Britannia Radio

TELEGRAPH    13.11.08
Abandon all hope once you enter deflation
The price of white truffles has fallen 84pc. Fines wines have dropped 
65pc. Lobsters are off 52pc. Deflation has reached the City. It has 
engulfed housing and now threatens to spread through the broader 
economy, lodging like a virus in the British and global monetary 
systems.

By Ambrose Evans-Pritchard

Deflation is sometimes likened to Dante's Inferno. "Abandon all hope" 
once you step into that Hellfire.

We are not there yet but Mervyn King, the Governor of the Bank of 
England, says it is now "very likely" that the UK retail price index 
will turn negative next year. This is a drastic reversal of the oil 
and food spike that played such havoc with monetary policy over the 
summer. "The world changed in September," said the Governor.

The Bank's fan charts point to zero inflation at current interest 
rates of 3pc, but the startling new feature is that price falls could 
gather pace. This is a clear signal that the Monetary Policy 
Committee will cut rates again in December - perhaps by a full point 
to the historic low of 2pc, last seen in the Great Depression.

Mr King let slip yesterday that there is "obviously" a risk of 
deflation, although he remains sure it can be averted by a pre-
emptive monetary blitz. Let us hope he is right.

The curse of deflation is that it increases the burden of debts. 
Incomes fall: debts stay the same. This way lies suffocation. It was 
bad enough in the early 1930s when US farmers faced a Sisyphean Task 
trying to meet mortgage payments on their land as crop prices kept 
sliding. They suffered mass foreclosure and fled West, as recounted 
in John Steinbeck's Grapes of Wrath.

We forget, however, that overall borrowing was modest in the 1930s. 
The great credit bubble of the last 20 years has pushed debt levels 
in Britain, the US and other Western societies to unprecedented 
highs. UK household debt reached a record 165pc of personal income 
last year. This is almost 50pc higher than the burden at the onset of 
the recession in the early 1990s. Our sensitivity to debt deflation 
is therefore greater.

"It is going to be absolute murder in Britain if inflation turns 
negative," said Professor Peter Spencer from York University. "The 
big difference with past episodes is that we are now much more 
heavily indebted. Few people owned their own houses in 1930s. Debts 
were miniscule."

Deflation has other insidious traits. It causes shoppers to hold 
back. They wait for lower prices. Once this psychology gains a grip, 
it can gradually set off a self-feeding spiral that is hard to stop.

It also redistributes wealth - the wrong way. Savings appreciate, 
which is nice for the "rentiers" with capital. The effect is a large 
transfer of income from working people with mortgages to bondholders. 
(These may be pension funds, of course).

The modern warning to us all is the "Lost Decade" in Japan, a loose 
term for the on-again, off-again slump that ultimately led to zero 
interest rates and - when that failed - to the printing of money. 
After 18 years, the Nikkei stock index is now trading at 8,700 - down 
from a peak of nearly 40,000. House prices have fallen by half. Yet 
after all the stimulus, the country is once again tipping back into 
deflation.

Governor King said Britain was likely to avoid this fate. "We've 
taken action much earlier than was the case in Japan," he said.

Not everybody agrees, even after the shock and awe cut of 1.5 
percentage points by the MPC. Albert Edwards, global strategist at 
Société Générale, has long warned that central banks in the Anglo-
Saxon countries have stored up trouble by stoking credit booms, and 
may find it harder than they think to engineer a soft-landing.

"This could easily go the way of Japan. It is true that Bank of 
England has moved faster, but Japan was a local bubble. This time it 
is the 'great unwind' on a global scale with leverage spaghetti 
everywhere," he said.
"The monetary authorities don't have foggiest idea themselves whether 
this is going to work. They're crossing their fingers and hoping," he 
said.

Nor is it clear whether rate cuts are gaining much traction. The 
average rate of tracker mortgages has risen 72 basis points since 
last month, and credit card rates have been rocketing. The Bank's 
transmission mechanism is not working properly. This a variant of the 
1930s struggle when the central banks found themselves "pushing on a 
string", in the words of John Maynard Keynes. He called for public 
works to lift the economy out of its liquidity trap. This is more or 
less what the US, Japan, China, and parts of Europe are now doing - 
with more in store after the G20 this weekend. Britain has pitifully 
limited scope on this front. [This is the crunch point!  Brown's 
mismanagement of the economy has left no room for manoeuvre at all -
cs]  We had a budget deficit of 3pc of GDP at the top of the cycle - 
when we should have been in surplus - and we are heading for over 
8pc. This is already nearing the danger level. If the Government now 
lets rip on fiscal policy, we could face a 'gilts strike' as foreign 
investors retreat from UK debt.

The Bank of England has not run out of ammo yet. It can cut rates to 
zero if necessary and then escalate to direct infusions of money by 
purchasing bonds - or indeed by buying a vast range of securities, 
assets and even houses if necessary. Ultimately it can print money to 
cover the budget deficit.

As the late Milton Friedman put it, governments can drop bundles of 
banknotes from helicopters. If they really want to defeat to 
deflation, they can. Mr Friedman may have overlooked the fact that 
gunmen can shoot down the helicopter - the Bank of France in October 
1931, when it ditched the dollar; perhaps Asian bond investors today? 
- but that is to quibble.

Professor Spencer says the Bank of England has learned the hard 
lessons. Without the constraints of the ERM, Gold Standard, or any 
other fixed exchange system, it retains great freedom of action.
"They are very aware of the deflation risk. They are cutting rates 
very fast, and if necessary they too will turn to helicopters. But in 
the end they will keep the wolf from the door," he said