Why we could all feel a little deflated

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"THE RISK-TAKERS", said a friend in a New York bank's weekly strategy meeting, "are coming home."

He was summing up the mood of the month, for we are now in a period where professional financial opinion has become extremely risk-averse. People have become so perturbed by the uncertainties in China, the threat of an economic meltdown in Japan and the new bout of tremors in Russia that they are seeking safety above all. It does not matter that there is a wonderful potential investment in, say, South Africa; the fact that it is not in the US or Europe makes it appear risky and at the moment the last thing people want is risk.

It is easy to see why this flight to quality has taken place, for each day that passes seems to bring worse economic news, mostly but not entirely from East Asia. But I think something bigger is happening. We seem to be in one of those periods of transition, where the old rules don't seem to hold true any more and we have not yet figured out what the new rules might be.

One example of the change in mindset needed is the attitude to investment. Japan's economic problem, it is now widely acknowledged, is partly the result of over-investment. It has invested too high a proportion of its GDP for the growth rate it could sustain. Accordingly investment was wasted. But wait, are we not still being told by the Chancellor that we need to invest more here in order to get faster growth? Understanding that over-investment can be just as damaging as under-investment and that investment is as much a response to growth as a cause of it are exactly the sort of changes in mindset we need to make.

The key thing changing the world is the move from inflation to deflation. Because it is the only thing we know, we still work on an underlying assumption that prices go up. Of course they don't all go up all of the time. The oil price last week was back to the level of the end of 1974; British house prices have only recently passed their 1988 peak and there are some people (mercifully not very many) still sitting on negative equity. But in most of our minds there is still the implicit idea that prices will tend to rise. That idea is explicit in the Bank of England target range for inflation, the mid-point of which is 2.5 per cent. If inflation creeps up like that then even bad investment decisions turn out sort of OK. Eventually inflation rescues the project.

What the Japan experience has shown is not just that too much investment is a bad idea, but too little inflation is a bad one as well. Japan has had several years of tiny rises in retail prices and falling wholesale prices. This year that pattern has taken a downward twist. Couple that with falling land, securities and property prices and it is clear that a lot of borrowers are bust. The result has been massive bad debts, and a loss of confidence in the banking system. Paul Krugman, the American economist, argues that what Japan needs is a little inflation, say 2.5 per cent a year, to enable the value of the bad debts gradually to be cut in real terms. Only slightly tongue-in-cheek, he wants an "irresponsible" Bank of Japan.

Because our experience is solely one of rising prices, it is worth taking a long look at what has happened to prices over previous periods. This is an area where there is plenty of data. In the graph, I have taken a recent IMF study of inflation in the UK and US since 1800 and then extended the UK figure backwards to 1264, using the information from the classic study of price movements in southern England by Professors Phelps-Brown and Hopkins, published in Economica in 1956.

As you see, there has been a pattern of long periods of zero inflation, followed by bursts of rising prices, followed again by a period of stability. Thus there was no overall change in the price level in England for 250 years between 1264 and 1520. Then there was a century when prices rose five-fold, followed by another 150 years of stability. The Napoleonic Wars saw a doubling of prices, then again there was more than a century of overall stability. The great inflation since 1940, with prices rising 15-fold in the US and more than 40-fold in the UK, is absolutely unprecedented.

So on a long historical view, it is at least plausible to suggest that we are heading into a period of a century of more stable prices: the Japanese experience of the last few years would become the normal one for the world for the next 100. We are beginning, dimly, to grasp why this might be so: a combination of the power of savers (or at least the power of the bond markets), the entry of more low-wage economies into the global trading system, and maybe also the desire of the growing army of elderly voters not to see their pensions whittled away by inflation. But this is only a guess. I don't think we really know why inflation is disappearing around the world any more than we can be sure that it is indeed happening.

But while I cannot prove that the world is starting a long period of zero inflation, a glance at the graph surely suggests that it is not a ridiculous idea. The graph, however, is quite a jagged one. Zero inflation overall means that there will be periods of inflation, when prices rise for a few years, and periods of deflation, when prices fall. And we may not be able to do anything about this, just as the Bank of Japan does not seem to be able to do anything about deflation there. (Paul Krugman may think it is being too responsible; I think that it is just too terrified.)

If this is right, what are the implications for us all? The initial reaction of most people is perhaps one of bewilderment, followed by concern - are we all going to lose our jobs? Actually it is important to realise that the condition inflation or deflation, of itself, does not have strong implications for economic growth. Britain, and particularly America, enjoyed very good growth through the last century, a period where overall prices actually fell. People get their increase in living standards more through falling prices than rising wages, which arguably is socially more fair: Children, home-makers and the retired share in the rise in general prosperity, rather than those people who happen to be in good jobs.

The adjustment process - getting to there from here - is liable to be disruptive. It is, furthermore, a journey without maps, for the last period of a transition from inflation to deflation, at the end of the Napoleonic Wars, is a long way beyond our folk-memories. Are there any rules or guidelines that might make this transition easier?

I suppose from a macro-economic point of view you could say that stability becomes especially important. Japan's problem is particularly severe because its bubble economy of the late 1980s was even more frothy than that of the rest of the developed world. Our Chancellor is absolutely right in his emphasis on stability. We need to try and avoid macro-economic mistakes, for they will make matters worse. Quite what constitutes a mistake, however, is harder to see, particularly at the time when it is made. I have a sneaking feeling that if we are moving into a deflationary world, starting with a tiny bit of inflation as Britain has at present, then it may be no bad thing. In much the same way, the reliable way in which British consumers go and spend money when they have it may also prove a strength instead of a weakness. Pity they go and spend so much of it on imports, but there you go.

From a micro-economic point of view the rules don't change. You need efficient companies, efficient government services, an efficient tax system, light but effective regulation and so on. Price stability, in theory at least, enables the market to signal more clearly how resources should be allocated, so overall economic efficiency ought to be greater under stable prices than under rapid inflation.

And from a personal point of view? What can we do to protect ourselves from deflation? The answer, I am afraid, is very boring: don't borrow too much, save and invest the savings cautiously, and generally behave in a sober and proper manner. Victorian values, I suppose. Sorry.