IFRS solve the valuation of variable item problems. Abandoning the stable measuring assumption will stop real value destruction in constant items. Then we are left with the destruction of the real value of money and other monetary items by inflation. The last frontier before real value Nirvana: a world where we do not destroy the real value of our medium of exchange simply by the way our economy works as our accountants are currently unknowingly destroying the real value of existing reported Retained Profits of all SA companies simply by the way they do accounting.
Accountants admit it is happening - or something is happening - I don´t think they really know what. The best they can do is to state that "inflation influences reported results". They mistakenly blame inflation as driven by the ANC´s economic policy and the SARB´s monetary policy - in their opinion. They are so wrong.
Kalinka, I still have to answer your question about who drives inflation. As you can see it is very foggy out there.
That will be in the next blog.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Inflation is a huge, hazy, vague, indistinct and confusing subject because of the monetary nature of money and the human nature of consumers and business people. We could have solved the problem very quickly if money was not a store of value (and only a medium of exchange and unit of account) and consumers and business people were not human beings. Remember, central bankers have to guess the collective effects of hundreds of millions of consumers and business people (greedy wall street bankers) exercising their individual self-interests.
I do not like discussing inflation because I question everything, I have already seen many theories disproved, I am not a macroeconomist, nor a central banker, every Tom, Dick and Harrry are experts in inflation and how it comes about is not that important to me.
It’s correct measurement is. Thank heavens for the people in the past who developed the Consumer Price Index. I could not believe it when I saw that Statistics SA had the calculation wrong in the past. That should never, ever happen.
We know exactly what the problem is in accounting: the stable measuring unit assumption and we know exactly how to get rid of it: financial capital maintenance in units of constant purchasing power as authorized by the IASB in the Framework, Par. 104 (a) twenty years ago. When our accountants stop assuming there is no such thing as inflation and never has been in the past as far as the valuation of the reported Retained Profits and other constant items in the SA economy are concerned, there will be zero real value destruction in the constant item economy.
We will be left with the final problem in real value destruction in the three economic items. IFRS solve the valuation of variable item problems. Abandoning the stable measuring assumption will stop real value destruction in constant items. Then we are left with the destruction of the real value of money and other monetary items by inflation. The last frontier before real value Nirvana: a world where we do not destroy the real value of our medium of exchange simply by the way our economy works as our accountants are currently unknowingly destroying the real value of existing reported Retained Profits of all SA companies simply by the way they do accounting.
Accountants admit it is happening - or something is happening - I don´t think they really know what. The best they can do is to state that "inflation influences reported results". They mistakenly blame inflation as driven by the ANC´s economic policy and the SARB´s monetary policy - in their opinion. They are so wrong.
Kalinka, I still have to answer your question about who drives inflation. As you can see it is very foggy out there.
That will be in the next blog.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
Thursday, 3 December 2009
Inflation at the micro level
Kalinka, yesterday we saw that no-one gains in SA from inflation at the macro level.
Who gains from inflation at the micro level?
Everyone who pays fixed prices and payments over time for the same real value – all else being equal. He, she or it gains in his or her personal or company capacity. It does not mean the economy gains. It may have the opposite effect in aggregate. See Zimbabwe.
You can see this too in very old lifetime fixed rentals in many cities in Europe. All these areas have been destroyed by these fixed lifetime rentals. The lessee or his or her grand children now pays almost nothing for apartments. This results in these apartments falling apart since the lessor does not get any money to invest in the maintenance of the building. This is however a much larger structural problem. Those lessees´ salaries were also not always inflation adjusted over the decades.
[Financial capital maintenance in units of constant purchasing power will eventually solve all these problems because its ultimate effect is economic stability in the real economy.]
Every month when inflation goes up a little, stays the same or goes down even, the real value of your Rands goes down a little, stays the same or maybe even goes up for one month.
So Kalinka, you gain when you pay the same price for the same products or services any time after a month from the first purchase – as long as your salary is inflation-adjusted with the change in the CPI too. If your salary stays the same and the prices stay the same you, obviously, do not gain.
Companies gain in the very short term by keeping workers´ salaries and wages the same while they put up their selling prices with inflation. This is very bad for economic stability. It is obviously the opposite of economic stability.
