George Kerevan: Deflation stalks UK streets but we may yet escape

Published on Tuesday 18 November 2008 20:36

BETWEEN the Lines

ARE we headed for deflation, Japanese-style? UK inflation fell in October from a 16-year high of 5.2 per cent to 4.5 (on the CPI measure) as oil and food prices fell. On the RPI index – which sensibly includes housing costs – the drop was even greater, to 4.2 per cent.

For a start, price rises of 4.5 per cent a year will destroy half the value of your savings inside a decade, so don't entirely write off the inflation monster. However, I do expect inflation to moderate further still, not least because broad money supply is contracting at an unprecedented rate thanks to the credit crunch. Cue a quick economics lesson.

A sudden jump in oil prices is not the same thing as inflation. Technically, it is a shift in the relative price of a single commodity and all other prices have to move in line. However, all things being equal, this is a one-off adjustment. That is what happened over the summer as petroleum prices headed to $150 a barrel thanks to a tightening of supply and some judicious speculation by hedge funds baling out of sinking equities. The boost to our fuel bills made us poorer, and in popular terms that is the mark of "inflation". But actually this was just markets adjusting as they should.

True inflation is when the whole monetary system goes haywire. This happens when the monetary authorities let too much money (i.e. credit) get pumped into the economy. Too much money chasing too few goods sends all prices spiralling out of control. As wages often go up in parallel (as they did in the 1970s), folk often find they can live with a dose of serious inflation – especially as it makes debts smaller to pay back in real terms. As governments are often the biggest borrowers, they like inflation too.

The downside is that soon no-one knows what anything is actually worth, so firms stop investing. And eventually everyone gives up saving – why bother, if your savings account won't buy anything? End result: the economy falls apart and unemployment soars. Don't go there.

This explains the emphasis over these past couple of decades on monetary stability, aka keeping the inflation dragon caged. But what happens if we overshoot and send prices tumbling down year after year? In the UK this happened between 1921 and 1933, and earlier between 1874 and 1887. In those periods, financial crises caused the broad money supply to contract, just as it is doing now.

Then everything went into reverse. Too little money chasing too many goods caused prices to fall year after year. The worry is that if prices are expected to fall, consumers and investors delay fresh purchases in order to take advantage of next year's bargains. Unfortunately, that means no-one is buying in the short term – and the whole economy shudders to a halt. Is that where we are going?

Again, we need a bit of theory. A fall in the price of consumer goods is actually a good thing: it means we can buy more with our wages. For most of the history of capitalism, the price of consumer goods has indeed fallen – the result of productivity improvements and technological change. When the original ballpoint pen went on sale in 1945 in Gimbels department store in New York, it cost $12.50 – roughly equivalent to $150 now. But these days, you throw away ballpoint pens because they are so cheap.

By and large, falling consumer prices do not in fact lead us to stop spending money in the shops. Think of the falling price of electronic consumer goods of all descriptions over the past 20 years. Did the drop in the price of televisions mean we stopped buying them? No, we just put one in nearly every room in the house.

The real danger with falling prices is not consumer goods but wealth-defining assets: property and shares. If these crash and burn over a long period, then we have genuine deflation. Asset deflation wipes out wealth, driving people to save to rebuild their nest egg. You can have long periods of consumer prices falling, but as long as asset prices are still rising, overall spending still goes up.

Is there a link between broad money supply and asset prices? Yes: a credit bubble usually triggers asset price inflation, as assets such as property are restricted in supply compared to consumer goods. Then we get a self-reinforcing cycle: higher assets values allow greater borrowing, which drives up the demand for property and equities. But when the bubble bursts, asset prices crash and credit dries up.

The most important example of genuine deflation in recent times was in Japan in the 1990s. In December 1989, the Nikkei share index hit 39,000. Today it is still under 8,500. Property prices in Tokyo's downtown Ginza district in 1989 were running at an insane $139,000 per square foot. Thereafter asset prices crashed. They key problem was the ridiculous level of debt that had to be eliminated, and the fact that the Japanese banks tried to cover up their losses for a long time. Japanese governments spent a fortune on fiscal stimuli, covering the country in concrete. But this had no great impact on frightened consumers.

Are we in Japanese deflationary territory? My personal view is no, at least not yet. While the UK has the worst private debt ratio of the leading economies (including America) it has not reached the levels seen in Japan at the start of the 1990s. The necessary correction will be difficult but need not be a decades-long affair.

The UK banks have also owned up to their losses (as far as they actually know them). And the drop in asset prices, while it still has a way to go, is hardly the stomach-turning variety. If we take the level of UK house prices in 1952 as 100, it stood at 9,738 in the third quarter of 2007. Last quarter it was at 8,736, roughly where it was two years ago. That's a drop, but hardly deflation in any historical sense.

It is also worth remembering that the Japanese economy is still the second-largest in the world. Their deflation blunted growth but the real economy purred away by selling machines and consumer goods to the Chinese. Britain's problem, even with a modest downturn in domestic spending, is where to find alternative export markets to make up the difference.

If the Bank of England ensures that the growth in broad money supply remains positive through next year, and asset prices bottom out at some reasonable level, we will not see a genuine deflation in the UK. My only worry is that the Bank has virtually given up targeting money supply – otherwise it would not have let it get out of control in the mid-2000s.