OMIGSA’s Chief economist, Rian le Roux, explains the risks of stagflation and why the current situation in South Africa should not deteriorate into anything as bad as the 1970’s and 80’s.
The chances of the South African economy lapsing into stagflation have risen in recent months, along with a similar increase in the risk of a bout of global stagflation. However, any such occurrence in South Africa will be more of a short-term cyclical phenomenon than a serious structural problem, according to Rian le Roux, chief economist at Old Mutual Investment Group SA (OMIGSA).
Moreover, says le Roux, any stagflation should be relatively mild compared to the country’s experience of the 1970’s and 1980’s, when growth averaged about 2.5% p.a. and inflation around 12.5% p.a. “Over the next two years we expect growth to average about 4% p.a. and inflation about 6.5% p.a.. While still a far better performance than that of the ‘70’s and ‘80’s, it is nevertheless a notable deterioration from the great conditions of the past four years when growth averaged 5% p.a. and inflation 4.8% p.a.”
“Stagflation” is a macro-economic term used to describe a period of relatively high inflation combined with economic stagnation (slow economic growth, often accompanied by rising unemployment). There is no official quantification for which exact combination(s) of high inflation and low economic growth officially qualifies as stagflation, so more acute and milder versions are possible.
“Stagflation typically develops because central banks fail to take tough, immediate action during the early stages of rising inflation,” explains le Roux. “Often the initial rise in inflation is brought about by an external shock (like a sharp rise in commodity prices or a currency collapse). It is then ‘allowed’ to spread structurally through the economy via higher inflation expectations and wage demands.” The reasons for central bank inaction can be varied and include: a belief that the reasons for rising inflation are beyond their control; tough action may be viewed as too painful for the macro-economy; or political pressure may prevent the central bank from acting decisively. Other factors that contribute to inflation becoming entrenched are protectionist policies, fiscal indiscipline and a serious loss of investor confidence, which, in turn, causes an extended period of acute currency depreciation.
As inflation becomes entrenched, shorter-term cycles in inflation and interest rates become more violent and boom/bust growth cycles typically become the norm. Gradually business and consumer confidence becomes structurally depressed, business planning becomes short term, often with a strong survivalist focus, and investment, the cornerstone of economic growth, eventually falls away structurally. Serious stagnation ensues.
Eventually, the only way to get out of the grips of stagflation is for the authorities to take a tough anti-inflation macro-economic policy stance (both monetary and fiscal). This must send a clear message that the authorities are intent on getting inflation under control, irrespective of the inevitable short-term pain, and that they will address the structural forces that contributed to past high inflation. These would include removing overly protectionist foreign trade policies as well as regulations that inhibited domestic competition. Eventually, in the same way that growth became structurally depressed via higher inflation, growth structurally recovers as confidence in future policies is restored.
Of course, failure to take the corrective actions described above or, worse, intensifying the misguided policies that led to stagflation, will quickly cause the situation to degenerate into full-scale hyperinflation, macro-economic depression, a completely worthless currency and a complete loss of capital and skills. Typically, the only ones to benefit from such a situation are the very policymakers, including politicians, in charge of policy, while the broad population degenerates into acute poverty. Zimbabwe today is a prime example of such a tragic macro-economic disaster. Correcting such a situation eventually requires intensely more pain than getting out of a serious bout of stagflation.
Le Roux believes that, although the risks are rising, the current situation in South Africa will not deteriorate into anything as bad as the 1970’s and 80’s or a Zimbabwe-style disaster.
“While there are clearly still upside risks to inflation over the medium term, the Reserve Bank’s tightening over the past two years has not only already started to slow domestic demand, but the Bank has also made it clear that it intends to get inflation back into the 3% – 6% range in due course. There is therefore no reason to believe that the Bank will not act decisively should inflation expectations and/or wage demands begin to pose a structural risk to inflation.”
Wage demands could prove to be challenging this year, however, he notes, given that negotiations will be taking place while CPIX is hovering around 9% y/y.
On broader macro-economic policy, he says, one has to assume that the ANC’s new policymakers will take a cue from Zimbabwe and our own past mistakes and not err too far on the side of populist policies. Such a policy outcome will rapidly drive away capital and skills, two ingredients without which South Africa has absolutely no hope of growing faster, create more jobs and alleviate poverty on a more sustainable basis. “The recent rapid fall of the rand should serve as a warning to future policymakers of the speed with which confidence can be damaged and capital and skills head for the exits.”
So, assuming a continuation of pragmatic policies, a now more competitive currency and an accelerating public infrastructure investment programme, le Roux believes the current slower pace of growth should prove to be transitory. “Beyond the next two years, growth should gradually begin to accelerate again beyond 4%, especially once global conditions begin to improve.”
The main risks to this scenario, le Roux believes, are twofold. First is that global policymakers allow the world to, once again, get trapped in stagflation. Such a global outcome would likely spread to South Africa, too. The second risk is that of serious, structural policy slippage in South Africa.
Misguided policies could spell disaster, he notes.
While global developments will have a key influence on the longer-term economic outlook for South Africa, local policy choices will likely prove to be far more important, concludes le Roux.