Indeflation ... tis a stickey wicket

By Samuel Brittan
Published: January 29 2009 18:49
Financial Times

Say after me:

Not all slumps are associated with deflation:

Not all deflations bring about slumps.

Too much that passes for financial comment is preoccupied with the bogey of deflation when it ought to be concerned with the reality of slump. By deflation I simply mean a sustained period of falling prices. This has sometimes been associated with falling output and activity, but not always. And you can have a severe slump while inflation is still in double digits, as any veteran of Latin American experience will confirm. It is more nearly accurate to say that slumps are associated with rapidly falling inflation, which may or may not take the recorded rate into negative territory, but even this generalisation is subject to many exceptions. By focusing on deflation we are picking on the wrong enemy.

We have been here before and not very long ago. Early in this decade when financial markets were getting jittery after the collapse of the dotcom bubble I wrote a column entitled “Take a razor to the deflation debate”. Some of the same short-fused commentators who now blame Alan Greenspan, the former Federal Reserve chairman, for overstimulating the US economy were then screaming for him to do more to offset the threat of deflation. A US economist, David Beckworth, has helpfully summarised the debate in the autumn 2008 issue of the Cato Journal. He distinguishes between malign deflation associated with a fall in overall demand and the benign kind associated with a productivity acceleration, the benefits of which are taken partly in the form of falling prices rather than entirely in rising wages. An example of this second type of deflation was the experience of the US between 1866 and 1897 when prices fell by an average of 2 per cent a year and output rose by nearly 4 per cent a year.

Such examples are, however, by no means confined to historical periods when prices and wages in industrial countries were more flexible. The UK consumer price index was rising last December at an annualised rate of less than 1 per cent if the comparison is made over six months rather than the conventional 12. The more popular retail prices index, to which many wage contracts are linked, had already fallen by an annualised rate of 3 per cent in a comparison over a similar period. This unusual behaviour was due to a combination of falling oil and commodity prices, the temporary value added tax reduction and price cutting in the shops, which together more than offset the effects of sterling depreciation. Should the British government reverse the VAT cut or plead with Opec, the oil producers’ cartel, to raise oil prices just so it can say that there is no deflation? Or should we commit the “essentialist” sin of trying to define deflation out of existence?

The obsession with deflation is not confined to lesser breeds without the law. The Bank of England itself hardly ever refers to the danger of recession or economic slowdown without adding the mantra that this would risk taking inflation below the 2 per cent target. Suppose that we had one day a recovery with output rising by 4 per cent a year and no inflation at all, which is quite conceivable, although not very soon. Would Threadneedle Street be besieged with howling mobs screaming: “Give us back our 2 per cent inflation”? The fact is that the Bank has chosen to act as if the 2 per cent inflation target were its only objective even though its frequently reproduced mission statement requires it to “support the government’s objective of maintaining high and stable growth and employment” so long as this can be done in a non-inflationary way. There may be members of the MPC who feel as I do about this logic-chopping but, once they are satisfied with actual decisions, do not have the energy left to quibble about wording.

The obsession with deflation stems pretty obviously from the experience of the US in the Great Depression of the 1930s. Between 1929 and 1933 US nominal incomes, real incomes and wholesale prices each fell by cumulative amounts of between 30 and 50 per cent. This was so obviously part of the same process that there seems no harm in labelling the whole process a major deflation. But important though it was, the Depression is not the whole of world recorded history and there have been other episodes when prices and output moved in opposite directions.

Finally, what about the spectre of “debt deflation”? This was invented by the leading US economist, Irving Fisher, after he had bankrupted himself in the 1929 stock market crash. The idea is simple. If a businessman borrows at 5 per cent and the inflation rate falls to minus 3 per cent he faces a real effective rate on repayment of 8 per cent. But this phenomenon is not confined to actual deflation. Suppose that he borrows at 10 per cent and the inflation rate falls to plus 2 per cent, he still faces an effective real interest rate of 8 per cent. The squeeze results from a sudden and unexpected drop in the inflation rate whether or not it reaches negative territory. This is an argument for gradualism when squeezing inflation out of the system when that is possible, which is far removed from our present problems.