The major argument amongst economists right now is the question of whether we are stoking up pressures for a major of inflation down the road in na tear or two’s time or whether we are heading for a major deflationary period.
Here Roger Bootle argues the likelihood of a deflationary future and disagrees fundamentally with what calls the ‘monetarist’ school. This school is perhaps best exemplified in my postings by the writings of Liam Halligan. Getting the correct answer to this dilemma is vial for our future!
The Telegraph has published two extracts from Bootle’s new book whicj I reproduce here.
Tomorrow I plan to raise the question personally with a major City banking house and if I understand their response properly I will impart it to readers.
But before the extracts below I give this mornings’s figures on inflation!
Christina
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REUTERS 13.10.09
Inflation at lowest rate in 5 years
LONDON (Reuters) - British consumer price inflation eased more than expected in September to hit its lowest annual rate in five years due to base effects from the spike in energy prices last year, official data showed on Tuesday.
The Office for National Statistics said prices were unchanged between August and September, the lowest rate of change since records began in 1996.
That left the annual rate of inflation at 1.1 percent, the lowest since September 2004 and below analysts' forecasts for an easing to 1.3 percent.
The Retail Price Inflation price gauge fell to -1.4 percent from -1.3 percent in August, less than forecasts for a bigger decline to -1.5 percent.
The ONS said the biggest impact on annual CPI came from the household services, principally gas and electricity bills, which were unchanged on the month but rose sharply a year ago.
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Roger Bootle 12/10/09
1. Past recessions point to future pitfalls
What is likely to happen to the world economy after the financial crisis?
By Roger Bootle
We could seek an answer in the common view, or in business opinion. But all along, people, both expert and ordinary, have failed to get the full measure of what has happened, continually looking on the bright side, first expecting only a mild downturn, and then an early recovery.
We could look to the economic forecasters for guidance. But bearing in mind their lamentable record in foreseeing what I call the Great Implosion, not to mention countless other major events, this would represent the triumph of hope over experience.
Alternatively, we could see what financial market valuations are implying. But that would be dangerous: stock markets have forecast 10 of the last three recoveries.
I think the best way of assessing what may happen is to take a sober look at the past. A reading of the historical evidence suggests that early recovery is unlikely, and the danger of a recovery petering out is considerable.
Of previous man-made shocks, what we have come to know as the Great Depression was far and away the biggest. As the crisis of 2007-09 deepened, the ghastly thought started to take root that what we face now is something like a repeat of the 1930s. Even if the current recovery does continue into 2010 and 2011, you would be ill-advised to put thoughts of the Great Depression aside. At the end of the 1930s, after a mild recovery, the US economy appeared to be slipping back into depression – until it was rescued by the demands of war.
Both the Great Depression and the Great Implosion had their roots in large asset price bubbles and both involved catastrophic problems in the banking sector. Moreover, like the Great Depression, the Great Implosion is truly global. And there must be a risk that the world will again succumb to protectionism, just as it did in the 1930s.
Thankfully, there are some significant differences. The greater size of the state has meant that there is now a larger chunk of the economy where expenditure is not automatically cut due to lack of finance or loss of confidence, and indeed there is more automatic cushioning of private-sector spending as the public deficit expands passively in response to lower tax payments and higher benefit spending.
Over and above these passive responses, policymakers have also been pro-active, using Keynesian-style expansionary fiscal policies. Moreover, central banks have slashed interest rates aggressively and have continued expansionary monetary policy once rates have hit near-zero, through quantitative easing. And policymakers have been quick to prevent banks from failing and depositors from losing their money.
So, on the basis of past experience, what are our prospects now?
Could the gloomy and fatalistic consensus view have overdone the pessimism? With the world economy now apparently recovering, this looks a distinct possibility. Perhaps we will look back in a few years' time and wonder how we could all have been duped into exaggerated pessimism. Common opinion, both expert and popular, may be as bad at anticipating the recovery as it was in spotting the downturn in the first place.
Although I think this is possible, I do not think it is likely. The game has moved on. Recessions are like the plague. The Black Death that ravaged Europe in the 1340s did not hit every city simultaneously. While it was raging in Milan, across the Alps in Geneva people thought they were safe, but within a few weeks Geneva was consumed by it too. Meanwhile, in Paris things continued as usual – for a while. By the time the time the plague was raging in Paris, it was finished in Milan, but London was yet to fall. By the time London had succumbed, Geneva was clear.
It is quite possible that even after the huge government bailouts of the banks in 2008, yet more public money will need to be poured in. Moreover, with the exception of the American giant AIG, there have so far been no insurance company failures, although it is surely possible that a significant insurance company will yet go under.
It is clear that the Great Implosion is the worst downturn of the post-war period. Whether it turns out to be even worse than that will depend largely on the policymakers.
