Half the world covets the UK’s precious inflation
Inflation is now a rare commodity in most of the developed world but the UK's falling prices are also a tax cut we should all enjoy
By Ambrose Evans-Pritchard
3:20PM GMT 13 Jan 2015
The Bank of England was right to ignore its inflation target at the height of the crisis Photo: AFP
Inflation is now the most precious commodity in the developed world.
The great economic powers are almost all trying to steal a little from each other by currency warfare. Perfidious Albion got there first. We are good at the game.
Britain still has an emergency reserve, thanks to the good judgement of the Bank of England.
The Monetary Policy Committee ignored the howling commentariat and the hard money populists when headline inflation spiked above 5pc. "The MPC should not be obsessive about bringing inflation back to target as rapidly as possible,” was how they nonchalantly put it in the minutes from January 2008.
The Bank of England ploughed on with full-blown quantitative easing even through the inflation scare of 2011. That showed courage. Historians will judge this to have been a masterful decision.
The effect was to erode the real debt stock, slash the ratio of household debt to disposable income from 170pc to 147pc, and broadly stabilize the overall debt trajectory. It ensured that the recovery reached “escape velocity” despite the headwinds of fiscal tightening.
The UK revived the successful reflation formula of the mid-1930s. It eschewed the failed deflationary formula of the 1920s, which merely pushed debt ratios even higher.
The shock fall in CPI inflation to 0.5pc does not yet put Britain at risk. Inflation expectations remain at safe levels. They are not close to becoming “unhinged” – with all kinds of nasty self-fulfilling consequences – though the experience of Japan and now the eurozone tells us how suddenly if can happen if you let your guard down.
The chart below shows five-year/five year forward swaps used to filter distortions and measure longer-term expectations. Britain is still well above the water line.
The beauty of having a safety buffer is that you can enjoy the benefits of an oil-price crash – a “positive supply shock” in the jargon – without sliding into a debt-deflation trap. It acts as a tax cut. Enjoy it.
It is no great mystery why the world is edging from “lowflation” to deflation. It lies in the structure of globalisation over the last quarter century. Above all it lies in China.
Chinese factory gate prices are falling at a rate of 3.3pc. There is massive spare capacity. The country's fixed investment was $8 trillion last year, more than in Europe and North America combined. The country is exporting deflation worldwide. And so is Japan.
As I wrote in last week’s column, there is an excess of global capital. The world's savings rate keeps rising and has hit a record 26pc of GDP. One culprit is the $12 trillion accumulation of foreign reserves by central banks, money that is pulled out of consumption and instead floods the bond market. Large parts of Pacific Rim and central Europe have reached a demographic tipping point. Call it worldwide "secular stagnation" if you want.
The eurozone already has one foot in deflation. This is not benign, for reasons that are by now well known. Firms make the entirely rational decision to put off investment, creating a macro-economic bias towards contraction. They each feed off each other in an amplification effect.
Deflation plays havoc with debt dynamics. The real interest rate on the existing stock of debt rises. The economic base of nominal GDP that supports this burden shrinks. This is the “denominator effect”.
It can be lethal for high-debt economies, and that now means the entire developed world (with minor exceptions). You can of course opt instead for an “Austrian-school” purge of the debt through mass defaults, but be careful what you wish for. We tried that in 1931 and lost a few democracies.
This contractionary effect is why debt ratios have continued to rise across southern Europe, in some cases at an accelerating pace. It is why Italy’s debt has jumped from 116pc to 133pc of GDP in three years despite deep austerity and a big primary budget surplus. Deflation is pushing these countries over a cliff.
Index: 2006=100. Source: Berenberg Bank
The ECB’s chief economist Peter Praet alludes to some of the dangers in this watershed interview two weeks ago.
“What we are increasingly worried about and what explains the sense of urgency expressed by our President Mario Draghi is the very high risk that after seven years of crisis and very poor economic performance in the euro area, businesses and households are reducing their long-term growth expectations and adapting to weak growth and low inflation," said Mr Praet. "To some extent this risk is already materialising: companies are starting to adjust to a '1pc growth/1pc inflation economy'.
"There is a risk of a real economic vicious cycle: less investment, which in turn reduces potential growth, the future becomes even grimmer and investment is reduced even further.”
He also warned that an "underemployment equilibrium" is setting in. This is the term used by Keynes in the 1930s.
One has to admire Frankfurt’s QE gang of Mario Draghi, Peter Praet, and Vitor Constancio.
They understand the problem perfectly. They have been battling for almost a year to overcome resistance to radical action.
One also has to admire the Bundesbank’s Jens Weidmann for arguing that sovereign QE on a large scale amounts to fiscal union by the backdoor, a constitutional leap without democratic consent. Both sides are right. It is the EMU construct that has led to this impasse.
We will find out soon whether the ECB is willing to launch QE on a big enough scale to stop a deflationary psychology taking hold. If they fail – and a respectable argument can be made that the inflation will recover of its own accord – Britain will find it hard to avoid being sucked into the deflationary vortex as well.
