The Risk Of Deflation In 2015
Back in June last year — when year-on-year inflation was as high as 1.9 percent — I warned that deflation was a looming risk for the U.K economy, and argued that "[b]elow-target inflation should make Osborne and Cameron uneasy". And now year-on-year inflation tumbled from 1 percent in November to just 0.5 percent last month. I am in danger of being proven right about deflation.
But David Cameron and George Osborne are far from uneasy about the falling rate of inflation. "We should not confuse this welcome news with the threat of damaging deflation that we see in the eurozone," Osborne told the Royal Economic Society on Wednesday, emphasizing that he thought "[r]ising real incomes, a recovery spreading to all parts of our economy, and family budgets that can stretch that little bit further" would be the outcome.
That may be because the falling prices are a political boon for the Chancellor and Prime Minister, who are locked in a neck-and-neck race with Labour for the next general election. After five years of painfully high living costs and energy costs, Cameron and Osborne can (rather dishonestly) point to falling U.K. inflation and cry: "Look! Our long term economic plan is working!"
Obviously, Cameron and Osborne have nothing to do with the various supply-side and demand-side factors that have driven global oil prices to the lowest they have been since 2009. But that won't stop them from trying to benefit from events, as any good politician would do. After all, high energy prices have been one of a number of millstones around the neck of the economy throughout the last five years.
Another one of those millstones, of course — and one that Cameron and Osborne had complete control over — was the completely unnecessary fiscal austerity program designed to appease non-existent "bond vigilantes" that has sucked spending power out of the U.K. economy. But they won't let that get in the way of their election campaign! And even with the severe headwinds of austerity that held the economy back in 2011, 2012 and 2013 (such that only 1 in 7 Britons claimed in 2014 to be able to feel an economic recovery), the present tailwind of falling inflation and energy costs give the government a major advantage in the run up to the general election, so long as wages do not begin to fall in tandem with prices.
But whoever wins the election and forms the next government may quickly find themselves dealing with a bit of an economic mess. Because while a small dose of falling inflation might be a tailwind in the run up to the general election, it is also a dangerous force in larger doses and in the longer term. Why? First of all, as Steve Keen points out, the U.K. still has a major private debt overhang. Deleveraging following the 2008 Minsky moment and resultant financial crisis has been painfully slow, leaving consumers and businesses with relatively less to spend on consumption and investment, slowing the British recovery. (This, of course, was not helped by the government's decision to try and deleverage at the same time as the private sector).
And the existence of all that debt overhang is the thing that makes deflation such a dangerous prospect for the U.K. When you've got a large load of past nominal debts to pay down, a downward spiral of prices squeezes deleveraging businesses' budgets, which over the months can lead to a downward spiral of wages which in turn squeezes consumer budgets and ability to service their debts, which can lead to defaults and the panic-selling of debt-backed securities (as occurred in 2008 in mortgage-backed security markets). This risks the debt-deflation spiral of liquidation leading to falling prices, leading to more liquidation envisaged in the 1930s by Irving Fisher.
And the broader context makes such a prospect even more likely. With interest rates still at all-time lows and close to the lower zero bound the Bank of England has little room for manoeuvre to get the economy out of deflation should it fall in. In previous times, the Bank could simply slash rates to boost spending and disincentivize saving and thereby boost inflation. Currently, it has no room to substantially reduce rates. It would have to rely on asset purchases to try to do that, a strategy that has not proven effective in countries that like Japan that have fallen into the debt-deflationary trap. And in any case, anything the Bank does to boost inflation would likely be somewhat offset by further fiscal austerity (which has been promised by both the Tories as well as Labour), something which actually occurred in Japan during its long depressionary years.
Now, obviously, the U.K. (which is currently experiencing something of a baby boom) does not face the same demographic difficulties as Japan, or even continental Europe that have contributed to those areas' depressed economic conditions. Nor does it face the same bureaucratic and monetary constraints as troubled sovereigns in the eurozone. And indeed, should oil prices bounce back and stabilize at a higher level (as they may well do as unprofitable wells are shut off) the risks of a deflationary spiral are somewhat reduced.
But the risk of entering the deflationary trap — as Japan did — is now clearer than ever. Iceberg right ahead, Captain. Ring the alarm bells.
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