Goodbye, dear friend
Inflation has been laid to rest, argues the economist Roger Bootle, but has our obsession with keeping prices down blinded us to the dangers of a full-blown slump? `We are dealing with the economics of fear'
Sunday 31 March 1996
Is this a purely imaginary world? No. It is the way things were most of the time before the onset of perpetually rising prices in the years after the Second World War. And it is the world to which I believe the countries of the West are gradually returning.
Inflation is a process of continually rising prices, implying a continually falling value of money. Acceptance of this process is ingrained in our habits of thought and action. Anyone born in the last 60 years has known nothing else but prices continually rising, and it is natural for people to assume that the future is going to be similar to the recent past.
Sometimes, though, this assumption can be dangerously off beam. It was wrong to think that the 1970s were going to be like the 1960s, just as it had been wrong to think that the years after the Second World War would be like the 1930s. Sometimes history reaches a break point. It is at a break point now.
It is already plain that there has been a dramatic change in the inflationary environment. In Japan, it is painfully evident. Far from the threat of inflation, it is fear of deflation that keeps the Japanese authorities awake at night. For many prices have already been falling. The Japanese have a marvellous expression for it: kakadu hakai or "price destruction".
But far from bringing on the state of nirvana which the collapse of inflation is so often alleged to induce, this fall in inflation brought the Japanese economy close to disaster, with the financial system in desperate straits, the property market shell-shocked, the stock market hovering on the brink of meltdown, and the banking system held together on a wing and a prayer. Moreover, having cut interest rates to 0.5 per cent by the end of 1995, the authorities had more or less reached the end of the line.
To make matters worse, although they launched several substantial packages of increased spending and tax reductions to boost demand (the policy advocated by followers of the great economist John Maynard Keynes), the authorities felt inhibited from using this standard remedy on a very large scale. They were worried by Japan's adverse long-term fiscal prospects due to its rapidly ageing population. At least by the end of 1995 there were again some signs of recovery, but no one could be confident that the crisis was over.
But this is not a uniquely Japanese difficulty. Throughout the West, government debt levels pose a problem, even with very low inflation. If the economy tipped over into deflation, most Western governments would probably feel constrained from adopting the Keynesian remedy.
Although we like to think that the economics of deflation are now so well understood that anything like a repeat of the 1930s is unthinkable, the Japanese experience is salutary. It shows that the dangers of deflation are very far from being over. And in most of the older industrial countries of the West (grouped together as members of the Organisation for Economic Co-operation and Development) inflation has collapsed (see graph). If it has not quite dropped as far as in Japan, it has at least fallen to levels last seen in the OECD as a whole in the 1960s. In 1995, inflation was 2 per cent in Canada and France and just under 2 per cent in Germany. Indeed, in the former West Germany it was lower still. True, it was a good deal higher in several countries which had suffered currency weakness - it was nearly 5 per cent in Spain and over 5 per cent in Italy. But these rates were low compared with those countries' inflationary history. And in one of the supposedly most inflationary countries of the whole group, the UK, inflation was under 3.5 per cent.
In fact, the countries of the West are closer to falling prices than published figures suggest. Official measures overstate true inflation. They consistently fail to take full account of quality improvements in what people buy, miss the emergence of new goods such as computers and mobile telephones (which tend to fall in price), and do not recognise the full effect of consumers switching to lower priced goods or sources of supply. Estimates vary as to how large this systematic overstatement of inflation is, but most economists reckon that it is in the range of 0.5 to 2 per cent. This means that when, in 1994-95, the world's monetary authorities and financial markets were obsessed with the dangers of inflation bounding up, across much of the Western world there was virtually no inflation at all. Not only was inflation negative in Japan, but it was virtually zero in France and Canada, minimal in Britain and the US and minuscule in Germany.
The implication is clear - the old regime of high inflation has collapsed. But no one is quite sure what has taken its place.
What the policymakers are all aiming at and hoping for is minimal inflation, that is to say, a regime where the price level continues to creep up a bit each year. Although the precise numbers differ from country to country, getting and keeping inflation somewhere in the range 0 to 3 per cent is the explicit policy objective of the German Bundesbank, the Banque de France, the
Bank of Canada, the Bank ofEngland, the Reserve Bank of New Zealand, the Bank of Finland, the Bank of Spain and the Swedish Riksbank. The US Federal Reserve does not have an explicit inflation objective in the same way, but its implicit objective is clearly very similar.
At the moment, price deflation is far from the intentions of policymakers. But, of course, what they intend and aim for is one thing; what actually results may be quite another. The world's governments and central banks did not plan for, forecast or anticipate the depression of the 1930s, nor the inflationary explosion of the 1970s. Rather, their hopes, intentions and plans were overwhelmed by events. In today's conditions, by setting policy so as to achieve a regime in which prices hardly rise at all, they run a serious risk that they will end up, not with a return to high inflation, but rather with price deflation.
Precisely because this would be so unexpected and ill-prepared for, it could have extremely dangerous consequences. If minimal inflation is the hope for the future, then price deflation is the fear.
