Band-Aid economics have their limitations

Several countries across the globe are in the midst of a severe economic crisis. The economic challenges they face show obvious commonalities. The affected countries are experiencing severe inflation, currency devaluations, all combined with large and abrupt portfolio outflows. Of course, the combination of these factors are putting pressure on the affected country’s public finances and external accounts.

East African Central Bank governors speak at a panel at an East African Community summit in Kigali, Rwanda (East African Community)

Universally, countries are attempting to curb inflation by raising interest rates and taxation. This is in line with the post COVID reality that in many countries broad money, or the general money supply, is now too high and fueling inflation. Accordingly, the fix is to pull money out of the market by raising interest rates on long term deposits and government bonds along with higher taxes applied to both incomes and general spending. 

While these intervention will address the immediate inflationary trends, it has other consequences. Raising interest rates and taxation will limit spending solving the immediate problem of too much money chasing too few goods. However, the decreased money supply also means decreased spending. This will eventually lead aggregate demand and consumption to drop. When consumption drops, so will spending, leading producers to produce less goods, and offer less services. As the demand for goods and services goes down, demand for labor goes down. When demand for labor goes down, unemployment goes up. 

When unemployment goes up, there is a secondary decline in aggregate demand and consumption. The newly unemployed can’t afford to buy the goods and services they once could leading producers to produce even less and lowering demand for labor once more. What will follow in future quarters in an economy is growing unemployment that will usher in a new crisis. Inflation will wane and will be replaced with higher unemployment. 

If interest rates go as high as 20 percent or more, as some developing countries have chosen to do, the problems that will follow won’t just be higher unemployment, but a more severe economic slowdown. Interest rates higher than 20 percent make the cost of borrowing too expensive for existing businesses to get affordable lines of credit, or for new businesses to borrow to start new ventures. Accordingly, domestic investment and FDI will stall.

If your currency is in a free fall, and your exports aren’t rising, there is a bigger problem beyond simple monetary and fiscal policy solutions. If capital flight has taken hold, and if worker’s remittances are going down, and your nationals see significant risk in keeping their money in their home countries and are putting their savings elsewhere, or at least not in their national currencies, there is a broader problem. This is when there is something more generally wrong with the structure of an economy and that is something Band-Aid economics can’t fix. 

Several African countries are dealing with a crisis of unparalleled proportions. Foremost among these economic challenges is the serious devaluation of their national currencies, coupled with rising inflation.

In response, select countries are now guaranteeing annual interest bearing deposits of up to 30 percent. Ask the question what justifies such high interest rates, and the answer you get is it’s necessary to combat inflation.

But, this would only be true only if the inflation you’re combating is too much money chasing too few goods. In my mind, this doesn’t pass the plausibility test.

Too much money would mean the money supply (M1) has grown to an inordinate level, and high interest rates are required to suck up the excess.

But, the countries now instituting these very high interest rates are also among the poorest in the world. In these countries, 60 percent of the population lives on under $3 a day. So, if the money supply is excessive, this isn’t induced by consumer spending. The culprit is government spending.

Inflation is likely being fueled by excessive government spending, not consumer spending. Every one of these African countries is import dependent for both foodstuffs and intermediate inputs. If your national currency has devalued from 50 - 120 percent in the last year, which is the commonality they all have, then consumer spending has already taken a hard hit. Import inflation has already put a serious damper on consumer spending. Consumer spending isn’t spurring inflation, it’s the victim of it. To offset government spending, the IMF is now telling every one of these African nations to shed state enterprises. But, this is also how these countries are generating much needed employment. Either way, decreasing government spending has nothing to do with interest rate bearing deposits close to 30 percent.

These high interest rates are clearly detrimental to private sector development. Why would anyone start a new business when you can put your money into a savings account that generates 30 percent interest? Why wouldn’t the rational investor just shudder his business, big or small, and put his money in a bank guaranteeing a 30 percent return? Why would anyone risk their hard earned cash in the stock exchange? Why would anyone borrow from banks that now charge very high interest rates on loans to make up what they have to pay on deposits?

All these countries now have one thing in common resulting from these exorbitant interest rates on deposits. Domestic investment has fallen off the cliff, and levels of consumer borrowing in select sectors have dropped to concerning levels. I fear the way these countries have tried to combat inflation is a misdiagnosis of their economic reality. The time for a rethink is now.