June 9, 2008 | posted by Michael Baxter in Taxation, credit crunch |

Beating inflation has been likened to squeezing toothpaste back into its tube.    The trouble is, because you can’t have negative interest rates, beating deflation is even harder – perhaps it is akin to squeezing toothpaste back into the tube, while at the same time you are standing on one leg, drinking a glass of milk and singing the national anthem backwards.

Policymakers must not let inflation get a hold again, but then again, neither must they let deflation get a toehold.

In classical economic theory, unemployment is not supposed to exist in the longer-term, or, as economists call it, equilibrium. If there is unemployment, then wages will keep falling so that demand for labour rises until unemployment reduces to zero. There are two problems with this theory.  Unemployment means low national income, which means low spending, which can lead to even higher unemployment.  If everyone was to take a cut in pay, the net effect on the economy will be lower consumer demand, and perhaps rising unemployment.

A classical economist will say, it just needs time.   Economic depressions sort themselves out, in the end.    They say, in the longer term there will be no unemployment.  By contrast, Keynes once said: “The long-term is a misleading guide to current affairs; in the long-term we are all dead.”

The second problem with this theory is based on the belief that equilibrium can never exist.    This is a theory that is currently being promoted by George Soros, but actually, the anti-equilibrium argument goes back decades.   It involves scientific concepts such as the second law of thermodynamics and entropy, but fascinating though this debate is, it is not relevant to today’s discussion.

It does seem to be true to say that the general thinking today would say this: 1930s-type depression requires tax cuts, lower interest rates and lots of money being pumped into the system by central banks.    A 1970s type stagflation requires painful tightening in monetary and fiscal policies – so that’s less government spending, more tax and higher interest rates.

Today, oil and food are shooting up in price – this suggests inflation. 

Today, asset prices, and house prices in particular, are crashing – not just in the UK, but in the US too, and in Spain.  This brings back memories of 1930s-type depressions.

The key to all this, though, surely rests with wage inflation. 

If wages rise in tandem with oil and food, then expect a rerun of the 1970s – inflation will soar.  

If unemployment rises, and wages fall, then expect the period of high raw material costs to end, expect demand for oil to plummet, and expect its price to fall, followed by falling prices elsewhere.    In short, expect deflation.

Now, browse the business pages of today’s newspapers and you won’t fail to notice that job losses are back on the agenda.  The Times headlined: “Major threat to building jobs as Persimmon closes new sites.”  The Guardian talked about 1,800 job losses at Norwich Union, and elsewhere headlined: “housebuilders begin to shore up unfinished properties and cut jobs.”   

Last week, a report from the Centre of Economics and Business Research (CEBR) predicted total job losses in the UK business services sector over the next two years of 40,000, the first reduction in the sector since 2001.   CEBR reckons people working for estate agents will be especially badly hit, with around 5 per cent losing their jobs.  

Meanwhile, analysts at JPMorgan Chase reckon 40,000 jobs will go in the City.

Actually, though, if you really want an idea of where we are going, look West.    Data from the US Labor Department revealed that US unemployment rose at its fastest rate in two years during May.  US unemployment is now 5.5 per cent, from 5 per cent.

So employment is falling a time of surging price of  oil.  Hence talk of 1970s-type stagflation.

But there is one big difference today.    In the UK, at least, unions do not have the power they used to have.     In the 1970s, pay cuts, even pay rises below inflation, were not considered acceptable.

But consider these words spoken by the GMB Union.    Martin Smith, from the GMB union told the BBC that his members were being asked to consider pay cuts of between 30 and 40 per cent.  “We’re also hearing on the grapevine from a number of our employers up and down the country that they’re also feeling the squeeze, and they want to start talking about pay cuts and other ways of saving money,” he said.

All of a sudden the question is being asked – will you accept a cut in pay in order to safeguard your job?  According to the BBC: “The Federation of Small Businesses says lower wages and longer hours may be the only way to prevent redundancies.”

Lower wages may prevent redundancies now, but the result could be a 1930s-type downwards spiral.  Pay cuts are the opposite of what Keynes would recommend.

At the end of 2006, we told of a report saying that in the US, corporate profits make up the higher percentage of GDP than at any time since 1929.    This suggests that businesses can afford to cut prices, by eating into profits.

The GMB warning is just that: a warning.     It may or may not prove to be a sign of things to come.

But, as you know, we are predicting that oil will, perhaps after rising this year, perhaps even after hitting $200, fall back eventually.   This could spell deflation.

It may be, just maybe, that inflation is not set to make a comeback at all.  That stagflation still sits in its grave, with a stake in its heart, and garlic infused in its coffin.      It may be that deflation is the real threat.

Policymakers need to watch this new pattern like a hawk.  But if pay cuts prove to be endemic, then they will need to immediately drop their hawk-like warning, and move into dove mode and slash rates. Fast.

At the same time, the government will have to drop its beloved fiscal rules – and borrow and spend – tax cuts in particular will be essential.

The time to act may not be now – but it may be soon.