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Opinions of Tuesday, 16 May 2006

Columnist: Bannerman, Nii Lantey Okunka

Today?s Menu: ?Cooked? inflation rate or inflating the inflation effort?

In his May Day speech (May 1, 2006), President Kufour reiterated his administration relentless ?fight? against inflation; this effort, he says, has resulted in a reduction in the inflation rate from about 42% in 2001 to 9.9% as at March 2006. Some have boldly questioned the accuracy of the government?s claim. Dr. Nii Moi Thompson, for example, would like the government to report the month-to-month rate (as opposed to the year-on-year rate). Mr. Moses Asaga the minority spokesman on Finance and Economic Planning called the 9.9% inflation rate, simply, a ?cooked? figure. Deputy government statistician, Prof. Nsowah Nuamah?s effusion that plans were afoot to rebase the consumer price index (CPI) to more current patterns of the population and thus changing the base from 1997 to 2002 may be clear proof that there is more to this inflation game than meets the eye. This should tell us that something is stale in this effort to hoist the right inflation figure.

Our interest lies in the following questions: (1) why is the government so obsessed with the rate of inflation? (2) How could the rate be possibly falling when, as Mr. Asaga noted, crude oil prices have been increasing? (3) why are we people workers 20% more if prices are stable and interest rates are low? (4)What should be the optimal rate of inflation for Ghana? (5) What else should we be looking at besides inflation? (6) Is very low inflation rate harmful or beneficial to the Ghanaian economy?

Let?s begin with some basic ideas on inflation, and why the rate can get out of hand. Statistically, inflation is defined as a persistent rise in the cost of the typical basket of goods and services consumed by the average household. Inflation is a situation where too much money chases too few goods with limited supply in the background. It can either be demand induced or cost inspired. The statistical service determines the basket of goods for the Ghana Living Standards Survey (GLSS). At the moment, there are 242 goods and services on this list, and the prices of these goods go into the computation of the inflation rate.

So it is conceivable that the fall in the rate may just reflect households substituting away from more expensive goods. To illustrate, suppose in 2001, the basket of goods is made up of a 2lbs beef, ?dumas? wax cloth, and beer. Consequently, the inflation rate will be calculated based on these goods. But if the average household is no longer able to afford these, then they might substitute consumption with a set of cheaper goods: for example with ?koobi,? a made-in-China wax cloth, and ?akpeteshie?. Note that, at issue here is not only the cheap cost but also the weights that the statistics folks attach to the new set of goods. The inflation rate, computed with this new basket of goods, may be lower, and could signify a fall in living standards, thus bad news for families. More generally, it is important that the basket of goods used by the statistical service accurately reflects what the average home consumes and be current; else the reported rate will be misleading.

The rate of inflation in Ghana has been high over the last 2 decades, and here are a few reasons why this is so. Our currency, the cedi, is ?legal tender for the payment of any amount,? says the government. But fundamentally, our willingness to accept some piece of paper for services rendered (e.g., a day?s work) is motivated by two factors: (1) we expect someone else to accept it (and that means enough goods out there) when we are ready to use the money; and (2) we are trusting the government not to print too much of the cedi, else its value will fall. The first point is related to the productive capacity of the economy: If I don?t expect the goods to be there when I need it, then why will I accept money now? If no one is willing to accept the cedi, the value falls (or put differently, prices rise). Similarly, if the Bank of Ghana prints too much of the cedi, the value falls. So in order to have an efficient monetary system, it is imperative that the monetary base (i.e., notes and coins) issued by the Bank of Ghana be consistent with the economy?s gross domestic product (or GDP, the value of goods and services produced in the same period).

As population grows, example Ghana, so does the demand for goods, infrastructure and services. If this demand is not met by increased output or production, this discrepancy in high demand and low supply, will lead to price increases thus devaluing the buying power of the cedi. This is referred to as demand pull inflation. Without any solid industrial base to meet local needs, the potential for this occurrence is very bright.

Remittances may also have contributed to the growth in domestic prices, but it is hard to determine the exact contribution. Remittances are estimated to have increased from a total of $200 million in 1990 to about $4.5 billion by 2005; about 45% of total GDP. Now, consider the $100 you recently sent to the family in Ghana. If it was meant to supplement the family?s income, then this will represent a pure transfer of money (with no reciprocal economic activity at the receiving end). And each time the recipient walks into the Forex Bureau and buys Cedis, the remittance causes Cedis to circulates faster (i.e., the cedi changes hands more frequently). In a way, this is tantamount to ?too much money chasing goods,? and it puts an upward pressure on prices. Remittances on the other hand may also end up shoring up the cedi. The more remittances that flow into the country, the less impact any upward pressures on foreign currency demands may have on prices. To mitigate the effect of remittances on prices, the Bank of Ghana has to closely monitor the flow of remittances, have a decent idea on the proportion that goes directly into consumption, so as to ?mop up? offsetting monetary base in order to keep the total money supply in line with total output. Obviously this is not going to be easy since the Bank of Ghana has no way of knowing about all the remittances that do not pass through formal channels.

