Stephen King: Deflation... the next big surprise?

The UK is unusual today because, unlike many other countries, inflation is a little too high

What is likely to be the big economic surprise over the months ahead? This might seem like a fatuous question given that surprises are, well, surprises. They're the events we typically don't expect. Nevertheless, it's not such a daft approach, if only because the economics profession has been consistently tripped up over the last couple of years by a collective failure of imagination.

By now, we should have recognised that the consensus gets things badly wrong. It may be the best measure at any point in time of the "central expectation" of economists and investors, but a central expectation hardly captures the hopes, fears and worries that are part of everyday life.

It's easy enough to argue that we're on the verge of a sustained recovery in economic activity. After all, interest rates are very low, plenty of money has been printed over the last couple of years, and governments have borrowed heavily in a bid to inject some vitality into the economic process. Yet much the same could have been said about Japan over the last 20 years. In Japan's case, how-ever, these "loose" policies just didn't work. Knowing, then, that policies seem to be supportive doesn't really get us very far. Are UK interest rates at their lowest level in 300 years because policy is very supportive, or because the underlying economy is very fragile?

These are difficult enough questions but, for policymakers, the questions don't end there. Paul Tucker, the Deputy Governor of the Bank of England, summed up many of the problems faced by your typical central banker in remarks to the Institute of Economic Affairs last month. Mr Tucker expressed concern about the dangers of supply disruptions. He noted that companies in the UK had chosen to – or had been forced to – mothball some of their productive capacity in response to the crisis. In Mr Tucker's view, the quicker this capacity was brought back into economic life the better. Should the mothballed capacity eventually be shut down, the economy's supply potential would be reduced on a permanent basis, creating supply bottlenecks that might feed through to higher inflation.

Mr Tucker's argument leads to a perverse conclusion: the quicker demand recovers, the lower the risk of a rise in inflation – because the risk of permanent mothballing of supply capacity is reduced.

This problem is not specific to the UK. It can also be seen in the US where, despite all the hullabaloo about a smaller-than-expected drop in employment last week, the really big worry is the rise in America's rate of long-term unemployment. This has gone up to its highest level by far in the post-war period, suggesting that it's not just machines being mothballed: people are also being affected. It's a well-known economic fact – and fits with common sense – that those who remain out of work for a long period typically see their skills atrophying and their attractiveness to would-be employers deteriorating. As this happens, the rise in the unemployment rate begins to reflect not just a loss in demand but also a loss in supply: to use the economics vernacular, there is a rise in the "natural" rate of unemployment.

Once the natural rate of unemployment begins to rise, the success of Keynesian demand-management policies begins to ebb. In these circumstances, a demand stimulus is more likely to lead to rising wages for those lucky enough still to have jobs, while the long-term unemployed simply watch from the sidelines. The result is a rise in inflation which, in turn, threatens the return of a 1970s-style stagflation: lower-than-expected growth mixed with higher-than-expected inflation.

Mr Tucker is right to emphasise the importance of an economy's supply potential. I am not convinced, however, that a loss of supply potential necessarily leads to an increase in inflation risk. To see why, think about an economy from the perspective of assets, liabilities and expectations about the future. Assets are worth what they're worth because investors reach a collective view about their potential future earnings potential. Investors will buy equities, for example, if the expected long-term profits outlook is improving, but will sell equities if the reverse applies. Meanwhile, liabilities often reflect our past, rather than present, views of asset values. A homeowner may now be saddled with a huge mortgage as a result of buying a barely affordable house a couple of years ago, but he may be regretting the purchase if, meanwhile, the market value of the house has dropped.

Imagine we collectively begin to realise that the crisis has done lasting damage to the economy. The economy's supply potential is dropping in line with the arguments set out by Mr Tucker and the experience of the US labour market. Our expectations regarding asset price returns are likely to become more pessimistic. Asset values themselves begin to fall and, as they do, we begin to regret the high levels of debt built up in earlier years. Collectively, we start to repay debt, leading to a loss of demand which, in turn, leads to a further mothballing of supply potential. We end up with a stagnant economy. But do we end up with higher inflation as well? Probably not.

As an economy stagnates, a mechanism has to be found to reduce the value of assets in real terms. One mechanism is, of course, higher inflation. Inflation, at least of the unanticipated variety, redistributes wealth from creditors to debtors. Anyone holding an asset will quickly discover that it wasn't all it was cracked up to be. This was the experience of investors in the 1970s. There is also another mechanism. Asset values – the prices of housing, stock markets, commercial real estate – can simply drop in nominal terms. As this process takes hold, so the incentive to repay debt increases, leading to persistently weak nominal demand and the threat not of inflation but, instead, of deflation. You only have to look at Japan over the last two decades to see how this mechanism works. And you only have to look at very low inflation rates and weak money supply growth in the US and the eurozone to recognise that Japan-type symptoms are being recorded in many parts of the industrialised world today.

True, equity prices have risen strongly over the last year or so, but temporary equity rallies were very much part of Japan's experience: sadly, they merely punctuated a longer-term bear market.

The UK is unusual today because, unlike many other countries, inflation is a little too high, particularly given the huge loss in demand over the last couple of years. However, given sterling's substantial drop in 2008, this is not that surprising.

I do not think that the biggest influence on prices will be supply-side bottlenecks – notwithstanding the evidence of supply problems on either side of the Atlantic. We are living in a world of deleveraging and debt repayment: it might be a world that damages supply potential but, for me, it's a world which ultimately is deflationary. That, I think, will be the big surprise in the years ahead.

stephen.king@hsbcib.com

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