They did that in Zimbabwe. Companies adjusted their selling prices to keep up with hyperinflation but kept salaries fixed. They first killed their internal economy – the workers had no money to buy anything - and in the end they killed their money, the ZimDollar. There is no ZimDollar today.
In the case of money you borrow, you will gain if you pay a fixed interest rate and inflation increases, but, your salary has to be inflation-adjusted too.
In the case of your book:
Not to lose any real value you should increase its selling price every time inflation increases, i.e. more or less every month. This obviously depend on the market for your book. If there is bigger demand you may even increase the real price. Lower demand may induce you to lower your real price (by keeping it the same during inflation). The CPI (not inflation) was the same in Oct 2009 as in Sept 2009. You would not change your price when the CPI does not change. The CPI is an internal exchange rate inside the SA economy between the Rand and real value within the SA economy.
The CPI is just an index number at a date. Inflation is indicated by the change in the CPI over a period of time. From 1 Oct 2008 to 30 Sept 2009 annual inflation was 6.1%. From 1 Nov 2008 to 31 Oct 2009 annual inflation was 5.9%. But, from 1 Sept 2009 to 31 Oct 2009 monthly inflation was zero percent: The CPI was the same in Oct 2009 as at was in Sept 2009.
See Statistics SA
I hope this helped a little.
Next I will try and answer your question about who drives inflation. That is a very sensitive question.
As I stated before: inflation is not my forte. I am only really interested in getting rid of the stable measuring unit assumption in SA.
Kindest regards,
Nicolaas Smith
Who gains from inflation at the micro level?
Everyone who pays fixed prices and payments over time for the same real value – all else being equal. He, she or it gains in his or her personal or company capacity. It does not mean the economy gains. It may have the opposite effect in aggregate. See Zimbabwe.
You can see this too in very old lifetime fixed rentals in many cities in Europe. All these areas have been destroyed by these fixed lifetime rentals. The lessee or his or her grand children now pays almost nothing for apartments. This results in these apartments falling apart since the lessor does not get any money to invest in the maintenance of the building. This is however a much larger structural problem. Those lessees´ salaries were also not always inflation adjusted over the decades.
[Financial capital maintenance in units of constant purchasing power will eventually solve all these problems because its ultimate effect is economic stability in the real economy.]
Every month when inflation goes up a little, stays the same or goes down even, the real value of your Rands goes down a little, stays the same or maybe even goes up for one month.
So Kalinka, you gain when you pay the same price for the same products or services any time after a month from the first purchase – as long as your salary is inflation-adjusted with the change in the CPI too. If your salary stays the same and the prices stay the same you, obviously, do not gain.
Companies gain in the very short term by keeping workers´ salaries and wages the same while they put up their selling prices with inflation. This is very bad for economic stability. It is obviously the opposite of economic stability.
They did that in Zimbabwe. Companies adjusted their selling prices to keep up with hyperinflation but kept salaries fixed. They first killed their internal economy – the workers had no money to buy anything - and in the end they killed their money, the ZimDollar. There is no ZimDollar today.
In the case of money you borrow, you will gain if you pay a fixed interest rate and inflation increases, but, your salary has to be inflation-adjusted too.
In the case of your book:
Not to lose any real value you should increase its selling price every time inflation increases, i.e. more or less every month. This obviously depend on the market for your book. If there is bigger demand you may even increase the real price. Lower demand may induce you to lower your real price (by keeping it the same during inflation). The CPI (not inflation) was the same in Oct 2009 as in Sept 2009. You would not change your price when the CPI does not change. The CPI is an internal exchange rate inside the SA economy between the Rand and real value within the SA economy.
The CPI is just an index number at a date. Inflation is indicated by the change in the CPI over a period of time. From 1 Oct 2008 to 30 Sept 2009 annual inflation was 6.1%. From 1 Nov 2008 to 31 Oct 2009 annual inflation was 5.9%. But, from 1 Sept 2009 to 31 Oct 2009 monthly inflation was zero percent: The CPI was the same in Oct 2009 as at was in Sept 2009.
See Statistics SA
I hope this helped a little.
Next I will try and answer your question about who drives inflation. That is a very sensitive question.
As I stated before: inflation is not my forte. I am only really interested in getting rid of the stable measuring unit assumption in SA.
Kindest regards,
Nicolaas Smith
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.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
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.
© 2005-2010 by Nicolaas J Smith. All rights reserved
No reproduction without permission.
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