Monetary Policy

Deflating the over-inflated anti-deflation balloon


With the news that inflation has fallen to 0.5 per cent there are “fears” that we might be about to slide into deflation. It is worth noting, firstly, that it is CPI inflation that has fallen to 0.5 per cent – RPI inflation is still 1.6 per cent, which is sufficiently high for prices to rise by 50 per cent in 25 years.

Putting aside debates about the appropriate measure of inflation, should we be worrying about deflation as almost every commentator, including those in free-market-leaning newspapers has suggested we should?

Deflation is often regarded as being problematic for three reasons. The first is that a lot of contracts are written in “nominal” terms or have “nominal” floors to them: it is easy for employers to raise wages, but not easy to reduce them; it is extremely difficult for pension funds to reduce pensions when the value of money rises; and certainly it is politically difficult for the government to reduce state pensions. Secondly, as the value of money increases, the real value of debts increases (corporate debt, government debt, mortgage debt etc). Finally, it is argued that consumers will defer spending and consume less in anticipation of prices falling.

Deflation and supply-side shocks

None of these arguments is valid in relation to the fall in inflation that we have recently experienced. The fall is almost entirely a result of the reversal of the commodities boom of 2007-2009. It is a one-off event and thus consumers will not be anticipating future falls in prices. Furthermore, the fall in oil and other prices simply makes goods and services cheaper for consumers and cheaper for firms to produce – in other words, more can be produced with a given set of resources. Under these circumstances, workers should benefit from lower prices and firms do not need to cut wages: the prices of firms’ products are only falling because the prices of their non-labour inputs (oil, energy, and so on) are falling. Furthermore, given that households will not experience a fall in nominal wages they should be able to service their debts, and governments may well enjoy a rise in tax receipts as productivity increases. Indeed, George Osborne should be rejoicing that at least one of the reasons for stagnant productivity and tax receipts (high oil and commodity prices) is now firmly behind him.

Permanent deflation

But what if the fall in inflation occurs for reasons other than commodity prices falling and we moved to a permanent state of prices falling by (say) 1 per cent per year? In my view, this would be a good thing. Of all the arguments summarised above, the main argument against deflation is that nominal wages are sticky in a downwards direction. This is certainly an argument for deregulating labour markets, but even the UK’s highly regulated labour market showed a remarkable capacity for adjustment when the financial crisis led to a necessity for wages to fall. Indeed, the much-expected prolonged rise in unemployment after the crash simply did not happen. In normal economic times, we would expect productivity to rise and people to receive rises in real wages. If those rises in real wages are received in the form of price cuts rather than nominal wage increases, this is arguably a more efficient mechanism than workers continually renegotiating their wages with employers. Stable wages and steadily falling prices should be a welcome combination.

When it comes to the problem of “debt deflation”, this is a problem that is no worse with deflation than with unexpected falls in inflation. When the Thatcher-Major governments reduced inflation, they were left with the problem that government debt sold at high interest rates when inflation was high still had to be serviced when inflation fell (and therefore nominal tax receipts not rising as fast as would have been expected). By comparison, a movement from +2 per cent to -1 per cent inflation is a trivial problem. Once we expect deflation, it will be taken into account when interest rates on borrowing and lending are determined: borrowers will pay lower interest rates but lenders will find their capital is worth more each year.

Deflation in the euro zone

None of this is to under-estimate the problems in the euro zone. There we have dysfunctional economies and a banking system that may well be incapable of adapting to deflation. Some countries could do so easily. But in other countries, the state of the banking systems and the corporate sectors, as well as the rigidities of the labour markets, may well cause problems if there is deflation. But it is these problems that should be addressed through reform. If countries have signed up to a single currency, they should reform their economies in such a way that the currency will work both in good times and in more difficult times.

Deflation-inflation asymmetry

And this takes us to the nub of the issue for both the euro zone and the UK. If deflation is always and everywhere to be rejected, even as a remote possibility, we are going to have a strong and dangerous bias towards inflation. We have an inflation target of 2 per cent and pretend that this is the same as price stability. If policymakers are going to be relaxed about going over target (as they were when oil prices rose) and paranoid about being below target, the average level of inflation will be over 2 per cent. In the euro zone the position is worse – commentators (though not central bankers) seem to be paranoid about deflation under any circumstances in any euro zone country. This is precisely the problem of asymmetric monetary policy that many of us feared when the euro began – if ever there were inflation in a particular EU country, the issue would be ignored; however, if there were ever deflation in any country, monetary policy would be loosened whilst ignoring the inflationary consequences for other countries.

So far, that has not happened. But we must not allow the anti-deflation doom mongers to dictate the terms of the debate. Low inflation right now in the UK is a good thing, and deflation in general is something we can learn to enjoy, just as British workers did in the late 19th century.

This article was originally published on Conservative Home.

Academic and Research Director, IEA

Philip Booth is Senior Academic Fellow at the Institute of Economic Affairs. He is also Director of the Vinson Centre and Professor of Economics at the University of Buckingham and Professor of Finance, Public Policy and Ethics at St. Mary’s University, Twickenham. He also holds the position of (interim) Director of Catholic Mission at St. Mary’s having previously been Director of Research and Public Engagement and Dean of the Faculty of Education, Humanities and Social Sciences. From 2002-2016, Philip was Academic and Research Director (previously, Editorial and Programme Director) at the IEA. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. He is a Senior Research Fellow in the Centre for Federal Studies at the University of Kent and Adjunct Professor in the School of Law, University of Notre Dame, Australia. Previously, Philip Booth worked for the Bank of England as an adviser on financial stability issues and he was also Associate Dean of Cass Business School and held various other academic positions at City University. He has written widely, including a number of books, on investment, finance, social insurance and pensions as well as on the relationship between Catholic social teaching and economics. He is Deputy Editor of Economic Affairs. Philip is a Fellow of the Royal Statistical Society, a Fellow of the Institute of Actuaries and an honorary member of the Society of Actuaries of Poland. He has previously worked in the investment department of Axa Equity and Law and was been involved in a number of projects to help develop actuarial professions and actuarial, finance and investment professional teaching programmes in Central and Eastern Europe. Philip has a BA in Economics from the University of Durham and a PhD from City University.



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