Hamish McRae: It's OK to feel a little deflated

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Prices in the shops are going down but prices of houses are going up. Wages are going up but for many people just retiring, pensions are going down. Or more mundanely, train fares are going up but air-fares are coming down.

Prices in the shops are going down but prices of houses are going up. Wages are going up but for many people just retiring, pensions are going down. Or more mundanely, train fares are going up but air-fares are coming down.

We're in a world of price stability, orvery close to it, but that does not mean that prices stay the same. Relative prices change in response to changes in supply and demand and advances in technology. But in a world of inflation that simply meant that some prices rose faster than others and it was quite hard to spot the relative changes. Now the shifts are much more explicit: you can clearly see the changes. And that will change the way society behaves.

Some perspective. The overall level of inflation in the Group of Seven largest economies is now on average about 1 per cent, well below the level at the beginning of the 1960s, as the left-hand graph shows. Very few people in the workforce today have experienced such low inflation during their working lives.

In Japan, where the overall price level has been stable or falling for the last four years, this is a new experience for just about everybody. But even here, though there is a little overall inflation, it is entirely in the service sector of the economy. As the middle graph shows, prices of goods are now clearly negative and have been flat for the past two years. Anyone in the goods business, from manufacturer or importer through to retailer, is operating in a world where prices are as likely to fall as rise.

On the other hand, service sector inflation looks embedded. It is much harder to achieve productivity increases in most service industries than it is in manufacturing – that is one of the key reasons why manufacturers are cutting jobs and services increasing them. So if money wages are going up by around 5 per cent, prices will have to go up by, well, at least 3 per cent. Expect these trends to continue: things will get cheaper, services more expensive.

But what about assets? We have plenty of practical experience of the volatility of asset prices. The plunge of hi-tech shares over the last 18 months may not affect very many people directly, but the fall in share prices generally, coupled with low interest rates, has savaged the value of defined contribution pensions. Typically a pension taken now will give an income up to one third lower than one taken two years ago: not only has the size of the pot of money fallen but annuity rates have fallen too.

By contrast, the value of most houses has risen by up to one-third over the same period – giving an enormous twist to the fortunes of many people. The capital value of the pension and the value of the home are most people's largest assets. If one suddenly collapses while the other soars, wealth is redistributed in a completely capricious way. Inflation redistributed wealth capriciously too, but the money value of most things, fixed interest securities apart, usually still rose. So the redistribution was not so evident.

It is because generally stable prices make relative price shifts and transfers of wealth more explicit, that you can expect people to become much more concerned about them. This will show up in a number of ways. For a start, both companies and individuals will become more cautious about taking on debt, veen though the lower interest rates associated with low inflation cut the cost of servicing that debt.

In Britain, there is a worry that consumers are using debt to sustain their spending habits. There is certainly a theoretical danger of a downward spiral. If people were to cut their borrowing, economic growth would slow, people would lose their jobs and be unable to service their debts, and so on. In practice, the proportion of income people are using to service debts is little more than half the peak of the late-1980s (see right-hand graph) and did not rise much through the 1990s. The rise in debt has been offset by the fall in interest rates.

Still, debt has to be repaid. When people knew they could repay in inflated currency it was rational to borrow without too much worry. Inflation eventually bailed out most of the people who bought houses at the property peak of 1988.

But it is not rational to risk over-borrowing in a world of deflation. Then the money that is doing the repaying is worth more than the money originally borrowed, not less.

This is happening in Japan at the moment. Interest rates are minimal but because the money has been invested in assets that keep falling in value, the collateral against the debt keeps falling and the real value of the debt keep rising. Result: individuals, companies, banks and the government are bound up in mountains of debt, much of which can never be repaid.

Mercifully, signs that the Japanese disease is contagious are limited. Debts in other developed countries are less burdensome, the banks are stronger, the experience of falling prices less evident. But there is that danger, and in any case we should expect social changes to follow even from our own limited experience of deflation.

These might include a general aversion to debt – as was evident in unwillingness to take out larger mortgages in the early 1990s – and a tougher response to price increases. Indeed, once people become accustomed to prices in the shops falling (as they are now) they may become much less tolerant of prices rising for services like public transport. You can see something of that, in the growth of budget airlines like Ryanair and EasyJet, the pressure on supermarkets for overcharging, and the attack on UK car prices.

We are already becoming accustomed to the world of deflation. Expect to become more accustomed in the years ahead.