So you thought the economic recovery was under way? Well, I’ve got a word of warning for you – deflation

As prices keep falling, so customers think about waiting before buying


Sometimes a small news item rings the loudest bell. When I read earlier this week that retailers in the UK had cut their prices during the January sales at the fastest rate for seven years, I was taken aback. Was this a wake-up call? Are we about to experience deflation – an unpleasant state of affairs not seen in this country since the 1920s and early 1930s?

The retailers’ trade body said prices had been falling for nine consecutive months. Discounting in shops selling clothing, electrical equipment and furniture was partly behind the drop. Prices had also declined in flooring, books, stationery and home entertainment, while DIY, gardening and hardware shops had entered “deflationary territory” in January. Yes, the trade body actually used the dread word. And I say “dread” because sustained deflation would bring about a serious recession. As it did in the 1930s.

The scary thing is that deflation has a doomsday-machine quality to it. Shop prices begin to fall, as described above. Gradually customers notice this and say to themselves: perhaps if I wait a few months, what I want to buy will be even cheaper.

They postpone their purchases, but as they do so they unwittingly bring further pressure to bear on the retailers – who in turn demand lower prices from their suppliers. And then perhaps these same manufacturers have to lay off staff in order to cut their own costs. Which reduces purchasing power within the economy. At this point falling prices are beginning to get very dangerous.

But first, there is an important distinction to be made between what I call “technical” deflation and the real thing. By the former I mean a short period of price declines that fortunately fails to start the doomsday machine because the episode is soon over. The eurozone as a whole, for instance, experienced deflation for five months in the second half of 2009.

Second, while an increasing number of experts have been issuing warnings about the risk of deflation in recent weeks – among them Christine Lagarde, the Managing Director of the International Monetary Fund – their worries focus on the eurozone countries rather than on Britain or the United States. Inflation averaged across the eurozone fell to 0.7 per cent in January, down from 0.8 per cent in December. Compare this with the UK inflation rate as measured by the Consumer Prices Index, which was 2 per cent in December compared with 2.1 per cent the month before.

I am not saying that Britain faces no risk of deflation, but that if it were coming, it would strike our Continental neighbours first. And there is indeed good reason to worry about them right now. For if you strip out increases in value added tax from Continental retail prices, then you find that Italy, Spain, the Netherlands, Portugal, Greece, Estonia, Slovenia, Slovakia and Latvia have all been in outright deflation since May.

Underlying prices have also been dropping in Poland and the Czech Republic since July, and France since August. There are also the first signs of consumers delaying their purchases. For retail sales in the eurozone fell sharply over the Christmas period.

This raises the possibility that deflation will arrive in Britain by the back door. For if the eurozone were seriously affected, then our substantial export business with the rest of Europe would suffer. That would be a serious shock to our economy.

Yes, but cannot the world’s finance ministers, central bank governors and their assorted officials take actions that would make deflation a non-starter?

After all, they succeeded in containing the 2007-2009 banking crisis by one means or another. Unfortunately not. The cure is easy to describe – deliberately create inflationary conditions to get prices rising again. But very hard to carry out.

Before he was chairman of the United States Federal Reserve, Ben Bernanke claimed in 2002: “... sufficient injections of money will ultimately always reverse a deflation”.

But that policy proved incapable of halting Japan’s long deflationary spiral. And we have recently been through an extensive period when money has indeed been “injected” by central banks (so-called “quantitative easing”).

It chased up asset prices, such as shares, property and pictures at auction, but made no impact whatever on the prices for goods and services. Perhaps that is why the Nobel prize-winning economist, the late and famous Milton Friedman, once proposed what he called the “helicopter drop” of banknotes as a remedy for deflation. Which only serves to emphasise that we don’t really know how to stop it once it gains a hold.

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