December 1, 2008 | posted by Michael Baxter in inflation |

There aren’t many hawks left these days. Time was when the central bank dovecote, was all but empty, and the hawks looked down from their lofty perch upon the economic terrain and made all kinds of squawks about the threat of inflation.

Well, in the US, they turned tail months ago. In the UK, the last few months seemed to see something of a hawk purge. But in the Eurozone, the hawks still seemed to dominate the sky, at least until very recently. In fact, incredibly, the European Central Bank voted to up rates to 4.25 per cent only in July.

But then, Friday saw the most dramatic news yet to suggest that has all changed. The stage is now set for big cuts in the Eurozone rate of interest, as the Bank of England and European Central Bank join a race to zero rates.

But dig a little deeper, and you find that the real forces that are at work are quite different from what you might expect.

In the Eurozone, inflation, as measured by the consumer price index, fell from 3.2 to 2.1 per cent. That’s a massive drop.

The index is now at its lowest level in 14 months, and just 0.1 per cent above the target rate.

At the time of writing, data was not available to show how the inflation figures break down, but one assumes falling food and oil were behind the declining index.

It seems the index is set to fall even further over the next few months.

You may know that Mervyn King, the Governor of the Bank of England, expects negative inflation as measured by the retail price index next year, and says there is a possibility of negative inflation as measured by the consumer price index.

For some time now, it has been argued here that this analysis is wrong.

Falling asset prices, falling credit availability and slumping demand mean prices are set to fall, and then fall some more.

And yet, ironically, maybe we will see a reverse of the conditions seen earlier in the decade.

Back then, asset prices soared, and food and energy costs went up. Other products, especially products imported from China, fell in price. So, for example, we had cheap furniture. It is possible that the next few years will see the opposite.

In the UK, the falling pound is making imports more expensive. In China, reports talk about factories closing and unemployment mounting. In the UK, the closure of MFI, and no doubt other furniture retailers will follow suit, may eventually lead to a shortage of furniture stores. Maybe the products that fell in price earlier this decade, will rise in price moving forward.

If this economic cycle proves to be symmetrical, then expect a funny kind of deflation moving forward.

There are two dangers with deflation. One is that falling prices mean we put off our spending, but it often seems that this is an exaggerated danger. People can’t put off their expenditure indefinitely. As for non discretionary items, such as food and petrol, there is hardly any option to delay expenditure at all.

The real danger lies with wage deflation. Employers may respond to falling demand and increasing looseness in the labour market by cutting wages. And this is the real dilemma.

Time was when economists used to argue that unemployment shouldn’t exist. They said wages were determined by demand and supply for labour. Supply was fixed, so, therefore, wages would sit at that level required to ensure there was no unemployment.

It was Keynes who spotted the flaw in that argument. If wages are falling, he argued, demand would fall too, leading to more job losses and a rather nasty downward spiral.

This is less of a danger in the Eurozone, where the labour market is inflexible. The minimum wage and union intransigence will surely reduce the danger of falling wages. In the Eurozone, sharply rising unemployment is more likely to be the result of falling demand.

In the UK, wage deflation is a more serious threat.

But then if it comes down to a choice between unemployment and wage deflation – it is difficult to know what to do.

It seems, however, that if deflation really does occur, governments via central banks do have one more weapon left in their armoury – there is always the printing press. There is the option of central banks lending to banks with negative interest rates – or through unfunded tax cuts.

You can’t do this, of course. We all know that if the government prints more money – inflation mounts. But if deflation is the danger, surely that is the right thing to do.

Except this. All that extra money the central banks create will not go away, and could leave an inflation legacy for years.

But, and this is where the opinion expressed here is unusual, there is another way of looking at this.

The last ten years or so have seen global capacity shoot up; this was caused in part by globalisation, in part through improving technology – although the improving technology also helped promote globalisation so, in a way, the surge in capacity is solely down to improving technology.

Under those circumstances it is right to increase the money supply.

In the days before the Industrial Revolution, the money supply was determined by the amount of gold that was in existence. In that era, innovation had to mean deflation. The finding of gold in the New World, and the development of banks and credit, surely underpinned the Industrial Revolution.

There is a good TV programme on at the moment – The Ascent of Money by Niall Ferguson. He shows how the growth in the banking sector created much of today’s wealth. At some stage during the series – it may be tonight’s episode – he will argue that the Mississippi Bubble in France 250 years or so ago, led to greater suspicions of debt-based economic systems in that country. He argues that is why the Industrial Revolution occurred in Britain and not in France.

We are of course seeing manifestations of that belief today, whenever Nick Sarkozy criticises the Anglo-Saxon banking model.

Ultimately, though, the crisis we are seeing today was not caused by silly bankers or booming house prices; it was not even caused by a lack of balance with some countries saving too much and others saving too little. These are surely symptoms of a deeper force at work. This deeper force is surely the mismatch between demand and supply, caused by rising global productivity.

When was the last time we had such a mismatch? – well, it may well have been the 1930s.