Stack of pound coins
Deflation means that the pound in your pocket is worth more each year. In an earlier age, deflation was regarded as benign at worst.

For a couple of hundred years before 1946, moderate deflation would occur over long periods of improving productivity. It was often associated with the good times.

It is easy to see why. The purchasing power of people’s incomes increased; people could take out life insurance policies knowing that if the sum assured paid for a funeral at today’s prices, it would pay for their funeral when they died; and businesses and individuals could sign contracts spanning the generations knowing that inflation would not lead to either party losing out.

Indeed, the economy can work better in a period of gentle deflation. If the price of housing rises for example, when prices in general are falling, we get an unambiguous signal that housing costs are increasing relative to other costs and that we should think about economising on housing. At a time when all prices are going up, it is difficult to work out what is going on in the marketplace.

Sadly, those days are past and we now have an economy that has adapted to inflation. The pound has had 97 per cent shaved off its purchasing power since 1946 and the Bank of England has a statutory mandate to target positive inflation, year after year.

A severe and unexpected deflation at any time can have serious consequences, but the consequences will be worse for an economy that has adapted to inflation…

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Philip Booth 154x154

Academic and Research Director, IEA

Philip Booth is Academic and Research Director at the Institute of Economic Affairs and Professor of Finance, Public Policy and Ethics at St. Mary's University, Twickenham. From 2002-2015 he was Professor of Insurance and Risk Management at Cass Business School. Previously, Philip Booth worked for the Bank of England as an advisor 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 and on the editorial boards of various other academic journals. 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.

4 thoughts on “The perils of a deflationary shock”

  1. Posted 10/12/2008 at 15:01 | Permalink

    The problem with deflation is largely the result of government intervention and union action. It is extremely hard to reduce nominal wages even if real wages remain the same or even rise.

    As an aside, your Great Depression example misses the point that the vogue was for RAISING wages in a depression to “increase the purchasing power of the worker”. This is what led to mass unemployment.

    Deflation also encourages saving and discourages borrowing, which is hugely beneficial economically.

  2. Posted 10/12/2008 at 15:01 | Permalink

    The problem with deflation is largely the result of government intervention and union action. It is extremely hard to reduce nominal wages even if real wages remain the same or even rise.

    As an aside, your Great Depression example misses the point that the vogue was for RAISING wages in a depression to “increase the purchasing power of the worker”. This is what led to mass unemployment.

    Deflation also encourages saving and discourages borrowing, which is hugely beneficial economically.

  3. Posted 15/12/2008 at 14:41 | Permalink

    Partly example with deflation was 2000-2008 trend of Russia’s ruble before current non-liquiduity of its financial market. Things really got better for people, as well as trade. Inflated currency does not have trust, and thus stops (to some degree) economic development.

  4. Posted 15/12/2008 at 14:41 | Permalink

    Partly example with deflation was 2000-2008 trend of Russia’s ruble before current non-liquiduity of its financial market. Things really got better for people, as well as trade. Inflated currency does not have trust, and thus stops (to some degree) economic development.

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