If, like me, you’ve spent your entire adult life fearing inflation as the universal bogie, welcome to the pantomime world of Post-Modern economics. Because there’s another bogie even worse: it’s called deflation. For those of you who are not familiar with the great British tradition of Christmas pantomime, the heroes of the drama innocently face the audience, while the monster always sneaks up from behind. And the kids all shriek: It’s behind you!
Let’s be clear about terms. Inflation is the rate at which the price level rises over a given period (normally a year); deflation is the exact opposite: the rate at which the price level falls. (Disinflation – insofar as economists agree at all – is the rate at which inflation falls and is an intellectual nonsense that should be ripped out of the economic textbooks.)
Why all the fuss about deflation?
In the brave new world that emerged after the dust clouds of the Credit Crunch dispersed, monetary policy, previously the domain of academic economists, took centre stage. Just as demand management (to obtain full employment), the universal mantra from the 1940s to the late 1970s, gave way to the fight against inflation in the 1980s, and then to sustainable non-inflationary economic growth from the 1990s to the first years of the new century, so changing economic conditions have heralded new economic priorities.
In the September 2015 edition of this magazine (Interest Rates are Due to Rise – or Maybe Not) I reflected that central bank chiefs, these days, are more prominent and more influential than finance ministers. The world is actually now run by this high priesthood of unelected sages whose awesome responsibility it is (exercised largely away from the prying eyes of elected legislatures) to do three things.
They set interest rates (essentially, they fix the price of money); they regulate the banking system; and (most obscurely) they maintain price stability. But in practice, these three things amount to managing the money supply. Put very crudely, too much money in the system (and most money is in the form of credit) and prices go up (inflation). Too little money in the system and prices go down (deflation).
The arts they use in the pursuit of price stability are obscure. As well as setting interest rates central banks engage in open market operations. They can lend money to banks (inject liquidity); they can buy banks’ bonds; or they can tell their counterparts in the Treasury to issue bonds which they then buy with invented money. As I said before, central banks make the illusionist David Blaine look like an amateur: they can conjure cash out of thin air.
The politicians have outsourced to their central banks the task of avoiding deflation because economists know from history that deflation can erupt from three scenarios.
Firstly, deflation often follows financial crises. This is because, after severe banking crises (and the Credit Crunch of 2008 was, in historical terms, gigantic) banks de-leverage; that is, they contract their balance sheets by calling in uncommitted lines and withdraw deposits made with other banks. As committed loans mature, they refuse to renew them except to borrowers of the highest credit quality.
Moreover, as now, there are always calls after bank failures for bank capital adequacy requirements to be tightened up. You may very well think that is sensible – HBOS and others were woefully under-capitalised before the Crunch. Hence, Basel II was upgraded to Basel III, by terms of which banks had to further increase their risk buffers against loan losses and, for the first time, to maintain liquidity buffers. Sensible, you may think; but all this accelerates bank de-leveraging (shrinking the balance sheet).
That much-loved British bank, RBS, is a case in point. Its balance sheet is currently well below half the size of what it was in 2007 – and it is still getting smaller. As banks deleverage, remember, they suck money out of the financial system, so the money supply declines.
Secondly, deflation can occur, as in the USA in the 1870s, in times of rapid mechanisation, when labour costs are falling as a result of technological innovation. Does that sound familiar? We are only now beginning to realise that much of the current labour market will be robotised over the next quarter century. Barely a day goes by without news of self-driving cars. So that’s a few million cab drivers on the dole.
In the late 19th century, the American experience was related to the opening up of the grain belts of the mid-West by the railroad, which pushed down unit labour costs. Pioneer farmers who had brought farmland from the Federal Government, financed largely by debt, were appalled to find that the value of their real estate, as well as the foodstuffs they sold, was falling in price and thus making their bank debt more difficult to service.
Thirdly, there has been de facto deflation in a swathe of consumer products in the first years of this century as a result of cheap imported goods from China, India, Vietnam and the rest. Go to Primark and check it out. Basic clothes and shoes are historically inexpensive, as is food. Much as dairy farmers complain (with good reason), the price of milk in the supermarket continues to fall. At 89 pence (ASDA, last week) for four pints of semi-skimmed, every cow must be a liability. No wonder The Archers (BBC R4) are in a funk.
