Deflation is Here — And The Government is Poised to Make it Worse

Consumer prices may not be deflating as quickly as Labour’s electoral chances did earlier this month, but — even after £300 billion of quantitative easing — price deflation for the first time in more than half a century is finally here. The Bank of England continues to throw everything at keeping prices rising at close to their 2 percent target. Yet it’s not working. And this is not just about cheaper oil. Core inflation has also been dropping like a rock.

I argued that “deflation was looming” for Britain last year, and feel a little vindicated that it has come to pass. But I don’t feel at all gratified about the thing itself.

In a highly indebted economy such as Britain’s — where private debt dwarfs government debt — deflation is a dangerous thing. Past debts — and the interest rates paid on those debts — are nominally rigid. Unless specifically stipulated as being inflation-adjusted (like TIPS) they don’t scale to price changes in the broader economy.

Under positive rates of inflation, inflation assists in keeping debt under control, by shrinking the present amount of goods and services and labour that equate to a nominal amount of currency. Under deflation, the opposite process occurs, and the nominal value of currency — as well as that of historical debt — rises, making the debt harder to service and pay down, especially with the ongoing accumulation of interest.

On the face of it, that is good news for net savers and bad news for net debtors. But raising the difficulty of deleveraging and debt service can often be bad for both, because debtors who cannot pay default, bankrupting themselves and injuring their creditors. It can also depress the economy, as individuals and firms are forced to stop spending and investing and start devoting more and more of their income to the rising real cost of deleveraging.

With growth last quarter dropping to 0.3 percent from 0.6 percent, this process might very well already be under way. This raises the prospect of the nightmarish debt-deflationary spiral above.

The last thing that the economy needs under that circumstance is more money being sucked out of it through slashing public spending. Sucking money out of the economy will make deleveraging even more difficult for debtors, and slow growth further as individuals and firms adjust their spending plans to lower levels of national and individual income. Yet that is the manifesto that the country elected to power in the election earlier this month. And although Osborne and Cameron can get out of it — via offsetting cuts in spending with tax cuts — if they go through with their election promises, the prospect of recession, continued deflation and rising levels of unemployment loom clearly.

What the economy really needed in 2010 was a deep and long commitment to public stimulus to provide the economic growth needed to let the private sector deleverage. Unlike the public sector, which is a sovereign creditor borrowing in its own currency — the private sector is far from a secure debtor. Private borrowers can — unlike the central government — “become the next Greece” and run out of money.

With interest rates in the last parliament having sunk down to new historic lows, such a thing was affordable and achievable. Instead, by trying to do public deleveraging at the same time as the private sector was deleveraging Osborne, Cameron and Clegg chose a much rockier path, one in which private deleveraging and public deleveraging are slow and grinding. With private debt levels still very high, the country remains vulnerable to another deleveraging-driven recession.

11 thoughts on “Deflation is Here — And The Government is Poised to Make it Worse

  1. Pingback: Deflation is Here – And The Government is Poised to Make it Worse « Financial Survival Network

  2. I believe exceeding low interest rates my be enhancing deflation in conjunction with the personal dept levels. I know it sounds contra intuitive.

    Going forward, I see deflation as here to stay: With wages stagnating due to off shoring and automation.

    • Some economists think this is the case. I think probably both effects (inflationary and deflationary) exist. I don’t the effects of an ultra-low interest rate environment are well understood.

  3. Pingback: Deflation is Here – And The Government is Poised to Make it Worse |

  4. I agree they are not well-understood which shows we are in desperate times. Low interest rates appear to create asset inflation which in turn causes deflation in the broad economy. As an example, if one over pays for a house he or she disposable income is shot thus limiting their economic activity.

  5. I think you are giving too much importance to the CPI. The real inflation in life of essentials is rising (and has rised) dramatically the last years. Rents/House prices, Transport costs, Energy (ignore last 6 months which is just a blio), Nursery and food have all risen much above 2%.

    There is no deflation. If anything we have experienced above average inflation the last years (see 8% increase in essential inflation in 2011 as calculated by Tullett Prebon).

    In reality, rates should have been much higher by now in order to address the low productivity and the housing market. But BoE is hiding behind the useless CPI.

    • I doubting there is inflation just not in the wage area of the economy which will inevitably cause real estate assets to drop in line with incomes.

      • I’m not doubting there is inflation just not in the wage area of the economy which will inevitably cause real estate assets to fall in line with incomes.

  6. Private debt is generally entered into voluntarily.

    Public debt, the opposite.

    (Legal contracts have to be voluntarily entered into)

    Therefore, private creditors generally deserve more consideration than public creditors, as the nature of the contract(s) in question will be less unfair.

    Indeed, commenting on the unfairness of public debt vis a vis its involuntary nature, Noam Chomsky recently stated that all public debt on Earth is illegitimate because its produced by rulers.

    So I am not sure we should care too much about reducing.

    Instead, abolish all austerity and just refuse to acquiesce to the creditors of public debt.

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