Finally, our own expectations that prices will rise can be self-fulfilling. Suppose the market (i.e., workers, homeowners, investors, etc.) expect prices to increase (because it has been increasing in the past), then economic decisions will be impacted by the expectations of future price increases. So for example, (i) the homeowner will charge a high rent, and/or seek a 2 or 3-year advance-payment now; (ii) workers might ask for higher salary on wage contracts, and (iii) the money lender will seek a higher interest rate to compensate for the future price hike. In each case, the price will to too high for renters, employers and borrowers. The ?dollarization? of the economy could be a signal that people take the expectation of price increases rather seriously and closer to reality. They believe it!!! The government is often faced with the stark choice of: either increasing the monetary base so people can afford these high prices (but that will fulfill the market?s expectation of inflation), or twiddle it fingers and allow the economy to stagnate for a while. More often than not, our monetary authorities accommodate these inflationary expectations.

The above summarizes our opinion on why inflation has been high in Ghana. But, is a very high inflation rate harmful to the economy? The simple answer is yes. When prices are high and rising, it hits us in our pockets. Families are no longer able to live off their paychecks, so they resort to corruption or exert pressure on employers to increase wages. If these wage demands are not matched by increased productivity, the employer will have to let some workers go. The latter in turn lead to increases in unemployment. It is for this reason and many more that the current 20% increase in public sector pay is very troubling. Let us be clear, we are not against it but it seems to contradict the austere mop up job by government. Note also that, often, such public sector pay increases induces similar increase in the weak private sector. The net result is that, liquidity is significantly increased again since workers have immediate need to spend.

High inflation also hurts firms? ability to access loans. Households provide the supply of loans (i.e., the amount available to be lent out). But in a high inflation period, savings are low for two reasons: (a) we simply don?t have enough left over after consumption, and (b) our expectations of even higher prices in the future become a disincentive to save. In other words, by the time you withdraw your money from the bank, inflation has ?eaten it away.? So, why save? You might consider saving if the bank promises very high interest rate to compensate for anticipated high prices. But the bank can only do so if it can pass this cost onto borrowers (firms). Since firms may not be able borrow at such high rates, output slows down and the economy is unable to create jobs. Again, unemployment rises. The bottom line is that, today?s high inflation feeds into expectations of even higher future inflation. All together, these cause the economy to stagnate.

On the flip side, low inflation removes the inflation-premium on interest rates, and the resulting low interest rates can stimulate investment. So we can see why a government that wants to stimulate growth in the economy will be inordinately fixated on inflation. And we believe the government is doing all it can to alleviate this inflation canker. For example, the Bank of Ghana now controls money growth more tightly and monitors remittances very closely. Points of payments of remittances (e.g., Western Union) report remittances flow to the Bank of Ghana. The Bank also estimates how much more may have been remitted through unofficial sources (e.g., friends or relatives). These new procedures may be helping in lowering the inflation rate, but is the Bank of Ghana?s relentless ?war on inflation? the right thing to do?

First, let us look at a wrong reason. Ghana is now a highly indebted poor country (HIPC). That means, our donors want to see us ?rehabilitated? and turned away from our free-spending habits before new lines of credit are restored. The West now wants to give money to good governments, and their assessment of good governance is based on universally-accepted standards (i.e., indicators) such as pro-market reforms, fiscal discipline, low inflation rate, etc. This is not necessarily a bad idea. In fact, Ghana will soon receive $500 million grant under the Millennium Challenge Account (MCA) for its performance. However, we hope that the government?s effort to reduce inflation is not driven purely by the ?fine aroma of MCA greenbacks.? That will be a mistake. At best, the government stands to be accused of ?fudging figures? (i.e., cooking the rate); and at worst, the timing of our anti-inflationary policy will be incompatible with poverty-reduction, welfare-enhancing policies. The tricky part of all this is that, inflation (and in particular, changes in relative prices) is not necessarily evil or a bad thing. In a market economy, relative prices act as signal of what our society values. A high price for rice may signal an increasing demand, and so more resources will be allocated to the production of rice. Same with occupational choices: If lawyers earn more than engineers, then more people may choose to go to law school. Thus excessive price controls, as in the 1970s and 1980s, can be disruptive and lead to misallocation of resources. If the market is allowed to operate with minimal interventions, then (relative) price changes can be very useful. Targeted capital investments may not be a bad idea after all.

