You are here:

Don't fear deflation

Created:
2 December 2008
Written by:
Chris Dillow

Britain is facing deflation. Economists at Barclays Capital expect the retail price index to fall by 1.7 per cent in the 12 months to next October. That hasn't happened since 1933.

Advertising

Is this a problem? Certainly, the cause - falling demand - is. But the main reasons usually given for thinking deflation a bad thing aren't as compelling as they seem. Let's run through them.

"A fall in the general price level means that real interest rates will rise with the result that monetary policy loses its ability to stimulate the economy. If prices fall 3 per cent then even a zero interest rate implies a 3 per cent real rate. Which is too high for an economy in recession."

True, conventional monetary policy loses its power. But unconventional policy doesn't. To see why, just ask why the price level in the UK isn't astronomically high as it is in Zimbabwe. It's because - by definition - UK bank notes have more value than Zimbabwean ones. And where does this value come from? Their scarcity. And why are they so scarce? Simply because the Bank of England doesn't print enough of them. If Meryvn King were to print tenners and drop them from a helicopter over the country, the price level would rise as the notes lost their scarcity value.

For this reason, Federal Reserve chairman Ben Bernanke has said: "Under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

"As prices fall, consumers will postpone spending in the hope of getting more bargains later."

Would you really starve yourself this month because you expect food prices to fall next? Or turn off Coronation Street tonight because lower electricity prices next summer will allow you to watch it on two TVs? Unlikely.

It's not just introspection that tells us this. So do hard facts. In much of the high street, deflation has been a fact for years. Prices of clothes, digital cameras, TVs and computers have been falling for a long time. And yet until recently spending on them rose healthily. This tells us that people's impatience usually outweighs their desire for a bargain later.

"Falling prices raise the real value of debt. The quantity of goods and services we must sacrifice to service debt rises. As people and companies struggle to do this, they are more likely to default, which spreads losses across the economy."

This is a danger. But there are two offsets.

First, deflation raises the real value of assets too. Those of us with cash in the bank get richer, and so can spend more. Irving Fisher's debt deflation is largely offset by Arthur Pigou's real balance effect.

Second, although deflation is, by definition, a fall in the general price level, it also involves changes in relative prices which can be benign. Many of us suspect the cut in VAT won't do much to boost spending. But the fall in the price level it will cause will hardly be a danger. Nor will falls in prices of petrol or utilities. Yet these three are the main reasons why we'll get deflation.

What's more, many companies most vulnerable to deflation aren't - or shouldn't - be highly indebted. One reason so many miners floated on Aim a few months back was because even banks weren't daft enough to offer big debt finance to firms whose cashflows were so sensitive to the risk of deflation.

All this suggests deflation might not be the danger some think it is.

Better still, it might even have some positive effects.

One is that if prices were falling and interest rates were zero, we'd have no need to economise on cash balances and waste time and effort transferring money to savings accounts. We wouldn't have to make so many trips to the cashpoint and wait for ages while the dork in front pores over his account statement. And as we'd get a good return on our current account - thanks to falling prices - so we could leave money in it. We wouldn't then have to worry about losing interest if we need cash to fix our boiler or car.

You might think these gains are trivial. Not quite. Bank of England economists have estimated that they are equivalent to 0.11 per cent of GDP for each two percentage point drop in inflation and nominal interest rates.

There's another gain. When prices and wages rise even in merely nominal terms we pay more in VAT and income tax. The higher is inflation, therefore, the higher are the deadweight costs of taxation - the extent to which they distort work and spending decisions. This is especially true of savings. Imagine prices were to fall 3 per cent a year and interest rates were zero. As you'd pay no tax on your savings your real return would be 3 per cent. That's better than the 1 per cent return a top-rate tax-payer would get with interest rates at 5 per cent and inflation at 2 per cent.

Deflation, then, removes the tax-induced bias against saving. Granted, this might depress demand in the short run as people save more and spend less. But it might have longer-term benefits, as a nation that saved more would be less vulnerable to recessionary shocks such as the ones we've just had.

All this raises a question. If deflation is not so terrible, why is it so feared? Partly it's because of cognitive biases. People mistake cause - a nasty fall in demand - for effect, a more benign fall in prices. Also, deflation is unfamiliar, and people hate the unfamiliar. And then there's guilt by association. We associate deflation with the 1930's depression, Woody Guthrie and John Steinbeck. We forget that deflation was common in the 19th century, and was quite often accompanied by reasonable growth in the economy and share prices.

But perhaps there's another reason why deflation is hated. It might, on average, be no disaster for real people. But it is a problem for the state, as it means rising real debt and lower growth in tax revenues. So governments hate it.

  • Back to top

Win £1,000 or a golf weekend

Enter IC's Fantasy Portfolio competition for the chance of winning £1,000 or a luxury golf weekend, courtesy of ETX Capital and Celtic Manor.

Enter here for your chance to win

Advertorial Feature

Take control of your investing with CFDs

Have you ever watched a move in the markets that you saw coming, but you weren't able to exploit?

by Dominic Picarda

Advertorial Feature

Spread your risks with spread trading

With so many big moves in the world's financial markets, there have seldom been more opportunities around for spread traders. Isn't it time you joined them?

by Dominic Picarda