This excerpt was originally published in The Trouble With Markets — Saving Capitalism From Itself, pages 60-64, London: Nicholas Brealey Publishing Ltd, 2009.
The deflation danger
So, in a nutshell, despite the widespread alarm about the inflationary danger, in today’s conditions I reckon that deflation is a more likely threat to stability than inflation. In The Death of Inflation I argue that the western world was just one recession away from deflation. In Money for Nothing I argued that the collapse of asset prices might well bring on that recession. Now we are in it. Falling consumer prices are almost upon us. After all, in 2009, the consumer price index fell in the US, the eurozone, Japan, and China. In the UK this did not happen, mainly because of the inflationary effects of the weak pound. Nevertheless, the price level given by the index used in the old-fashioned measure of inflation, the RPI, did fall.
In 2010/11, however, surging commodity prices caused consumer inflation to rocket pretty much everywhere. Deja vu. Although commodity prices caused an upward shock to the price level in 2007/8, so they subsequently caused a downward shock when they fell. This could happen again. But the key point is that unless something else changes, inflation will return to its underlying rate. The question is what that underlying rate will be.
As I argued at the beginning of this chapter, in today’s conditions there is a good chance that the underlying rate of inflation will fall sharply — even into negative territory. For the collapse in the level of aggregate demand will put major downward pressure on inflation. As prices are cut in the face of weak demand, firms’ profits will collapse and they will sharply reduce their payrolls. Unemployment will rise. In these circumstances, the rate of pay inflation will collapse. Indeed, there have already been some cases where the workforce has agreed to significant wage cuts in order to preserve their jobs. The last time such a major change in the climate governing pay happened in the UK was in the early 1990s. Pay inflation came down sharply from 8-10% to about 4%, where it has remained until now, when it is lower.
To get into mild deflationary territory, pay does not have to fall; it merely needs to rise by less than the rate of productivity growth, with the result that unit labor costs fall. Once you reach that point you have the precondition for deflation, without any help from lower commodity prices or squeezed profit margins.
In most of the developed west, the underlying growth rate of productivity is about 2%. Accordingly, if the average rate of pay increase falls below 2%, the conditions will be in place for sustained deflation.
Because this did not happen quickly in response to the rises in unemployment that followed the Great Implosion, many people, ordinary and expert alike, have tended to believe that their initial fears of deflation were misplaced. They should beware. The time lags can be quite long. In the case of the Japanese “Lost Decade,” although the economy went into recession in 1991, it was not until 1994 that price deflation set in, and pay did not start to fall on a sustained basis until 1997.
In fact, I reckon that we could be in a state of underlying deflation quite soon. Once we have reached this stage, expectations of deflation can start to build, and thereby become the cause of further deflation, mirroring what happened with inflation.
Deflation is not necessarily a disaster. Indeed, in stable times a moderate rate of deflation could even be a good thing. But we are not in stable times. The danger now is that the expectation of falling prices will inhibit borrowing and spending and persuade people to sell assets in order to repay debt, thereby extending the depression through the process known as debt deflation, which the American economist Irving Fisher laid out, in theory, in the 1930s, and which the people of Japan experienced, in practice, in the 1990s.
Still, why worry? The textbooks show that deflation is dead easy to cure. So it is — in the textbooks. What is more, so is inflation. That should give pause for thought. The problem is that usually the textbooks are purged of all politics, all conflict between different interest groups, and all uncertainty. Central banks choose the inflation rate they want and that inflation rate duly emerges. If they don’t like deflation then they can, and should, stop it. Just increase the money supply. He presto. “With one bound, he was free,” and such like.
So why did the Bank of Japan find it so difficult to stop deflation in the 1990s? Because it did not apply a large enough dose of the monetary medicine? Yes, of course. But why not?
I have puzzled over this long and hard. I think the answer lies within the interaction between uncertainty and the different interests of various groups in society. In the textbooks there is no problem over the issue of how much monetary stimulus should be applied. If the central bankers don’t know by how much to increase the money supply, they should just increase it by a dollop, and if that doesn’t work, just apply more, and more, to the point of infinity.
Yet too large a dose might create inflation — just as some monetarists worry about today. Moreover, some people gain from deflation and others lose. The temptation is for the central banks to advance cautiously, applying small doses of the medicine and hoping it will be enough, then giving more, and then still more, if this proves not to be sufficient. The result is a natural tendency for the central banks to act too little, too late, and for deflation to ensue. What was true for Japan in the 1990s could easily apply to most of the rest of us in the decade ahead.
I tackle this issue in more depth in Chapter 8, where I discuss measures to get us out of the mess we are in. Here I will confine myself to saying that although quantitative easing has already been deployed on a massive scale, which will probably be increased, I suspect that this will still not be enough. Central banks will be reluctant to push the policy to the extreme. The result could easily be a bout of deflation, which could rumble on for years.
Moreover, the economy could readily experience more than one burst of it. For the factors I discussed above that are pushing us toward deflation will not exert their full force simultaneously. High commodity prices have caused measured headline inflation to pick up, just as the collapse of demand and rising unemployment are starting to bring falls in core inflation, accompanied by sharp downward pressure on pay. Currently high inflation could be followed by deflation, followed by inflation, followed by — who knows what.
It is important for people not to be taken in by the current bout of inflation and not to be persuaded that the deflation danger is over. The deflationary threat will be grumbling along for a good time yet.
The new policy regime
Deflation will be more likely if the monetary policy regime changes in the way I expect. I am going to discuss the desirable and likely future policy regime in Chapter 9. But, at the risk of letting the cat out of the bag, I must say something here. Straightforward targeting of the CPI with no special regard to asset prices looks to be merely a staging post on teh way to a new policy regime. Having been through what we have experienced, the Greenspan doctrine (which I explained in Chapter 1) is dead. Bubbles are so last year.
If I am right about the coming policy regime, the result will be that when, at some point in the future, asset prices start to show signs of a boom, the monetary authorities will seek to suppress them again, even if this implies consumer price inflation turning negative. The implication would be greater instability of inflation in the short run — sometimes plus 1%, 2%, or 3%, and sometimes minus 1%, 2%, or 3% — in the interests of greater stability, more broadly defined, in the medium term. If I am right, moderate deflation will become part of our normal experience.
However, to emphasize the point with which I started, this does not mean that we can forget about inflation. Although The Death of Inflation was a good title, it upset quite a few policy makers, several of whom reacted as though they thought the booksellers who had listed it under the fiction section had got it right after all. Surely, they said, inflation cannot be dead in the sense that it could never reappear? Of course not. There is a continuing danger of inflation; there always is.
Yet a major resurgence of inflation doesn’t look likely any time soon. Even though we experienced a commodity-induced bout of higher inflation in 2010 and 2011, and even though we will always need to keep the stakes and garlic at the ready, to my mind inflation looks like giving the appearance of being dead for many ears to come. Wouldn’t it be ironic if, just as the backwoodsmen were stirring up renewed anxiety about inflation, the world were to fall into its first experience of sustained price deflation since the 1930s?
It would be ironic, but it wouldn’t be nice. It would heighten the chances of experiencing an extended economic downturn, reminiscent of the Great Depression. That is why, in Part III, I lay out an approach to boosting aggregate demand and forestalling deflation. However, before we go on to discuss the treatment, we need to establish just how sick the patient is. Sticking plasters are fine for superficial cuts and grazes, but they are absolutely useless in cases of severe internal bleeding. What has happened to the world economy is not minor and it is not accidental. The Great Implosion, and the possible deflationary, or inflationary, dangers yet to come, are the direct result of a profound weakness in our economic system — the trouble with markets.