Secondly, inflation can be likened to room temperature: you don?t want it too hot or too cold. An aggressive anti-inflationary policy reduces effective demand, providing less incentive for firms to produce. On the other hand, a high inflation regime increases the cost of doing business. The trick, therefore, is to keep it at an acceptable level among other factors. But the question is, what should be the target rate? Should it be 10%, 2% or 0%? Unfortunately, no simple answers here. The determination of an inflation target is a search process; part of a complete diagnosis of our economy. The key here is the economy?s ?potential growth,? and this has more to do with technological growth, human capital, demographics, institutions, and perhaps, a cultural shift. For example, the economy of Ghana is reported to be growing at a real rate of 4.5%. This means that, on average, if I borrow 100 cedis and invested in Ghana, I should get a return of about 4.5% plus inflation. So if the inflation rate is 9.9%, then I expect to be charged a rate of about 14% on the loan. Anything higher, I will be looking for the door marked ?exit.? But where in Ghana can you find a loan-rate of 14%? The best rate (i.e., for good-credit rating) is about 24.5%. So either (1) banks are charging about 10% more to compensate them for a good-credit risk; or (2) the inflation rate is higher than the reported 9.9%. The latter point is reinforced by a recent proposal to increase public sector wages by about 20%; a rate that will be consistent with reported inflation rate plus the 10% discrepancy.

Either way, interest rates are still too high. At the current rates, only the very high-growth sectors (e.g., communication) can afford to take loans, with most small-scale businesses left out. Even then, investment and firm capacity takes time to build. So anyone looking for a desirable outcome from the declining inflation rate will have to wait much longer. Are there other channels through which efforts to a lower inflation will payoff quicker in Ghana? Unfortunately, not much! Take for example, the real estate market. Suppose we have a ?real? real estate market, where every homeowner has a title to their home. Then the value of their homes will increase each time inflation and interest rates falls (because real assets become more attractive with falling rates). Homeowners can then borrow against their homes, or simply refinance their homes at a lower rate and this will put extra cash into their pockets. In other words, their investments pays off each time rates fall, yielding money that can be used to boost consumption, and hence output. This direct and immediate ?wealth effect? of low interest rates is missing, because many homeowners have no titles to make it possible to ?collateralize? their homes. We need to fix our asset/real estate markets so as to make monetary policy more effective.

The naked truth is that we are running and forcibly executing western economic dogma without western economic structures to boot. This therefore makes it impossible to reap the full benefit of inflation reduction efforts. For example, why worry about inflation reduction when your private sector barely exists? The mechanism, fiscal tool and financial policies that make it possible for the citizenry to enjoy low interest and mortgage rates are just not there. The average farmer or civil servant is not in a position to walk into any bank to obtain a loan to either increase production or renovate his or her house. The point that ought to be forcefully made here is that, without addressing the fundamentals like ID systems, address system, property registration system and land reform, we will not make the kind of economic progress that we hope to. What we are currently doing is like building a house without foundation. All it takes is one good rainfall and our house will wash away. Also, inflation reduction must be in conjunction with other economic tools. A systems approach may be much more effective.

We also need to save more to keep borrowing rates at growth-promoting levels. One way is to devote greater attention to the basic needs: food, affordable housing and health. These three together form a large component of household expenditure. We have to reduce the rural-urban divide. This will mean a concerted effort to shift resources into the provision water-pumps to grow food, improve both food security and access to food, and health care; the sort of investment that will reduce expenditures on basic needs so households can save for the long-run. The savings can then be channeled into investments. Having said that, we conclude with a troubling observation. Ghanaians are increasingly buying from elsewhere (e.g., China) at competitive prices. This can be both good and bad. On one hand, this means low inflation, and consumers get cheaper products. But too much of the cheaper imports destroy Ghana?s productive capacity. And if that happens, we will remain less competitive even after interest rates have fallen enough. This is why we must find ways to develop local industry that produces at competitive rates. But we must also make it easier to do business in Ghana by removing the many bureaucratic hurdles.

Nii Lantey Okunka Bannerman and Edward Kutsoati

Views expressed by the author(s) do not necessarily reflect those of GhanaHomePage.