One of the strange characteristics of this economic crisis is the conflicting forces at work on prices. The are good reasons to fear inflation. It is already too high, and with the extreme measures being taken in the US to put life back into the economy, there are plenty of reasons to fear inflation could escalate.
Yet, equally, deflation is a worry too.
Yesterday, Sir John Gieve, Deputy Governor at the Bank of England, put his pennyworth into the debate.
He warned of the challenge of “balancing that upside risk to inflation from the commodity price shock against a downside risk that the credit crisis would drive down activity too far and push inflation below target in the medium term.”
He said: “The biggest risk to the financial sector is also the biggest downside risk to the economy: namely that damage to bank balance sheets would lead to tighter credit conditions, lower asset prices, lower consumption and investment, and to a severe feedback loop into more losses for banks and so on down a spiral. That feedback is already working to some degree, not just in the US but in the UK too.”
There are the reasons to fear deflation. In the past, periods of deflation have coincided with crashes in asset prices; for example, 1930s US, and Japan’s lost decade. Right now, we are witnessing a crash in both house prices and equities. Don’t forget, both the Dow and FTSE 100 are lower today than at their dotcom peak. An equity bubble in China has also well and truly burst, while the Russian stock market is in crisis.
Deflation can also occur if there is a shortage of credit. When someone borrows money and then goes out and spends it, the money spent is received by someone else, who in turn goes out and spends, and so on. The supply of credit determines the amount of money being spent. This can create inflation. The credit crunch means the opposite of that; credit is, well, crunched.
On the other hand, the recent steps taken by the US treasury to bail out the economy could lead to inflation down the line. It has been suggested that US borrowing this year could top $1 trillion. It was argued above that UK public debt is set to balloon.
Economics text books all agree, when government borrowing surges, inflation often follows.
The truth is, deflation at a time of enormous household debt and rising government debt would be disastrous. Sure, deflation may mean low interest rates, but the real cost of debt would effectively rise. Imagine your debt was the equivalent of half of your salary, and over a period of five years you repaid interest only on the debt, and your salary halved. All of a sudden, your debt would equal your salary.
For that reason, deflation is something that must be avoided.
Quite frankly, it seems the most likely consequence of the Paulson new deal will be that the forces of inflation and deflation cancel each other out.
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