Should that moment ever threaten, the Bank of England will have to turn on the printing press yet again. Next time let us do it differently. Let us use the money to rebuild our crumbling infrastructure, or dust down the old “Chicago Plan”, or simply do the proverbial Helicopter Drop of money until the problem is solved.
It is always possible to defeat deflation if you really mean it, and if you are a sovereign nation.
But that argument is for another day.
The effect was to erode the real debt stock, slash the ratio of household debt to disposable income from 170pc to 147pc, and broadly stabilize the overall debt trajectory. It ensured that the recovery reached “escape velocity” despite the headwinds of fiscal tightening.
The UK revived the successful reflation formula of the mid-1930s. It eschewed the failed deflationary formula of the 1920s, which merely pushed debt ratios even higher.
The shock fall in CPI inflation to 0.5pc does not yet put Britain at risk. Inflation expectations remain at safe levels. They are not close to becoming “unhinged” – with all kinds of nasty self-fulfilling consequences – though the experience of Japan and now the eurozone tells us how suddenly if can happen if you let your guard down.
The chart below shows five-year/five year forward swaps used to filter distortions and measure longer-term expectations. Britain is still well above the water line.
The beauty of having a safety buffer is that you can enjoy the benefits of an oil-price crash – a “positive supply shock” in the jargon – without sliding into a debt-deflation trap. It acts as a tax cut. Enjoy it.
It is no great mystery why the world is edging from “lowflation” to deflation. It lies in the structure of globalisation over the last quarter century. Above all it lies in China.
Chinese factory gate prices are falling at a rate of 3.3pc. There is massive spare capacity. The country's fixed investment was $8 trillion last year, more than in Europe and North America combined. The country is exporting deflation worldwide. And so is Japan.
As I wrote in last week’s column, there is an excess of global capital. The world's savings rate keeps rising and has hit a record 26pc of GDP. One culprit is the $12 trillion accumulation of foreign reserves by central banks, money that is pulled out of consumption and instead floods the bond market. Large parts of Pacific Rim and central Europe have reached a demographic tipping point. Call it worldwide "secular stagnation" if you want.
The eurozone already has one foot in deflation. This is not benign, for reasons that are by now well known. Firms make the entirely rational decision to put off investment, creating a macro-economic bias towards contraction. They each feed off each other in an amplification effect.
Deflation plays havoc with debt dynamics. The real interest rate on the existing stock of debt rises. The economic base of nominal GDP that supports this burden shrinks. This is the “denominator effect”.
It can be lethal for high-debt economies, and that now means the entire developed world (with minor exceptions). You can of course opt instead for an “Austrian-school” purge of the debt through mass defaults, but be careful what you wish for. We tried that in 1931 and lost a few democracies.
This contractionary effect is why debt ratios have continued to rise across southern Europe, in some cases at an accelerating pace. It is why Italy’s debt has jumped from 116pc to 133pc of GDP in three years despite deep austerity and a big primary budget surplus. Deflation is pushing these countries over a cliff.
Index: 2006=100. Source: Berenberg Bank The ECB’s chief economist Peter Praet alludes to some of the dangers in this watershed interview two weeks ago.
“What we are increasingly worried about and what explains the sense of urgency expressed by our President Mario Draghi is the very high risk that after seven years of crisis and very poor economic performance in the euro area, businesses and households are reducing their long-term growth expectations and adapting to weak growth and low inflation," said Mr Praet. "To some extent this risk is already materialising: companies are starting to adjust to a '1pc growth/1pc inflation economy'.
"There is a risk of a real economic vicious cycle: less investment, which in turn reduces potential growth, the future becomes even grimmer and investment is reduced even further.”
He also warned that an "underemployment equilibrium" is setting in. This is the term used by Keynes in the 1930s.
One has to admire Frankfurt’s QE gang of Mario Draghi, Peter Praet, and Vitor Constancio.
They understand the problem perfectly. They have been battling for almost a year to overcome resistance to radical action.
One also has to admire the Bundesbank’s Jens Weidmann for arguing that sovereign QE on a large scale amounts to fiscal union by the backdoor, a constitutional leap without democratic consent. Both sides are right. It is the EMU construct that has led to this impasse.
We will find out soon whether the ECB is willing to launch QE on a big enough scale to stop a deflationary psychology taking hold. If they fail – and a respectable argument can be made that the inflation will recover of its own accord – Britain will find it hard to avoid being sucked into the deflationary vortex as well.
Should that moment ever threaten, the Bank of England will have to turn on the printing press yet again. Next time let us do it differently. Let us use the money to rebuild our crumbling infrastructure, or dust down the old “Chicago Plan”, or simply do the proverbial Helicopter Drop of money until the problem is solved.
It is always possible to defeat deflation if you really mean it, and if you are a sovereign nation.
But that argument is for another day.
0 comments:
Publicar un comentario