Hamish McRae: The brave new world of deflation need not be all bad

We'll have to get used to a period when prices - and wages - go up as well as down
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The Independent Online

Welcome to a world where prices are as likely to go down as up. Last month the retail price index, the most widely used measure of price changes, was down 1.6 per cent year-on-year, the sharpest such decline since the index was launched in 1948. But it is also a world where wages are likely to go down, or at least be frozen. Just this week British Airways pilots offered a 2.6 percent pay cut, plus other concessions, to help BA survive and the head of the Audit Commission has called for a freeze of all public sector pay.

Neither could have seemed possible even a year ago, when the oil price was still soaring and the recession had yet to develop. Nor could it have seemed possible for most of post-war history. We did have runaway inflation in the 1970s and double-digit interest rates to curb that. We also had periodic house price reverses, though always following a boom. But the price of goods in the shops and the day-to-day services families buy always went up. As for actual wage cuts, that hadn't happened on any scale since the 1930s. So what's up? And what are the longer-term consequences of this phenomenon, this taste of deflation?

Three things are happening. First of all there is of course a global recession which inevitably puts downward pressure on prices. But this one comes at the end of the longest and most universal boom in history, a boom which drove prices of energy and raw materials to historic heights.

So one of the reasons why prices are falling now is because they were so inflated a year ago. For example the main downward pressures on that RPI figure come from fuel and food; a year ago the oil price had been pushing $150 a barrel, whereas now it is around $60 a barrel. Similar, though less extreme, movements have taken place in world food and commodity prices.

The second thing to note is that the RPI is very affected by housing costs, which have whistled down in the wake of falling property prices. The newer European measure of inflation, the consumer price index, was up 1.8% – below the government's target of 2% – but it does not include housing costs, actually one of its main weaknesses. So while the RPI has indeed gone negative, if you exclude housing costs there is indeed a little inflation left in the system. We are used to a world where the price of some things, computers for example, keeps coming down, but others, such as train fares, seem to keep going up. If house prices resume their long-term upward trend, we will have the RPI going up again too.

The third thing that is happening is that society at all levels has responded to the financial pressures with much more flexibility than it has done in the past. Companies have sought to curb their wage costs not so much by sacking people (though sadly that has happened to many) but by adopting more flexible employment policies: short-time working for white collar staff as well as factory workers and greater holiday time as well as pay freezes and cuts.

Sometimes these concessions have been offered by workers freely; sometimes and quite understandably they lead to friction, as is the case with some of the BA workforce. But the general point surely stands that people in the private sector are coping with the downturn more calmly and constructively than they would have done in, say, the early 1980s or even the 1990s. We don't yet know what will happen in the public sector, for the squeeze there has yet to begin but for the time being at least the UK seems to be coping with the social and economic pressures reasonably well.

It is too early to analyse with any confidence why this should be so but it is worth noting that other countries also seem to be adjusting to the downturn. In the US, where unemployment has risen much more swiftly than here, there has been very little disruption and, to generalise, a pretty cohesive response with communities all over the land finding ways of supporting people who have lost their jobs.

In Germany companies and their workforces have responded with their customary pragmatic calm. Even in France they seem to be coping relatively smoothly, though the threat by some sacked workers to blow up the factory does show some Gallic ire is still evident. In Ireland, which has been stuck by about the most savage recession in Europe, society is responding with remarkable co-operation. The economy is forecast to shrink by 8.3 per cent this year and annual inflation there was down 5.4 per cent in June.

That leads to what seems to me to be the most interesting aspect of this experience the world is having of a period of falling prices. It is coping much better than it did during the experience of very rapid inflation. Both create winners and losers in a random way – though everyone who loses a job as a result of the disruption suffers under either condition. Inflation handed a bonus to those who had borrowed money at fixed rates and bought property; but it hit people whose savings were whittled down in real terms.

Deflation is similarly random in its effects. It is helping people on secure incomes who benefit from lower prices; but it is hitting home-owners with negative equity. Among home-buyers there two classes of borrower: on the one hand those on fixed rates who may well see their mortgage costs increase when they need to roll the loan over; on the other hand those whose mortgages tied to base rate find they have a monthly windfall. Savers who are dependent on interest income have been absolutely hammered for their prudence, something that cannot be right either financially or morally. It will be a modest comfort to know that the capital value of their deposits is being preserved.

Any kind of financial disruption is unfair, sometimes desperately so. But for the time being at least society seem to be managing the stresses in an orderly way. I worry this calm may not continue.

If deflation continues in the months ahead it will put huge strains on society and in particular between those who are largely insulated from the pressures – especially public sector employees and pensioners – and those that are not, the much larger group of people in the private sector who are having to face wage cuts and job losses as costs continue to be ground down. The gap between those on public-sector pensions and most of the rest of the retired community is particularly large and seems set to get larger.

So what will happen? Deflation won't go on forever. One of the main reasons why the world's central banks, including the Bank of England, have been finding different ways of pumping money into the financial system has been to try for forestall it. Everything we know about monetary theory suggests that they will eventually succeed: create enough money and you will get a return to inflation and the problem then will be how to get things back on an even keel again.

But meanwhile I think we will have to get used to this world where prices – and wages – go down as well as up. That should make us more cautious and maybe less greedy. If it really does that, then a period of deflation will have some useful consequences too.

h.mcrae@independent.co.uk

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