Prepare for falling house prices and pay cuts

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When the official figures suggest that the British economy may be skirting the edge of recession, I can never get out of my mind the risk of deflation, that is, a prolonged period of falling prices. I recently asked the professional managers of a large investment portfolio of securities and property what they considered to be their major risk in meeting their commitments. Their reply: deflation.

When the official figures suggest that the British economy may be skirting the edge of recession, I can never get out of my mind the risk of deflation, that is, a prolonged period of falling prices. I recently asked the professional managers of a large investment portfolio of securities and property what they considered to be their major risk in meeting their commitments. Their reply: deflation.

In some sectors of the economy, deflation has already taken hold. For instance, prices for clothing and footwear have fallen by more than 5 per cent in the past year – the fastest decline for 50 years. None the less, prices in general are still gently rising – at around 1 to 2 per cent per annum in Germany, France and the UK. I sometimes wonder what will happen here when the boom in residential property comes to an end and house prices dip – would we then tumble into deflation?

Among the advanced economies, only Japan has succumbed. Consumer prices have now fallen for 30 consecutive months both for goods and services. So when my wife and I went to visit our younger son in Tokyo last week, I couldn't help but try to get an impression of what deflation feels like. What difference does it make to one's life?

I was surprised to find that wages are being cut. Economists tend to assume that this will not happen except in rare circumstances. When companies come under pressure, they reduce employment rather than wages. Indeed, trade unions have always appeared much more willing to accept job losses than pay cuts. Japan has moved past that.

Even local authorities in Japan are reducing salaries and the teachers unions, for instance, are accepting the outcome. In the case of one local authority, the first step in the argument was that severe cuts by private industry meant that local authority workers had become comparatively well off. Then staff were polled and it was found that about 60 per cent supported salary reductions or thought that they were unavoidable.

So wages are being cut by 5 per cent for three years, but the funds thus released are not simply being pocketed by the administration. Part is being used to hire new staff for education and social services and part is going to establish a fund to support employment creation in the private sector. Only about a third of the savings in wages is being banked.

None the less, wage cuts, inevitable though they may be, tend to perpetuate deflation. In the same way that rising wage demands used to fuel inflation in this country during the late 1960s, the 1970s and the 1980s, so wage cuts entrench a deflation mentality more deeply. And that in turn has dire consequences. For when prices are falling, debt, whether held by individuals or companies, becomes more expensive in real terms. In other words, if your salary has been reduced, or your company's prices have been cut, then paying interest or repaying capital becomes much more demanding. It makes individuals reduce other expenditure; it drives companies into bankruptcy. Worse still, the solvency of the nation's banks comes into question. All this is visible in Japan. And calamity is being avoided only because interest rates have fallen to virtually zero.

Perhaps, therefore, I shouldn't have been astonished that ordinary people are taking their money out of banks and putting it into their safe boxes at home. The hottest investment vehicle these days in Japan is literally cash, actual yen bank notes that you can count and stick into an envelope. The interest rate being foregone is an almost invisible 0.001 per cent a year. In addition, there are bank charges for using cash dispensers and making transfers. Holding physical cash avoids paying these. And in a society where crime rates are low, cash kept safely at home grows more valuable as deflation gathers pace. In the last three months of 2001, Japanese savers took the equivalent of £30bn out of their banks – and didn't spend any of it!

The longest and steepest decline, however, has been in property prices – a strange idea to the British. That began 11 years ago. Since then, property prices, residential and commercial, have fallen every year. So have rents. Values dropped by 6 per cent in 2001 and the rate of decline appears to be accelerating. Tokyo property used to be the most expensive in the world; now London holds top place. In these circumstances people prefer to rent rather than to buy. It doesn't occur to my son and his wife, who are long-term residents, to purchase a property. Moreover, the decline in the cost of housing means that people are returning to city centres. From 1988 to 1998, the population of central Tokyo steadily declined; now it is rising again.

All this has lessons for us. We have been fortunate for some years to live in an economy in which inflation is low and more or less harmless. But it wouldn't take much to tip us into deflation. And then we should find, as the Japanese are now doing, that it is difficult to get out of that trap. Nothing the Japanese government has done has had much effect. The problem is confidence. Once it has been lost, it is difficult to restore.

aws@globalnet.co.uk

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