The financial crisis exceeds every expectation. Fresh alarms appear. I noted here in early March that forced selling of securities had begun and I even managed to extract some comfort from the fact. This period was, I wrote, "the final stage of the crisis, the climactic event that brings it to an end". By forced selling, I meant disposals insisted upon by the banks from which investors had borrowed money.
However I didn't think the process would go on for so long. I hadn't expected it would turn into a sort of doomsday machine that once started has been impossible to halt and which continues still.
Nor did I foresee that the losses taken by the banks would be on such a scale that their willingness to lend would be substantially inhibited. Most of all, I didn't envisage that there might be a further, even more daunting stage of the crisis: deflation.
The central banks tell us that a period of declining consumer prices is unlikely to occur. But look carefully at what the US Federal Reserve said in its statement accompanying its decision earlier this week to reduce its interest rates to virtually zero. It spoke of the need to "preserve price stability" even though American consumer prices are in fact flat. Preserving price stability in this context means acting to prevent prices from falling.
Deflation is the worst. It also has a doomsday machine quality to it, a downward spiral which is difficult to stop. And if it is to be halted, it requires central banks and their governments to take measures for which there is only one precedent – a half-precedent I would call it – and that was Japan during the late-1990s and early years of this century. Moreover governments of democratic societies find it difficult to act decisively and effectively in such circumstances; the Japanese didn't.
There is technical deflation and there is the real thing. We will almost certainly experience the first, a brief period lasting a number of months during which the retail price index declines. It would be a dip rather than a prolonged submersion. One reason why this may occur is the temporary cut in the rate of value added tax. And provided there is a quick rebound, none of the ill consequences I am about to describe should come to pass – though even here some caution is necessary. If, at the first sight of a generalised decline in prices, consumers stood back to see if they would fall further, then the dip might become a plunge.
To understand why real deflation is so scary, consider some examples. A company enters a period of declining prices, for instance, with a certain amount of debt on terms that commit it to pay a few percentage points of interest each year. Let us say the rate is 5 per cent. If it has to keep on cutting the prices at which it sells its goods or services in order to remain competitive, then the 5 per cent interest rate becomes steadily more onerous. Greater and greater amounts of business would have to be transacted to meet the interest due. Let us say that before prices began to fall, three day's turnover each month would have met the interest charges. After two years of deflation, however, perhaps four or five days' sales would be required. And then if prices went on declining?
Even so, the example I have sketched out doesn't seem too bad. But then consider a company that enters a prolonged deflationary period with its finances already under strain. It would find it hard to survive.
If not all companies have borrowings, few of them, on the other hand, own their own premises. They have rent to pay. The mechanism is exactly the same. Rent is a fixed charge that cannot be adjusted until the lease allows a review, generally at five yearly intervals. Until a re-negotiation can take place, deflation would raise the real cost of accommodation. Bearable for many, perhaps, particularly as there is always a rent review to come, but consider the company that has to downsize and is stuck with surplus space that cannot be sub-let except at a loss, if at all.
It is examples like these, multiplied many times over, that have led economists to believe that the rise in the real value of debt as prices fall (and of rents, too, I would add) could trigger a downward spiral of mass insolvency, falling demand and further deflation.
There is one further problem that deflation poses. None of the familiar instruments of economic policy are particularly effective. Already the Federal Reserve, and doubtless the Bank of England shortly, have little or no scope to cut interest rates further. Tax rates can be reduced but consumers will not spend the extra cash in their pockets if they think that falling prices are here to stay. Better to wait and see, they will think. In any case, consumers have just as great a need to save to pay off their own debts, made more expensive in real terms as their wages decline, as do companies.
That in turn is why policy makers have begun to examine what originally appeared to be a joke when the Nobel Prize-winning economist, the late Milton Friedman, proposed what he called the "helicopter drop" of bank notes as a remedy for deflation. This week, for instance, Eric Lonergan, a fund manager at M&G Investments, has briefly outlined what would be involved in the Bank of England literally printing money and handing it out to consumers to spend as they saw fit, no questions asked, until activity revived, prices began to climb, assets went up in value and banks felt strong enough to resume normal service.
In Mr Lonergan's scheme, the Government's only role would be to decide if transfers should be equal, or skewed to lower income groups. The Bank of England would actually manage the operation and judge the best moment to bring it to an end. It would indeed be a very remarkable experience to open the post one morning and find that the Bank of England had sent me some money to spend as I please. I would probably go and buy a bottle of champagne so that I could toast the sagacity of the Old Lady of Threadneedle Street.
Unfortunately, though, this is not a joke. For the chances of a scheme as bold as the one outlined by Mr Lonergan being carried through are small. Which is why the spectre of deflation, now appearing dimly through the mist, is indeed frightening.Reuse content