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Ignore the ghost of deflation Samuel Brittan: Financial Times 11/10/02 The doomsters warn us that deflation will increase the real value and servicing costs of debts. But in some cases modest price deflation would be the lesser evil. Financial market crystal ball gazers are focusing on the danger of a double-dip world recession. One of the most eloquent warnings comes from Stephen King of HSBC. He notes that the German recovery has more or less stopped and Japan is still in the doldrums. In the US and the UK, the slump in equities and the overhang of excess capacity from the recent equity boom make for gloomy capital spending prospects. This leaves us with the Anglo-American consumer, who has heroically sustained the world economy. He has been able to carry on with low or negative savings because of the property boom. Should that subside, the consumer will be faced with the reality of the debt mountain and have to retrench. Faced with the threat of a double-dip recession, it is the output and income prospect we should be worrying about, rather than the prices Why, then, are our monetary rulers so hesitant to provide further stimulus? Official forecasters are, in effect, asking: "Recession, what recession?" The 2001 dip was one of the shortest and shallowest ever and since then world growth has followed the same pattern as in the last recovery. But why not take pre-emptive action, as the balance of risks is on the downside? One reply could be that world broad money supply growth has remained vigorous. The recent sharp fall in velocity could prove temporary and injecting even more money could fuel the next boom and bust cycle. What worries me most, however, is the lack of weapons if a second-stage recession really does arrive. The eurozone countries have to be careful about long-term budgetary imbalances. In the US, the budget surplus has swung into deficit in the twinkling of an eye. Moreover US short-term interest rates are already so low that there is not much more scope for conventional monetary stimulation. There is a way of bringing fiscal policy back into use in an emergency without endangering long-term budgetary stability. This is to make any tax cuts temporary. A temporary cut in consumer taxes would boost spending power and provide maximum incentive for that power to be used. All we need is a reduction of taxes such as value added tax in Europe and, in the US, federal aid to enable states to reduce their local indirect taxes. The UK in fact had a consumer tax regulator in the 1960s and 1970s; it was employed once or twice but was misused. What does not, however, make for good contingency planning is the recent alarmism about "deflation". Apart from Japan, the world has not seen deflation for 70 years; and it is now seen as an ill-defined but terrifying spectre. I did myself write a column saying inflation could be too low as well as too high. I was referring of course to the long-term trend. But, faced with the threat of a double-dip recession, it is the output and income prospect we should be worrying about, rather than whether prices will rise by slightly more or slightly less than zero. The doomsters warn us that deflation will increase the real value and servicing costs of debts and, by increasing the risk of loan defaults, jeopardise the future of financial institutions. This is true in some circumstances. But in others modest price deflation would be the lesser evil. Let us start with the growth of nominal gross domestic product, that is the national income in current prices. A normal rate of growth for nominal GDP is some 5 per cent per annum, divided between 2-2? per cent inflation and 2?-3 per cent real growth. Worldwide nominal GDP has been growing by rather less than this guideline but not yet alarmingly so, except in Germany. Let us assume - not predict - that nominal GDP growth will average 2 per cent over the next year. Would it be better if this were the result of zero real growth and 2 per cent inflation, or consisted of 3 per cent real growth and minus 1 per cent inflation? Is the zero mark that statistically divides inflation from deflation that important? In a low-inflation economy there are bound to be fluctuations, occasionally taking the price indices into negative territory. Moreover everything depends on the exact price index used. If you look at the consumer price indices or the GDP deflator in the US or the eurozone, inflation is 1 to 2 per cent. But if you look at producer price indices, they have been negative for all of the past year. My suggested fiscal regulator would intentionally cut prices. The effect might be enough to push some price indices in some countries over into statistical deflation? Is that a reason for not using it? But the danger of focusing on deflation is brought out most clearly by imagining a Middle Eastern imbroglio, with several oil producers out of operation and oil prices shooting up to between $70 or $100 a barrel. The impact, as I have said before, would be to bring back inflation, as normally measured, with a vengeance - and thus keep deflation at bay. But does anyone think the resulting slashing of purchasing power would be at all helpful and be other than the price for combating terrorism and rogue states?
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