Hamish McRae: Time to hit the panic button as deflation inches nearer

Deflation, already established in Japan, has inched a little nearer. Germany is now hovering not just on the brink of recession but also is unable to ease monetary policy to ward off deflation. And while the fall of the dollar may help the US ward off deflation for a while yet, interest rates there are so low that the Fed has in effect no ammunition left. Sure it can cut rates a bit further but so what?

At the weekend the Group of Seven finance ministers at last acknowledged the danger, as had the heads of the Fed and European Central Bank the week before. Yesterday Alan Greenspan described deflation as "a threat that, even though minor, was sufficiently large that it does require very close scrutiny and - maybe, maybe - action on the part of the central bank".

When central bankers say this is really a small danger and we really should not be too worried, but warn that they may have to take some action, it is time to hit the panic button. After all, the Japanese monetary authorities used to deny that there was a danger of deflation there.

In the light of Dr Greenspan's comments the Japanese story is worth a closer look. There were special factors there that so far have not been replicated fully elsewhere. There was a speculative bubble in the late 1980s, an even greater boom than that of the US in the late 1990s. The Japanese banking system, which had financed the boom, was undermined and technically is probably still bankrupt. And the Bank of Japan was slow to cut rates in the face of falling demand. Elements of this conjunction of forces have occurred in much of Continental Europe and in the US but not the whole bundle.

What is however disturbing is the evidence that once deflation takes hold it is very hard to dislodge. You can see this in the first three graphs. In the left-hand one you can see how GDP growth tailed off in the run-up to the second two periods of deflation, in 1995 and from 1998 to the present.

You can also see, in the next graph, how ineffective it has been to use a budget deficit to try to boost demand. The more that the public sector spent (on borrowed money) the more the private sector cut back.

And in the third graph you can see the ineffectiveness of monetary policy. Last year the Bank of Japan pumped huge amounts of money into the banking system, as shown in the jump in the top line. But while bank deposits went up, broad money (which is determined by people's willingness to borrow from the banks) hardly grew at all. The money just sat in the banks without creating additional demand.

Now the good news is that the US and eurozone experience has been different so far. The final graph shows how much lower Japanese inflation was than inflation in the US or Europe right through the 1990s. But as Dr Greenspan said yesterday, before the Japanese experience of the 1990s deflation was thought to be unlikely in currencies that were not linked to some underlying good, such as gold.

So what can be learnt from the Japanese experience? The HSBC economic team has been trying to second guess what the Fed might do. It notes a five-stage strategy. Stages one and two have already been put into action: cutting short-term rates aggressively and acquiescing to a fiscal loosening.

If these policies fail stage three would be to try to nudge long-term interest rates lower too. There are ways it can do this, by, for example committing to keep short-term rates at a very low level for five years. That would push down interest rates on five-year notes and to a lesser extent, on 10-year debt too.

Stage four would be to give government bail-outs to companies that are too heavily in debt, or even to nationalise them - as has happened with some Japanese banks.

And stage five is to create inflationary expectations so that people start buying now before prices go up and are prepared to take on debt because they think the real value will fall in the future.

There are however problems with all these policies. As we have seen, cutting short-term rates and running a large fiscal deficit have not worked in Japan, so one and two have their limitations. Three has not worked in Japan either: long-term government debt yields about 1 per cent. Four only works if taxpayers think they will not have to pick up the tab for the bail-outs at some later stage and cut back their spending in anticipation. And five is risky and difficult to sell. It means telling the public that you will follow an irresponsible policy on inflation. That is not something that increasingly elderly electorates are likely to vote for, and it would be a policy that would run counter to everything that central banks have been promising for the past two decades.

HSBC's view is that there are likely to be two huge changes in the economic landscape. One is the emergence of big budget deficits. Devices such as the eurozone Stability and Growth Pact and Gordon Brown's golden rules will wither away. The other is that central bank independence and inflation targeting will increasingly come under attack. The structures that were designed to crush inflation will be replaced.

This is really ground-breaking stuff. I am not sure whether it is right or not. A world of price stability has been the norm for most of the past 750 years in Britain; the inflation of the past 40 years was historically very unusual. Deflation of itself need not be a catastrophe. Indeed, falling prices are a good thing in that they distribute the benefits of rising productivity widely. The social destruction of very rapid inflation is extremely dangerous: remember Britain in the 1970s. The recent house price boom in the UK has been socially divisive, rewarding the rich home-owners and punishing the poor council tenants.

One could go further. I am not sure that the central banks could create inflation even if they tried. Oh, I suppose if they really tried to debauch the currency by printing huge amounts of money and scattering it from lorries in the streets (or the electronic equivalent) then, yep, I guess they could. But I cannot see older people voting for that.

As for ever-larger fiscal deficits, some day governments will have to acknowledge that they will be running up huge debts that young people as taxpayers will have to spend the rest of their working lives paying off. I cannot see the young voting for that.

Certainly the political mood in much of the developed world seems to have moved sharply against inflation. Deflation is quite popular in Japan because most people seem able to buy more with their income. The surge in inflation in Europe after the introduction of the euro was deeply unpopular. One of the main reasons why European consumers are cutting back their spending is they are so furious at the price rises - which incidentally have not been captured in the official statistics.

My guess is that price stability is here to stay, with a touch of deflation some years and a touch of inflation in others. And we had better get used to it.