What's Wrong With Deflation?

We kept getting told that deflation is the greatest threat facing the economy. In my Moneyweek column this week, I'm suggesting we shouldn't be so sure about that. Here's a taster....


Like a last-minute twist in a movie, March turned out not to be the first month of deflation after all. Despite widespread predictions of the first fall in prices for half a century, the Retail Price Index was stuck at precisely zero percent.
All the experts ready to warn us about how deflation was the greatest threat since the black death had to put their lectures on hold. The wise-sounding reminders about Japan’s ‘lost decade’ had to be wrapped up for another month. But they won’t go away. As more and more money is printed, we’ll carry on being told that the threat of stuff getting cheaper is the real danger the global economy faces.
It’s nonsense. The truth is, there is nothing to fear about deflation. Indeed, it has been central bankers’ paranoid and irrational fear of falling prices that has helped to land us in this mess in the first place. To start clawing our way out of the economic crisis the world needs to start learning to accept there is nothing wrong with prices dropping occasionally.
Deflation is fairly simple phenomenon. It means prices going down a bit year on year, rather than going up. Our Victorian ancestors would have found nothing very odd about that. In the 19th century, according to statistics published by the House of Commons library, prices went up some years, then down in others. In 1854, for example, prices rose by 15%, then came down by 8.4% in 1858. The net result was that in 1914, prices were roughly the same as they had been a century earlier. By contrast, prices have risen every year since 1945, making an aggregate rise of 22 times.
Most people might think stable or falling prices sounds quite good. A whole army of economists, however, keep telling us how terrible it is. On close examination, however, it turns out that most the arguments against it are remarkably threadbare.
We keep getting told that it will hurt the economy because it will force people to postpone decisions. Why buy that sofa today if it will be cheaper in six months time? Demand will collapse, and people will be thrown out of jobs.
The trouble is, it’s not really true. If it was, we wouldn’t have a computer or electronics industry. Both are subject to savage price deflation, and yet are among the most innovative and fastest-growing businesses in the world. The reality is that people adjust. They know they can buy a better and cheaper PC in six in six months time. Against that, they really want one right now. Quite quickly a balance is struck.
True, deflation is bad for people who’ve borrowed lots of money. The debt stays the same whilst their income may go down. That will hurt. Against that, however, they could always try working a bit harder, and paying back their debts honestly, rather than letting inflation do the job for them.
Then there is the upside of deflation, about which we hear remarkably little. Whilst it is bad for borrowers, it is good for savers, who find themselves getting magically richer year on year rather than poorer. It may well have a positive impact on consumption as well, despite what we kept being told. After all, if you reckon that falling prices will be make you slightly richer next year, why not spend a bit more now?
In truth, deflation, like any other economic event, is fairly neutral. It has winners and losers. Its gets a bad press largely because the losers are a lot more powerful than the winners.
Deflation is bad news for the chief executives of big companies. So long as there is some inflation out there, they can push prices steadily upwards, and keep profits growing without doing very much. They can even slip through some stealth pay cuts for the workers by increasing their wages at slightly less than the inflation rate. With deflation, none of that is possible.
It is even worse news for the City. One of the main ways the financial industry makes money is through inflation. Without it, the private equity firms would be completely finished. So would most of the hedge funds (who rely just as much on debt). Inflation usually means savers – the customers, that is – get clobbered, whilst borrowers – the city institutions – get rich.
And, of course, it is great for the government. It gets stealth tax rises (by leaving thresholds where they are). And it sees its vast debts quickly wiped out. Deflation would hammer the Chancellor of the Exchequer before anyone.
The people who it benefits – mostly small savers and ordinary consumers – are far less powerful.
That doesn’t mean they should be ignored, however.
Indeed, fighting deflation is one of the ways we got into this mess.
The past decade should, looking back, have been a period of gradually falling prices. Globalisation, and particularly the integration of India and China into the developed economy, put a lot of downward pressure on costs. So did technological change: computers have made lots of things cheaper to produce. In the U.K.’s case, the strong pound was another factor – with everything we import getting cheaper, prices on the high street should have been falling.
Overall, prices by 2007 should have been 5% or so less than in 1997.
But central banks fought that. In thrall to a paranoid fear of deflation, they kept printing more and more money to stave it off. They succeeded, as we know. The price, however, was a massive asset price bubble. Now that it has burst, the world has been plunged into recession.
It would have been far better to accept a short period of deflation, ignoring the industrialists and financiers who warned it would lead to catastrophe. And you know what? It still would be.