Philip Booth in the Daily Telegraph on the perils of a deflationary shock

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. What could happen in practice if prices suddenly fell by (say) 10 per cent next year?

Deflation would mean that financial obligations of individuals, governments and businesses would rise in real terms (ie, in purchasing power terms). For example, if an employer expected to pay a salary of £100, the purchasing power of that £100 would rise to £110.

Prices have fallen, so a given sum of money is worth more. This is a bonus for the employee, but a disaster for the employer who is selling goods and services at lower prices and still facing the same wage bill.

Unless wages adjust rapidly, the cost of employment rises and people are laid off – this was one of the reasons for the unemployment of the Great Depression.

The story does not end here. Tax revenues will fall – the link is obvious in the case of consumption taxes such as VAT. But government spending will probably not fall. Will the Government be able to reduce public sector wages and social security payments to match the fall in prices?

It is highly unlikely. The more regulated and unionised the labour market, the worse these effects are, as employers and employees find it more difficult to change contracts and reduce wages and other benefits.

The real value of debts also rises, so individuals and companies find it more difficult to service and repay their debts, especially if interest rates on those debts were fixed at high levels before the period of deflation began.

If deflation does not cripple companies because of its effects on the level of their debts, then their pension liabilities will probably cripple them instead. Many pensions are linked to rising prices but not to falling prices.

Indeed, this is all reminiscent of what happened after the Berlin Wall fell. Helmut Kohl foolishly decided to give East Germans one Deutschemark for every Ostmark. All very nice – unless your debts were in Ostmarks, in which case you suddenly owed a lot more. Jobs were decimated.

Pensioners will also suffer from falling interest rates. A bout of deflation probably means a period of zero interest rates. This is not an enticing prospect for those relying on their savings to provide them with an income, though at least the purchasing power of their capital will rise.

So, what do we do? Inflation is a disease of money (too much). Deflation is a disease of money too (not enough). Just as the Bank of England should not have allowed monetary growth to get out of control in the boom, it must not allow severe monetary contraction either.

The Bank of England is reducing interest rates to try to stop deflation happening. But what happens when interest rates hit zero or if reducing interest rates has little effect?

There are other ways of increasing the quantity of money. As Milton Friedman suggested, banknotes could be dropped from a helicopter if necessary. Ben Bernanke, Mervyn King’s equivalent in America, is considering less crude but potentially equally effective ways of directly influencing monetary policy – we should do the same here.

The Government’s so-called fiscal stimulus, on which so much energy was expended, will be useless at best. The Government is piling its own debt on over-indebted households and promises a whacking great tax increase in a couple of years’ time. Instead, energy should be focused on monetary policy.

But Gordon Brown has made this all much more difficult by his reforms to the Bank of England in 1997-98. The Bank has the responsibility for preventing deflation, but Mr Brown gave many of the instruments that can be used to achieve this to an agency of the Treasury.

This dismembering of the Bank of England caused chaos when the authorities tried to “co-operate” during the Northern Rock affair. I hope that co-ordination to avoid deflation, if it proves necessary, works better: the stakes are high.

Professor Philip Booth is Editorial and Programme Director at the Institute of Economic Affairs

See also
Money and Asset Prices in Boom and Bust by Tim Congdon.