The Age of Deflation

February 17, 2009

The Age of Deflation
A sustained fall in prices would cause immense economic disruption and hardship; policymakers are right to fear it and to focus all efforts on preventing it .

Figures released this week in the UK and the US are likely to confirm that the annual rate of inflation is decelerating. On some measures, inflation might even turn negative. Lower prices - not just weaker inflation - will sound like good news to households where incomes have been squeezed by tax rises and higher bills. But a sustained period of falling prices (deflation) would have huge economic costs.

While the risk that deflation will take hold of the Western economies is small, it is not trivial. The prospect is powerfully exercising the minds of central bankers and explains the urgency with which the Bank of England and the US Federal Reserve have cut interest rates. Their apprehension is justified: deflation would be the worst of outcomes for the global economy.

In Europe and America, the possibility of deflation goes against all postwar experience. During the Second World War, policymakers worried that the postwar economy would suffer prolonged falls in prices as troops were demobilised and capacity constraints were eased. Yet the enduring problem proved instead to be inflation. J.M. Keynes was the great intellectual influence on Western policy till the mid-1970s, yet his writings contained little on countering inflation beyond the view that expansionary policies should be relaxed before full employment had been achieved.

In practice, full employment, upward pressure on wages and earnings, and the willingness of governments to engage in deficit financing caused a build-up in inflationary pressures. Only with punishingly high interest rates and recession did central banks manage to tame inflation in the early 1980s. Since then, and especially since the mid-1990s, inflationary conditions have been broadly benign. Cheap imports from China helped to dampen inflation and allowed central banks to keep interest rates low.

Unfortunately, easy monetary policy also stimulated an unsustainable boom in asset prices and an irresponsible expansion of credit. The collapse of the housing market bubble and the credit crunch are now pulling the global economy down into recession. Inflation is decelerating sharply, helped by falls in commodity prices.

In the UK, the annual rate of consumer price inflation - the measure that the Government targets - declined a full point to 3.1 per cent in December. The Bank of England expects the figure to fall below 1 per cent this year. Annual inflation as measured by the retail price index, which includes mortgage repayments, has been falling even more rapidly and is approaching its lowest level since 1960.

A short period of falling prices would do little damage. Consumers are used to seeing the prices of some items fall consistently - particularly in electronic goods, as computing power has become much cheaper. But a long period of general price falls, as happened in Japan in the 1990s, would be damaging. Consumers would postpone purchases, as they would be able to buy goods more cheaply in a year or two. Employment and investment would collapse. Stock prices would fall as corporate earnings would contract. Most damaging, households with debt - either mortgage debt or unsecured loans - would suffer intense hardship. Adjusted for inflation, the value of their debt burden would rise. Deflation would cause hardship, eviction and widespread corporate and personal bankruptcy.

This is the risk, if not yet prospect, that central banks now contend with. Previous deflations are almost beyond living memory. The Great Depression was marked by hardship and hunger. The Long Depression of 1873-96 generated international friction, trade warfare and financial panic. These precedents are uniformly terrible; the stakes are extremely high.

http://www.timesonline.co.uk/tol/comment/leading_article/article5748227.ece