Hamish McRae: Governments will use inflation to cheat their way out of debt

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The Independent Online

Well, the first Budget of the year is over and the second one is to come.

Yes, even were Labour to get back there would have to be another Budget to clarify the details of the forthcoming squeeze on public spending and the further tax increases in store. The common feature of both main parties' plans will be – because there has to be – a credible programme to get the deficit down over the next five years. Even so, the country will have to add something like £600bn to the national debt. Investors being asked to stump up their savings might reasonably ask how they are going to be repaid.

Of course, it is not just Britain that is in a mess. Nearly all other developed countries are trying to cope with the surge in their borrowing needs in the coming years. They are taking part in a beauty parade before global savers, and the less attractive they appear, the higher the rate of interest they will have to pay for their money. This is partly about numbers, including the size of the stock of debt and the rate at which it is rising. But it is also about trust. To what extent can a country be trusted to pay its debts? We have seen just last week what happens to a country when trust evaporates: in effect, Greece has to hand over control of its fiscal policy to the European Union and the International Monetary Fund.

But the pressure on all governments will be to try to minimise the burden of debt, and one way of doing that will be to try to erode its real value, either by devaluing the currency and/or by encouraging inflation. This cannot, of course, be done openly. It has to be done by stealth. Some countries are more to be trusted than others. At the top of the trust league come Germany and Switzerland; the US and UK are in the middle; then, in Europe at least, Greece comes at the bottom. The more you are trusted, the cheaper you can borrow. The league table changes and perceptions shift. A couple of years ago, the UK could borrow 10-year money at the same rate as Germany. Now it costs us nearly a percentage point more: on Friday, Germany was paying 3.15 per cent, the UK 4.03 per cent.

One of the largely unwritten stories is how the UK's commitment to controlling inflation has gradually slipped over the past decade. You may recall that when the Bank of England was given its independence to set interest rates it was required to hold inflation close to 2.5 per cent, as measured by the Retail Price Index (RPI), excluding the swings in the index brought about by interest-rate changes. Then the target was switched to the European harmonised index, which is calculated differently, excludes housing costs, and tends to show a lower outcome. It was renamed the Consumer Price Index (CPI) and the target central point was set at 2 per cent.

The trouble is that though the official target has not changed, the Bank has tended to overshoot it. Over the past four years CPI inflation has averaged 2.8 per cent, well clear of the target. Worse, the Treasury assumes that real inflation in the economy will continue to run above the CPI target. True, its fiscal consolidation plan (which most of us think is inadequate) is predicated on CPI inflation at 2 per cent from 2012 to 2015. But the wider measure of inflation in the economy, the GDP deflator, is assumed to rise to 2.75 per cent, while the RPI is assumed to run at 3.25 per cent.

You see the point. On the face of it the Government is sticking to its 2 per cent CPI target. Inflation at 2 per cent and bond yields at 4 per cent would give the saver a real 2 per cent return on savings, if you ignore taxation. But look at the fine print on page 182 of the Budget report and you see there has been a slither from the commitment of the early days of the Bank's independence. The Treasury is actually assuming RPI inflation will be 0.75 per cent above the original 2.5 per cent central point. Think of it that way and the real return to the investor in gilts is only 0.75 per cent. If he or she pays tax on the interest, that turns into a negative return. Suddenly, UK government stock looks a dreadful investment.

But so, too, does all investment in government stock, given the pressure on governments around the world to cut the real value of the debt. We are not alone here. Indeed, it may be that the world is in the early stages of a long cycle during which there will be a return to higher inflation.

Back in 1925 the Russian economist Nikolai Kondratieff published a book, The Major Economic Cycles. In it he set out the idea that there were long waves of 50 to 60 years' duration, during which prices tended to rise and then fall. This work was developed by another economist, Joseph Schumpeter, who also incorporated Kondratieff's work with that of the French economist Clement Juglar, who had observed that there was a business cycle of seven to eleven years. Most of us are all too aware now of the force of the Juglar cycle, for that was the one Gordon Brown sought to abolish, but studying Kondratieff is thought to be a bit nerdy.

Well, have a look at the graph. It has been pulled together by Simon Ward, chief economist at fund managers Henderson. It shows, on the left-hand side, the swings in price levels from 1790 through to 1940; and, on the right side, the swings in the annual rate of inflation from 1950 onwards. From 1950 through to the mid-1970s there was a surge in inflation, with a peak in 1974. Then inflation gradually declined, hitting bottom in 2001, from which it has gradually climbed. Long-term interest rates lag behind inflation by about seven years, so they peaked in the early 1980s and they hit a trough in 2008/9. Now they are set to rise. The peak of inflation, if you buy the idea of such a cycle, will be around 2028, with interest rates again lagging behind a bit. Cynics might observe that 2028 is around the time when the UK might have got its national debt back to below 50 per cent of GDP.

What should we make of all this? I have always felt intrigued by the idea of a long-wave cycle, but have been more convinced of the usefulness of the seven- to eleven-year business cycle as a basis for planning. We have just had a classic, though particularly serious, downswing. We can now be reasonably confident of the growth phase, but we should recognise that there will be another recession in another seven to eleven years' time. Getting public finances into reasonable shape before that hits us is the great challenge facing all developed countries, especially our own. But, from an investment perspective, the Kondratieff upswing in inflation should serve as a warning because it fits in with what many of us fear governments will do: cheat savers by inflating away the real value of their savings.

How on earth else can our government pay back its debts?

Official: women work harder and an extra drink can be fun

I am always intrigued by the microeconomics work of our great discipline: how people live, work and behave, rather than how the economy behaves – or currently misbehaves. So here are three gems from the Royal Economic Society annual conference, which starts tomorrow.

The first is some work by Mirco Tonin and Michael Vlassopoulos, who have found that women are 10 per cent more productive when their work is directly linked to a social cause than when they have a similarly paid job in the private sector. Men show no difference in productivity. This may help explain some of the gender gap in earnings: women are more likely than men to enter careers involved with a social cause, whereas men go for the dosh.

Another study shows that permanent workers are less happy if they lose their job than people in flexible employment. Worse, the job loss has a far greater "scarring" effect on these workers, and that continues long after they are back in a job. This research, by Colin Green and Gareth Leeves, was based on Australian experience, where temporary work is well established.

The third study, by Bénédicte Apouey and Andrew Clark, shows that winning the lottery makes people happier but they also smoke and drink more. The authors of the paper looked at lottery winners two years after they had hit the jackpot and concluded that, despite these extra indulgences, their general health was just as good afterwards as it was before. They might be taking more risks with their physical health but their mental health was significantly better.

There is such a huge amount more going on that it is, in a way, unfair to pick out particular papers. The economics profession takes a lot of stick. But when it helps explain how people respond in the real world it should enable policy to be framed more effectively.

It has been a glum week – and not just for economists. So a profession which can show that having the odd extra drink does not do people too much harm surely deserves a modest slap on the back.

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