The current precipitous oil price collapse, which started around Q1 2015, is certainly deflationary. As I write, the oil price has fallen well below the psychologically important US$30 per barrel threshold – its lowest level for 12 years. Yet a low oil price, of itself, should be a cause of jubilation. How good to fill one’s tank for less than £1 per litre. And think of the benefits for manufacturers, logistics companies, retailers and airlines. But the dramatic and sudden fall in the oil price and, given the supply side, the concerns that it may not go back up again in the medium term, have triggered deep anxieties that this will be the catalyst for a major global deflation.
Let’s be clear: fear of deflation drives deflation (it’s the same with its opposite, inflation). Let’s call this phenomenon: deflationary expectations. (There is probably an academic economist out there who coined that phrase before I did, but I’ll take credit for it for now.) Recall President Franklin D. Roosevelt’s line about how we have nothing to fear but fear itself.
Commodities across the board, as you will read elsewhere in this issue, are in free-fall. But I am not persuaded that the collapse in the oil price is part of some overall decline in commodities in general, which would be entailed in a major global economic slow-down. The supply side of the oil equation is relatively easy to manipulate for political reasons, in a way that the price of cocoa (for example) is not. My own take is that the Saudis originally started to increase production (supply) to spite the US frackers, but then realised that a sustained bear market in oil might take out some of their more conventional competitors as well. Plans to exploit the Arctic Ocean for its huge as yet untapped reserves (principally by the Russians) have been shelved. (Excuse the pun – Arctic Shelf… Never mind).
Fourthly, demographic changes are driving a fundamental re-balancing of the global economy. Many recent studies show that, currently, global demographics are conducive to deflation as the baby boomers retire. Globally, the ratio of new workers entering the labour market to the number of mature workers withdrawing (due to death, alternative lifestyles or conventional retirement) from the labour market is declining. At some point in the next 20 years it will fall below 1:1. That’s what armchair economists call a tipping point.
In fact, this critical, but little monitored ratio, has already fallen below 1:1 in Japan, which is, in so many ways, the only model that we have of what life is likely to be like in the world of Post-Modern, Post-Keynesian economics. I believe that we are now beginning to see that even Abenomics – quantitative easing on steroids, damn the consequences – will not return Japan to long-term growth, despite unparalleled levels of productivity. Ultimately, if Japan wants to grow, it will have to import people – which it is culturally and politically disinclined to do. Therefore, logically, it should manage GDP decline as the population declines in a way that maintains, if not improves, the quality of life for its people.
If Japan could do this it might indeed become a model to other nations which face similar demographic challenges, like Germany. It is already becoming a world leader in robotics – of necessity. Robots already care for old folk and even pets in Tokyo. Though there is a snag with this scenario. Japan already has a debt-to-GDP ratio of around 225% and as the economy shrinks, this will grow. Admittedly – a key strength – nearly all of this debt is domestic, as the fiscal regulations benefit citizens who lend to the Government. But there will come a point when the interest payments on this debt become unsustainable, even if super-low interest rates are perpetuated. Default would hit retirees worst: all those good people who have providently prepared for their old age by patriotically lending to the nation.
Granted, the world’s population is still getting bigger (though the rate of growth is slowing). But it is also getting older – fast[i]. People about to retire tend to stash cash and, once in retirement, they curtail consumption. (This is all linked to economists’ notion of the consumption function – the idea that, over their lifetime, people save while in employment and dis-save in retirement.) An ageing global population is deflationary; but the impulse towards deflation (because of deflationary expectations) will manifest itself well before the tipping point occurs.
Would global deflation really be so terrible? The policy makers fear deflation even more than their former enemy, inflation – because they think that it would render the management of government finances a nightmare. And they are right. This is especially problematic for debt-laden governments, which would struggle to service their debt repayments as the economy contracts and tax revenues dwindle.
And after just a few years of creeping deflation, the finances of already debt-strapped governments would go into melt-down. Tax receipts would dwindle though spending commitments would initially be sustained. (Look at the so-called advanced European economies after the 2008 Crash: they proved quite incapable of cutting welfare. Despite years of bluster about austerity in the UK, Lord Sugar and Rupert Murdoch will still receive generous winter fuel payments come December.) Therefore deficits will burgeon further at a time when debt-to-GDP ratios are already under severe strain. Over time, the situation will only get worse.