The very pain inflicted by the process of reducing inflation (disinflation) makes a tip-over into deflation more likely. If the economic system were completely adjusted to minimal inflation then the danger of falling prices might be remote. But it is not. Consumers have become heavily indebted, particularly in order to purchase property, on the assumption of continual inflation. Without it, they will find their debts more burdensome. Many companies are both heavily indebted and substantial owners of real assets. Governments throughout the Western world have massive liabilities predominantly in long-term, fixed-interest form. As inflation falls, their balance sheet positions will deteriorate.
The effect of all these factors is to constrain spending and to weaken confidence as inflation falls. In principle, there ought to be gainers to offset these losers, but two factors undermine these forces. First, the very novelty of the economic environment I am describing unsettles confidence - falling prices for real assets such as property, very low interest rates, decreases in the general level of prices. Secondly, the rising real value of financial assets owned by creditors is of no benefit if it means that the debtors cannot pay.
The effects would be still more alarming if it came to be believed that, as substantial owners of non-performing assets, the banks were in trouble. For then the integrity of people's savings, and indeed the very monetary system itself, would seem to be imperilled. Once this stage is reached, we are beyond the rational models of economists and into the realms of mass psychology. We are dealing with the economics of fear.
Indeed, it is possible to imagine a vicious circle developing between falling asset prices, falling prices in the shops, rising real debt levels and downwardly spiralling expectations, reminiscent of the 1930s. If consumers expect prices to fall then they defer purchases, which puts more downward pressure on prices. Falling prices raise the real value of debt and force debtors to cut back on their spending. Some debtors inevitably go under, thereby endangering financial institutions and the banking system, which depresses confidence still further.
The behaviour of stock markets may play a key role in this process. They are vulnerable to massive changes in sentiment which undermine the existing basis of valuation, causing a collapse of asset values and a loss of confidence that can spread beyond the realms of finance into what economists call the real economy, that is to say, the world of production and jobs. Whether or not it is a stock market crash that leads the move towards deflation, a crash could well occur as a result of a move originating elsewhere, or the two could develop symbiotically, as happened in Japan in 1994-95.
A rise in prices year after year without fail is an aberration. It happened after the war for two interrelated reasons. First, demand was high and growth strong, buoyed up on a self-reinforcing wave of optimism. And, by a combination of luck and judgement, for the first 25 years there was no major demand shock to shatter this combination.
Secondly, because of the various inhibitions against lower prices and the restraints on competitive markets, prices, let alone pay, showed no tendency to fall even when demand was on the weak side. In those conditions, it would have taken a mammoth demand shock to bring on price deflation.
But neither of these conditions obtains today. We begin with generally modest growth and relatively high unemployment (except in the US and the Far East). And confidence is fragile. Meanwhile, just about all the structural and institutional inhibitions to falling prices are crumbling. The result is that today a significant downturn in demand would produce falling prices.
The deflationary danger is increased by one oft-forgotten but extremely powerful fact - interest rates cannot be negative. The reason is simple. Currency (notes and coins) does not pay interest and its nominal value is fixed. It is precisely this which means that currency loses value from inflation. But it also means that it gains in real value if prices fall.
The implications are devastating. Once the interest rate has hit zero, the authorities have lost the power to boost aggregate demand by cuts in interest rates. They have used the last shot in the locker.
The result is that if prices fall, real interest rates are bound to be positive. And if they fall at a faster rate, then real interest rates rise, even though the system is clamouring for lower or even negative real rates.
This characteristic makes systems with a very low inflation rate extremely dangerous. They are vulnerable to sharp downturns of demand that conventional monetary policy is powerless to resist.
The great danger facing the world now is that the policymakers will insist on policies that are too tight, and in particular that they will impose short-term interest rates that are too high. This danger is all the greater because interest rates which seem dangerously low by reference to the last 20 years are in fact dangerously high in a world without inflation. It is the years before the persistent inflation of the post-war period that provide the clues to the future. But it is the years immediately after the inflationary explosion of the 1970s that inform the thoughts and fears of policymakers.
Making the adjustments necessary to cope successfully and prosper without inflation will present enormous political problems. But perhaps the greatest barrier is one of perception. There are plenty of people who, professing a higher form of cynicism, reject any claim that the inflationary environment is fundamentally changed.
The Economist magazine, for example, has seen it all before. Only the gullible, it believes, will be taken in by the current signs of low inflation. The old demon still lurks round the corner, and we must all be constantly on our guard. It says that: "The more extreme version of the argument - that inflation has gone forever - verges on the economically illiterate." It is apparently impressed by the fact that: "Of 48 forecasters tracked by the Bank of England in August 1995, only five expected Britain's inflation to fall within the aimed-for range of less than 2.5 per cent by the end of next year."
But so what? Virtually none of these 48 had forecast the fall of inflation after the pound left the ERM. All they were doing was mouthing the same unthinking conventional wisdom. The Economist was then recycling this in print, as though this somehow lent it credibility.
Since when has the conventional wisdom in British economics been right? From the fear of depression after the war, to the desperate attempts to maintain unemployment at very low levels, to the intricate absurdities of incomes policies, to the obsession with monetary targets, then the supposed all-surpassing importance of ERM membership, the economic establishment has got all the big issues wrong.
q The above are edited extracts from Roger Bootle's new book, `The Death of Inflation - Surviving and Thriving in the Zero Era', price pounds 16.99, to be published on 17 April by Nicholas Brealey Publishing.
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