I’ve written in a previous article about the various concepts involved in economic inflation and how it can affect the value of your money, your wages and the things you buy.
The opposite of inflation is deflation, which I’ll explain in this article before going on to discuss the probable and possible situations in the UK for the next few years. The ‘deflation versus inflation’ argument is more important in the UK today than it has been at any time in the last 30 years, so it’s worth thinking about in some depth.
So, deflation. If inflation is a general increase in prices and/or wages driven by the greater availability of money (whether ‘real’ money or debt), then deflation is a general decrease in prices and/or wages driven by the much reduced availability of money. This is widely considered to be a bad thing.
But isn’t a reduction in prices a good thing? At a simple level, yes it is. Your wages – assuming they aren’t cut at the same rate – go further, your savings buy more over time and there’s less of a ‘treadmill’ effect where people feel that they are working ever harder to chase money to buy the same purchases, as happens in inflationary environments.
But politicians and economists fear deflation for a good reason. Fundamentally it stops the economy dead in its tracks. Nobody will buy something today that they don’t really need if they know it’s going to be cheaper tomorrow. This applies to companies as much as to individuals, which means that investment stops, companies cut back their staffing levels and unemployment rises. We end up with a deflationary spiral that’s every bit as traumatic as a highly inflationary one.
Deflation also makes it harder to pay off the principle amount of any debts, because wages tend to go down in nominal terms but the amount owed remains the same. This, incidentally, is why some newspaper pundits are now calling for deliberate inflation in order to wipe out the value of many people’s (and the nation’s) ill-advised debts, though such pundits are ignoring several important points about the banking industry’s methods of counteracting inflation through charges and wider interest rate spreads.
To summarise, deflation is great if you have plenty of cash, no debt and a very secure job. But only as long as you don’t mind living amongst poor, hungry and angry unemployed people, many of whom will be chained to debts that they will never pay off.
Both high inflation and high deflation cause problems for an economy. One can argue with some force that the UK has experienced inflation for the last decade, but that it has conveniently not shown up in the official measurements because it has mostly ended up in property. However, there has also been a spillover from property into other areas of the market (which is why the property market is seen as such a driver of the economy), so deflation, if it occurs, is unlikely to confine itself to the plunging value of your house.
As recently as earlier this year, public sector workers were being told that they had to be content with ‘below inflation’ pay rises because they must ‘do their bit to reduce inflation’, yet now we’re at a point where the Bank of England is seriously considering the money-printing option (effectively adding more money to the economy without the creation of new wealth) to combat the vicious deflation of the housing market, plummeting oil prices and falling retail sales.
This is an important point. Not only has the official line swung from inflation to deflation in less than a year, but if you look at the Bank of England’s Inflation Report going back over the last few years, you’ll find it has been hopelessly and embarrassingly wrong; in some cases real inflation has been way outside even the margin of error of the Bank’s fan charts.
Hindsight is a wonderful thing, of course, but the point I’m making here is that you would be unwise to base your expectations of the future on predictions made by any government or quasi-government organisation that has got it so badly wrong in the past.
But if we take the government and the Bank of England at their word, what we have now is a straight battle between the deflationary effects of the credit ‘crisis’ (aka sudden return to sensible lending levels) and the inflationary effects of the actions taken by the Bank and the Treasury to combat this deflation. The stated outcome is to keep inflation at roughly 2%, with a margin of error of one percentage point either way.
What is apparent from the dismal failure of inflation targeting policies to date is that any target is hit more by luck than judgement. Exactly how much money should the Bank of England ‘print’ in order to counteract the dramatic reduction in the imaginary value of the UK’s housing stock? How much extra money should be paid in tax credits, public sector wages and MP’s expenses to offset the reduction in spending by ‘hard working families’ who can no longer ‘release the equity’ in their houses and blow it all on a new car and a holiday to impress the neighbours? How will the Bank know when/if it’s achieved its aim, and to switch off the printing presses before mild inflation turns into high or even hyper-inflation?
Given the predictive abilities of pretty much everyone to date, it seems fair to assume that any success will be accidental. Failure, at least in the short term, is more likely. We can look to Japan for some hints (its property bubble burst in the early 1990s, since when it’s stumbled on with a deflationary home economy, exporting inflation to other countries via the carry trade through its low interest rates), but things are rather different here, as the UK is a nation of spenders rather than savers and will, on past experience, take on any and all debt offered. And as other countries are slashing their rates just as fast as the UK, it seems unlikely that inflation here could be exported to anywhere
I don’t know what’s going to happen. In a straight battle of market forces, I think deflation is likely in the short to medium term. But governments hate deflation with a passion and will do all they can to avoid it. Inflation is preferable to them, and not just because it’s a subtle theft of wealth from the population that encourages people to work ever harder. Given the steps this government has taken to date, I wouldn’t rule out a concerted effort to either reinflate a past bubble or inflate a new one through a significant ‘helicopter drop’ of new, debt-free money.
Unfortunately, all that would do is give us a few years’ grace before the whole thing starts again.
© Alex Cruickshank 2008
The author has taken steps to protect himself against both inflation and deflation. So he’s guaranteed to lose some money whatever happens.
