Why Zimbabwe is now in the grip of deflation

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IN most parts of the world, prices have risen steadily for decades. While some things — computers and electronic products, for example — have become cheaper over time, the prices of most goods and services have risen inexorably. In SA, prices overall as measured in the consumer price index are today 70 times higher than 50 years ago.
Occasionally, individual countries, such as Japan, have experienced steady falls in overall prices. Because falling prices, or deflation, are always accompanied by economic stagnation, central banks usually react aggressively to counter it. Japan’s failure to counter deflation has led to two decades of poor economic performance.
Prices are also falling in Zimbabwe. That this should be happening in a country that only recently experienced the highest hyperinflation in history is, at first glance, astonishing. Yet the two are directly linked. Hyperinflation led to the adoption of the US dollar as Zimbabwe’s national currency. This is now causing deflation.
Economics students are taught that the supply of money in an economy, multiplied by the velocity at which this money circulates, is always equal to the overall level of prices multiplied by the quantity of goods consumed. This relationship is arithmetically always true. It was used by some economists to explain the high inflation that occurred in most countries in the 1970s.
Monetarists, led by Milton Friedman, argued that inflation was caused by rapid increases in the money supply. To cure inflation, central banks should limit growth of money supply. Many central banks responded by setting targets for money supply growth. For a variety of reasons, these targets were seldom met.
Instead, increases in interest rates were then used by central banks to successfully reduce inflation in the 1980s.
As Zimbabwe uses the US dollar, its supply of money is limited to the circulation of dollars locally. This is compounded by a poorly functioning banking system. Because of the trauma of hyperinflation, most transactions in Zimbabwe today are paid in cash. When salaries are paid into bank accounts, they are withdrawn almost immediately. Even this is restricted, as banks lack the dollar notes their customers require. Because of the shortage of notes, their owners hoard them as long as possible.
This means the supply of dollars in Zimbabwe is limited and their velocity of circulation is low. The result is that prices are falling and economic activity is stagnant. The International Monetary Fund calculates that consumer prices fell 1.6% last year and gross domestic product grew 1.4%.Advertisement

A further problem for Zimbabwe is that the rand has weakened rapidly.
This means the prices of goods produced in SA, costed in Zimbabwe in dollars, are falling rapidly. Zimbabwean consumers are encouraged to replace domestically produced goods with South African imports, putting further pressure on their country’s domestic output and jobs.
How can Zimbabwe remedy this? Neither of the traditional tools for economic stimulus — monetary policy (interest rates) and fiscal policy (government spending and taxes) — are available to the Zimbabwean government. The weakness of the banking system renders monetary policy ineffective. And as the government is already struggling to pay its wage bill, it cannot increase spending or cut taxes.
The painful memories of runaway inflation are so fresh that Zimbabwe is unlikely to reintroduce its own currency soon. Any attempt to do so would lead to runs on the banks and hoarding of dollars on such a scale that economic activity would grind to a halt. To increase the available dollar supply, Zimbabwe needs to export more than it imports, or attract foreign inflows. A trade surplus is unlikely when domestic production is so weak and the dollar is strengthening so rapidly against the rand. Attracting capital inflows requires policy changes that are politically unacceptable.
Sadly, the most likely outcome is continued economic stagnation and growing reliance by many Zimbabweans on remittances from abroad.
This article was originally published in timeslive.
*Gavin Keeton is with the economics department at Rhodes University