Down they all would go, one after another, like a row of skittles; Japan technically defaulting amongst the first; France, of course, the United Kingdom, all of the Eurozone, even immigrant-loving Germany. And they would take the bond and stock markets with them. The chimera of the infinite welfare state will die suddenly, not because brave politicians take deliberate action, but because the governments of liberal deflationary states have no more cash machine.
I wrote about sovereign default at some length back in the MI Magazine of July last year (Sovereign Default is a Funny Old Business). Spain has gone bust about six times since the Napoleonic Wars. But a modern “welfare state”, which Spain is, has not really gone under yet (we’ll put Greece in a separate box). The consequences for the millions who have been weaned on unlimited welfare will not be happy.
And there is another economic reason for concern. John Maynard Keynes, in the General Theory of 1936, points out that there is an apparent asymmetry between inflation and deflation. Inflation, he says, just effects prices. But deflation diminishes both prices and employment[ii]. This is because, in the Keynesian model, deflation stifles investment and therefore reduces demand. I admit that many right-of-centre economists these days are dubious about Keynes’s policy prescriptions (deficit spending, and so on). But his fundamental model of how the economy works is still very influential.
In a deflationary world, output contracts in both nominal and real terms, but debtors still have to repay debts that were taken out when price levels were higher. For a person or company with no debt, you could argue that, net-net, life continues as before. But for companies that have financed investment by debt, their capacity to repay that debt is enfeebled.
Both inflation and deflation have been regarded by policymakers as negative, yet perfect price stability is historically the exception. Overall, our rulers have opted for modest inflation – the current official target in the UK is still, incredibly, two per cent. This is at a level that most people will hardly notice if wages are rising modestly. And it also acts as a stealth tax on the cash-rich.
I was researching this last year when I downloaded a remarkable spreadsheet from one of the outposts of the US Federal Reserve. In fact, in the USA, over the 214 years between 1800 and 2014 for which we have data, in no fewer than 54 of those years the price level fell[iii]. Though, for my peers who gained economic consciousness in the late 1970s, it will always seem that inflation is the ogre.
My parents’ generation, who came into the labour market just after the end of WWII, rode an inflationary escalator for virtually all of their working lives. This enabled them to buy houses with borrowed money and to watch as the value of those houses steadily rose and the relative value of their original debt declined. Moreover, as the value of their wages rose in real terms, the burden of servicing that debt grew lighter as a result of persistent inflation. All this was possible despite nominal interest rates of 8-12% which then obtained.
But just imagine a world in which this scenario is reversed. Putting aside the problem that most young people can’t afford to enter the property market today, suppose that a young professional couple scrape together sufficient finance to purchase a median level London flat (which would cost them nearly £500,000 today) with a 25% deposit. They then spend the next 25 years repaying their £375,000 mortgage on declining wages as the value of their flat declines, putting them into negative equity, with little chance of escape. (A deflationary property market seizes up: once liquidity is drained there is no natural floor, and prices just keep falling. The Spanish residential property market over 2007-12 is such a case study.)
The response to the deflationary threat, of course, has been a historically unprecedented programme of money creation by central banks called quantitative easing or QE. True, QE may now be officially over in the USA and the UK, but in Japan the central bank’s foot is hard down on the accelerator, and the money printers are working round the clock. Back in Europe, the European Central Bank (ECB) Chief Mario Draghi announced on 22 January that QE in the Eurozone will be ramped up further. The ECB, it seems, is even buying Eurozone government bonds – much against the Germans’ better instincts.
Here in the UK, Bank of England Governor Mark Carney is agnostic on QE; but, as his tenure has evolved, the signals on the future of interest rates (and of future QE) have grown more obscure. So that’s all right then. Central banks will pump money into the system by buying government bonds (whatever) and price stability will be maintained.
Except that, just as hiking interest rates to combat inflation is often termed a blunt instrument by economists because it kills investment, QE may also be regarded as crude. With interest rates at effectively zero or negative, savings are dis-incentivised and, ultimately, investment is funded by savings. The tangible outcome of five to seven years of printing money has been that asset prices (houses and the stock market) have exploded – great news for the rich, of course – but with no real change to the volume of corporate investment which drives growth.