For my money, the aspect of the current situation that will present some of the most serious challenges, and over which the policymakers will be most liable to make a serious mistake, is something that played a major part in the events of the Great Depression of the 1930s, the Long Depression of the 19th century, and the Japanese Lost Decade in the 1990s – namely the threat of a progressive fall of the price level, which we know by the term deflation. The problem is now all the more intense, and the dangers all the greater, because at the time that the deflation threat is most pressing, most people and institutions fear its opposite: inflation.
This will be the subject of my next extract.
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Roger Bootle 13/10/09
2. The perils of deflation are still lurking
In our second extract from his latest book, Roger Bootle warns of the danger of debt deflation.
In The Death of Inflation, I argued that the Western world was just one recession away from deflation. In Money for Nothing, I argued that the collapse of asset prices might well bring on that recession. Now we are in it. Falling consumer prices are upon us. In 2009, the consumer price index fell in the US, the eurozone, Japan and China. In the UK this did not happen, mainly because of the inflationary effects of the weak pound.
The collapse in aggregate demand is putting sharp downward pressure on pay inflation. There have already been some cases where the workforce has agreed to significant wage cuts to preserve their jobs. The last time such a major change in the climate governing pay happened in the UK was in the early 1990s. Pay inflation came down sharply from 8pc-10pc to 3pc-4pc, where it has remained ever since – until now. To get into mild deflationary territory, pay does not have to fall; it merely needs to rise by less than the rate of productivity growth, with the result that unit labour costs fall. Once you reach that point you have the precondition for deflation, without any help from lower commodity prices or squeezed profit margins.
In most of the developed West, the underlying growth rate of productivity is about 2pc. Accordingly, if the average rate of pay increase falls below 2pc, the conditions will be in place for sustained deflation.
Deflation is not necessarily a disaster. Indeed, in stable times a moderate rate of deflation could even be a good thing. But we are not in stable times. The danger now is that the expectation of falling prices will inhibit borrowing and spending and persuade people to sell assets in order to repay debt [On a national scale this is what Gordon would do! -cs], thereby extending the depression through the process known as debt deflation, which the US economist Irving Fisher laid out, in theory, in the 1930s, and which the people of Japan experienced, in practice, in the 1990s.
Still, why worry? The textbooks show deflation is dead easy to cure. So it is – in the textbooks. What's more, so is inflation. That should give you pause for thought. The problem is that usually the textbooks are purged of all politics, conflict between different interest groups, and uncertainty. Central banks choose the inflation rate they want and that rate duly emerges. If they don't like deflation, then they can, and should, stop it. Just increase the money supply. Hey presto.
So why did the Bank of Japan find it so difficult to stop deflation in the 1990s? Because it did not apply a large enough dose of the monetary medicine? Yes, of course. But why not?
Too large a dose of monetary expansion might create inflation – just as the monetarists worry about today. Moreover, some people gain from deflation and others lose. The temptation is for the central banks to advance cautiously, applying small doses of the medicine and hoping it will be enough, then giving more, and then still more, if this proves to be insufficient. The result is a natural tendency for the central banks to act too little, too late, and for deflation to ensue. What was true for Japan in the 1990s could easily apply to most of the rest of us in the decade ahead.
Although quantitative easing has already been deployed on an apparently massive scale, I suspect this will not be enough, and central banks will be reluctant to push it to the extreme. The result could easily be a bout of deflation, which could rumble on for a few years.
Moreover, the economy could readily experience more than one burst of it. For the factors that are pushing us toward deflation will not exert their full force simultaneously. It is quite possible that the end of the falls in commodity prices will cause measured headline inflation to pick up, just as the collapse of demand and rising unemployment are starting to bring falls in core inflation, accompanied by sharp downward pressure on pay. In that case, the initial bout of deflation would be followed by a low rate of inflation, followed by deflation, followed by – who knows what? It is important for people not to be taken in by the end of the first bout of deflation and not to be persuaded that the deflation danger is over. The deflationary threat will be grumbling along for a good time yet.
That is not to deny the danger of inflation. Yet a resurgence of inflation doesn't look likely any time soon. Even if we experience a commodity-induced bout of higher inflation in 2010 or 2011, and even though we will always need to keep stakes and garlic at the ready, to my mind inflation looks like giving the appearance of being dead for many years to come.
Wouldn't it be ironic if, just as the monetarists were stirring up renewed anxiety about inflation, the world were to fall into its first experience of sustained price deflation since the 1930s? It would be ironic, but it wouldn't be nice. It would heighten the chances of experiencing an extended economic downturn, reminiscent of the Great Depression.
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These are extracts from The Trouble with Markets by Roger Bootle, who is managing director of Capital Economics and economic adviser to Deloitte. The book will be published on Thursday by Nicholas Brealey, price £18. It is available from Telegraph Books for £16 plus £1.25 postage and packing. Go to books.telegraph.co.uk.
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