We must learn how to live in a world of low inflation

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The Independent Online
A new week and - after the dismay of the past few days - a new burst of enthusiasm on the markets. For the moment at least all that concern seems to have evaporated; all those parallels with October 1987 or even 1929 seem to have been brushed aside.

But the concern itself is interesting: this natural desire to seek patterns of the past which might give a guide to the future. This is perhaps the dominant feature of financial analysis at the moment. On the one hand, people do believe the future is going to be different from the immediate past: hence all this justification for the continued share price boom. But to get a feel for the possible financial conditions which will dominate the first years of the next century we tend to look backward, not forward.

There is one question - is this cycle like all the others? - which has been widely discussed. There is another, which is only just starting to come up on the radar - in what ways will the world economy and financial markets be different in the next 50 years from everything that we've experienced in the past 50? Here are five thoughts on this second question.

Thought one is that demographic change alone will have an enormous impact on financial markets. We will have to see a shift away from state pensions to private ones: pensions being paid by people's own savings, rather than taxation on the dwindling proportion of people of working age. So there will be a big surplus of personal savings over the next 20 years, which will then be run down as the savers draw their pensions. This surplus of savings, at least in the developed countries, will mean that for a couple of decades there will be a lot of money swishing around. This suggests that real rates of return on capital will tend to fall but that capital values of assets will be underpinned.

Thought two leads on from this. Many of the investment opportunities will be in what we still think of as the developing countries. At some stage in the first decade of the next century (the World Bank reckons 2004, the IMF nearly 2007) it looks as though the combined output of the developing world will exceed that of the developed, reversing a situation which has existed for about 150 years. Money for at least part of this progress will be funded by the savings of the developed countries.

So while there will be a shift in economic power towards the developing countries, ownership of many of their assets will shift to the developed world. This ought to be a mutually beneficial economic arrangement, similar to the surge in international investment at the end of the last century. But it would be naive not to admit that it will create political tensions, some of which we've caught a glimpse of in the past few weeks in Malaysia. Expect continued rapid growth of developing countries and expect high returns. But expect, too, big bumps, political and economic.

Thought three is that the trend towards lower inflation is now secure and the next century, like the last one, may be one of stable prices. Disinflation is driven by three forces: the power of the bond markets, which meet any rise in inflation with higher long-term interest rates; the extension of international trade to many large low-wage countries; and the values of older voters who will not wish to see their pensions eroded by inflation.

This we can see. What we've hardly begun to think about, except perhaps in Japan, is the danger of overshooting and experiencing a long period of falling prices. In theory this is fine. All people - children, non- workers, the retired - would benefit from falling prices rather than workers benefiting from rising wages. The whole of society would thus share the results of productivity gains rather than people who happen to be in the right jobs. But adjusting the stable prices is tough on people who have only known inflation and tough on policy-makers who won't know how to cope. Expect those to make mistakes.

Expect, too, lower nominal returns on cash. Getting used to a world where interest rates are 3 to 5 per cent is tough for people used to returns of double that. Getting used to the idea that growth and falling prices can go together will be harder still.

Thought four carries on from here. The first years of the next century are going to be a period of big adjustment. The great engine of productivity will keep on generating gains. We will go on thinking of ways of producing better goods more cheaply and better and cheaper services. But these gains will not mean much higher living standards. Instead the benefits will be siphoned off into the costs of coping with the ageing population. The smaller workforce will see less of a return for itself. Meanwhile, savers will become more concerned with preserving the real value of their savings, rather than trying to achieve the double-digit gains of the past 20 years. If you want higher returns, you'll have to go abroad, which will mean accepting higher risks.

So risk will be different, and this is thought number five. Instead of there being large inflation risks, there will be deflation risks. Instead of there being large swings of interest rates, there will be smaller movements, but in a world of stable prices, smaller movements will have larger effects. Currency risk will change, with major currencies having a more stable relationship, though not as stable as the Bretton Woods exchange rate system of the immediate post-war years. That does not mean that a single European currency will find it easier to survive, particularly if it becomes associated with slow growth of living standards. But it does mean that it will have a more stable relationship with the dollar and other currencies.

Company risk will change, too. The idea that earnings of most large companies will reliably increase year after year will have to go. A larger proportion will be unable to produce improved results each year. For higher returns, people will have to go to smaller companies and to start-ups, accepting more risks. There will be greater rewards for spotting new, growing firms and fewer rewards for over-analysing large, old ones.

Of course these five propositions will in some measure be wrong. What will almost certainly be right is that the early years of the next century will be very different from anything which people aged under, say, 70 will have experienced in their lifetime. It's so hard to see turning points when you're on the cusp. We may or may not be in a cyclical turning point in the markets, but it does look as though we're between two big secular trends, the inflation world of the post-Second World War period, and something quite different in the most globalised economy the world has ever known.