economonkey

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.

Although most people have a rough idea of how the UK economy works (or, if you’re being cynical, doesn’t work), the functions of the various components and their relationships to each other can be quite elusive. We’ve covered some aspects of money on this site in the past (here, for example), but there’s more to the economy than money itself. In fact, arguably more important than money is the way in which that money is moved around the economic system of the UK.

Over the next few articles I’m going to look at each of the main institutions involved in the movement and management of money in the UK. I’ll be looking at the Treasury, the FSA, the City of London as a whole and, to start with, the Bank of England (you may have spotted the one glaring hole in this list, more important than all the rest, which I’ll cover at at a later date).

The Bank of England is not a bank in the traditional sense. You can’t deposit your money there directly, and nor can you borrow from it directly. Banks, however, can. This is the fundamental aspect of one of the Bank’s stated core purposes: to maintain financial stability in the UK economy. By lending to banks that are suffering from cash-flow problems, unusual circumstances or moronic management, the Bank can act as a buffer to prevent problems in one area of the economy spilling over into others. Hopefully.

To quote from the Bank’s own documents: “Financial stability entails detecting and reducing threats to the financial system as a whole. Such threats are detected through the Bank’s surveillance and market intelligence functions. They are reduced by strengthening infrastructure, and by financial and other operations, at home and abroad, including, in exceptional circumstances, by acting as the lender of last resort.”

You may feel a hollow laugh coming on at this point, given the last year’s experience of a crumbled, nationalised bank, a bursting bubble of overpriced housing, rising inflation – especially in food and fuel – and incomes that fail to match expenses. It doesn’t look much like financial stability, does it?

Put two economists in a room together and you’ll get three different opinions on the state and future direction of the economy. Surely economics, the dismal ’science’, could learn something from one of the true sciences, such as physics?

Certainly there have been efforts to do so, particularly among large investment banks and hedge funds, who have used quantitative analysis tools running on powerful computer systems to try to tease out the signals from the noise of price movements, taking into account thousands of different influences from interest rates to tax variations, asset prices to currency exchange rates and much more, all on the basis that there is some underlying predictability, some ‘law’ that governs price movement.

Which makes it all the more surprising that so many of them got it so spectacularly wrong; to the tune of $188 billion and counting. Why?

It sounds like a daft question, doesn’t it? Money is the notes and coins in your pocket, the numbers on your bank statement, the limit on your credit card. You use it to buy things. Simple as that.

However, as with many seemingly daft questions, this one is worth scrutinising more carefully. For instance, why are those particular notes and coins ‘worth’ something? Why can’t we make our own? Why do we need money in the first place? How do the electronic numbers in bank accounts become the ‘real’ notes and coins in our hands? All of these questions and more spring up when we ask what money is.

Not all the questions can be answered in one short article, but we can lay the groundwork here. We’ll start with a basic premise and work upwards. Here goes: money is a medium of exchange.

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