Is South Africa headed for a battle between the twin evils?

There has been a recent revival of an old 60’s classic that largely lost favour in the early 70’s as more progressive ideas came to the fore – the Phillips curve. For decades the debate on the trade-off between inflation and unemployment raged among economists. The idea that the trade-off exists was formalised by the economist William Phillips in his landmark paper published in 1958 titled, ‘The relationship between unemployment and the rate of change of money wages in the UK 1861-1957’.

The belief that a trade-off exists between inflation and unemployment gained momentum throughout the 60’s when both inflation and unemployment were generally low and increases in unemployment were often accompanied by decreases in inflation and vice versa. The original Phillips curve was essentially a statistical device, which focussed exclusively on data taken only from the UK and Germany. However, in the 1970’s both inflation and unemployment increased simultaneously, resulting in a phenomenon commonly referred to as stagflation and the notion that there was a predictable relationship between unemployment and inflation lost favour amongst most macroeconomists.

World-renowned economist Milton Friedman had his doubts about the practicality of the Phillips curve even before it’s hey day in the 1960’s. He argued that workers would demand higher wages to protect themselves from the rise in inflation and therefore any artificial stimulus from the government would be to increase inflation for the same level of employment. So, as a result of the simultaneous increases in unemployment and inflation a number of new theories developed and evolved in the economic literature for the last 40 years.

The consequences of each of these two evils – inflation and unemployment – should be clear to the majority of South Africans. For a lesson on the consequences of inflation we only have to look as far as our neighbour Zimbabwe, where inflation is currently in excess of one thousand per cent. This is an extreme case but nevertheless provides some insight into inflation’s negative effects.

Under inflationary conditions it becomes impossible to plan or to make any rational economic decisions, as people are more concerned with anticipating inflation than with seeking out profitable new production opportunities. Individuals spend almost all of their income on consumption and virtually no money is saved. But the importance to society of savings is critical. Savings lead to investment, which finances the purchase of machinery, equipment and research and development. These types of investments make workers more productive and result in higher wages. In the absence of savings, individuals become worse off and their quality of life declines.

Inflation also has negative implications for trade because it adversely affects the competitiveness of export industries and import-competing industries. The negative consequences for industries can be compensated by a depreciation of the currency but this is just a temporary remedy that raises the cost of imports and increases their prices. Furthermore, inflation benefits borrowers at the expense of creditors because it erodes the real value of money. Given that government is generally the biggest borrower, inflation invariably redistributes wealth from the private sector to government. A stable money supply is therefore imperative.

The consequences of unemployment for the majority of South African’s are clear and omnipresent. Chronic unemployment has firmly established itself as a regular fixture in our economy. According to the latest labour force survey conducted by Statistics SA, the official government statistical agency, approximately 4.2 million potential workers were unemployed in SA, which equates to an official unemployment rate of 25.6%.

If we include discouraged work seekers, those that have given up searching for work because they believe that there is simply no work available, the number of unemployed jumps to 7.9 million, representing an expanded unemployment rate of approximately 39%. Levels of unemployment have remained relatively stagnant at these unacceptably high levels for decades. We would of course expect to find people who are between jobs reporting themselves as unemployed even in a healthy economy so some unemployment is natural.

However, there is nothing natural about an unemployment rate of between 26- and 39%. Clearly the unemployment problem does not stem from a lack of supply of labour, nor is it due to a lack of demand for labour. The problem lies in the fact that there are simply too many constraints to hiring those that are currently unemployed. Indeed, small and medium sized businesses find it difficult to hire people on short notice, and similarly find it difficult to fire people on short notice when there is a dampening in demand – for instance, when interest rates are forced higher.

Reducing chronic unemployment in SA therefore requires government to remove artificial constraints on the functioning of the labour market. Increasing the rate of inflation through expansionary fiscal or monetary policies will certainly not lead to a reduction of unemployment, as Phillips originally suggested. This one-size-fits all approach is clearly not appropriate for a developing country such as SA. Rather, the solution is not to abandon the market or to dictate to it by setting artificial barriers, but rather to make it more efficient and to remove constraints that have been imposed upon it.

Author: Jasson Urbach is an economist with the Free Market Foundation. This article may be republished without prior consent but with acknowledgement to the author. The views expressed in the article are the author's and are not necessarily shared by the members of the Free Market Foundation.

FMF Feature Article/ 09 January 2007 - Policy Bulletin / 25 August 2009