Ultimately, QE doesn’t actually create value, it just maintains confidence. And that confidence is now ebbing. Arguably, as the macro hedge fund manager Hugh Hendry has argued, QE stimulates growth in one part of the world economy while taking it away from another[iv]. Hendry thinks the rise in US growth was directly related to the fall in growth in China. So it’s not just a zero-sum game; it’s a sleight of hand. If QE was a long-term wonder-cure, you would expect Japan (ferociously conscientious workforce, state-of-the-art technology) to be doing better.
One view is that QE has diminishing marginal returns. The more you do it, the less it works. Like the druggie who finds that he needs a bigger and bigger dose to get the same kick. Money creation in this way may be ultimately ineffective – much of it ends up on the bloated balance sheets of the central banks themselves, who hold deposits of currency with one another! Very little of this wave of new money seems to have found its way into new investment.
So there is a possibility that, even despite QE, or even QEII, deflation may gain traction anyway. This is especially so in the Eurozone where, frankly, normal growth is unlikely to be resumed until the inherent structural problems of monetary union are resolved. And they are unlikely to be resolved in the short term. In a Reinholt-Rogoff[v] perspective, the Eurozone is a classic emerging market which is likely collectively or partially to default sometime soon.
The USA would probably escape official default by bilateral negotiations with its largest creditor (China) as it still holds, for now, the trump card of the world’s most desired currency. But it would not emerge as the sole global superpower. Perhaps there are parties for whom such an outcome is devoutly to be wished.
What are the chances of this scenario becoming reality? The odds have been rising of late as a number of financial pigeons come home to roost. George Osborne is right to be worried about a cocktail of risks. My own view is that, over the three to ten year window (crystal ball territory, I admit), unless there is some fundamental development that I cannot foresee that changes the model (and there often is), it is now more likely than not.
When Gordon Brown handed over control of interest rates to the Bank of England in 1997 – following the trend in other major economies – we thought that the Old Lady of Threadneedle Street would be compelled to set a natural rate of interest – that, is technically, one which keeps savings and investments in equilibrium. That is not how things have turned out. Instead, the model changed. Central banks, like health and safety nannies wearing high-viz jackets, just set rates that would minimise risk for the children.
What do rational money managers do if they fear deflation? Of course they pay down debt. Household debt has been rising again in the UK. But if you have the cash, it may be a good idea to pay off your mortgage, your credit card balance, your car loans – the lot. A recent research note issued by RBS apparently advised: sell everything! In a deflationary world, only cash appreciates in value in real terms as goods decline in price.
Big corporations on both sides of the Atlantic have been deleveraging for some time. But, ay, there’s the rub: this deleveraging further accelerates contraction in the money supply and so the fear of deflation risks becoming a self-fulfilling prophecy.
During the great American deflation of the last quarter of the 19th Century, the renowned William Jennings Bryan made a bid for the presidency on the platform of replacing the gold standard with the silver standard. The idea was that silver, which was more widely held, could restore price stability. If deflation does take hold you can be sure that the champions of silver will re-emerge, as when the Hunt Brothers tried to corner the silver market in the 1970s (at a time of rampant inflation).
I am not sure if it is reassuring to reflect that central bankers probably understand economic history better than finance ministers. But what if they have got it wrong over the last seven years or so? What if they really are facing the audience with those silly two percent inflation targets? And canny investors are the clever kids watching the pantomime closely – the ones who can see things the Ugly Sisters can’t. It’s behind you!
[i] Falling populations in richer countries fuel fears for future, Leo Lewis, The Times, Saturday, 22/11/2014.
[ii] The General Theory of Employment, Interest and Money. JM Keynes, Macmillan, 1936. See the final paragraph of Chapter 20, The Employment Function (on page 291 of the 170 Macmillan edition).
[iii] My calculation sheet, based on Fed data is available. The price level data comes from the Federal Reserve Bank of Minneapolis website at: https://www.minneapolisfed.org/community_education/teacher/calc/hist1800.cfm
[iv] MoneyWeek, December 2014.
[v] This Time is Different, Carmen M Reinhart & Kenneth S Rogoff, Princeton University Press, 2009.