Why we should be worrying about deflation

Even though prices are soaring, deflation is a real threat to Western economies. The problem with deflation is that people start to hoard money rather than take entrepreneurial risks.

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Who's to blame for the collapse of house prices?

Now that the housing market is clearly collapsing, many of the pundits who said that soaring prices were perfectly justified, are now scrabbling to find reasons why the current slump is a unique, unforeseeable and entirely new phenomenon.

According to this particular group, rampant house price growth was justified. The world was in a new era, where interest rates could remain permanently low because of the internet and globalisation and independent' central banking, and all the other good things that have happened to us over the last decade.

So needless to say, the credit crunch came as a bit of a surprise for them. And now they expect the Government to step in and bail us out. This would make things worse of course, so it's a good thing the Government is basically too broke to do anything of the sort.

The reality is that all of this was in fact predictable. You'd have to be psychic to pick the exact date, and the exact manner of the collapse. But it was obvious that there was too much money flying around the world. The bubble was bound to pop sometime.

So can we learn anything from this? And more to the point, will we listen to the lessons?

The idea that monetary policy has been far too lax for the past decade at least, is not especially controversial. It's just that people were having too much fun in the boom times to accept that it was true.

No less authority than the Bank for International Settlements (also known as the central banker's central bank) makes it pretty clear where it believes the fault for the current crisis lies.

"The fundamental cause of today's emerging problems was excessive and imprudent credit growth over a long period. Policy interest rates in advanced industrial countries have been unusually low," says Dr Bill White in the BIS's latest annual report.

As we've said many times before, Alan Greenspan and the rest of the world's central bankers got away with keeping interest rates ludicrously low, because price inflation was kept down by cheap Asian imports. In fact, for a short while a few years ago, the Bank of England's biggest challenge was to keep Consumer Price Index (CPI) inflation from falling below 1%, which would have also entailed writing a letter to Gordon Brown, the Chancellor of the time.

But of course, keeping interest rates low merely fuelled other imbalances in the economy. All that borrowed money ended up in the housing market, and we know where that got us.

So what should central banks have done differently, if anything? Ambrose Evans-Pritchard argues that "in the 1990s, they should have torn up the rulebook and let inflation turn negative in light of the Asian effect."

This is a good point. But the use of the word inflation' gives away what the core problem is. When Evans-Pritchard talks about inflation here, he means the consumer price index, or some other measure of prices.

Now most central banks and policy-makers fear negative inflation, or deflation, more than anything. That's partly because genuine deflation goes hand-in-hand with depression, but mostly because Western societies have become obsessed with the idea that the key to constant growth is consumer spending.

The worry is that if prices are falling, then people will stop spending because why buy now if you can buy cheaper later? And why spend your savings now when they increase in value by the day?

But the trouble with judging inflation and deflation by what's happening to a basket of specific individual prices, is that it makes no distinction between good' price changes, and bad' price changes.

Take milk for example. If all the cows in Britain became twice as productive overnight, and the price of milk halved tomorrow, would you buy more or less? Well, you'd probably buy the same, or maybe a bit more and stick it in the freezer. Would you put off buying it at all because you thought it might halve again next week? Of course not, it's milk.

What would be bad about milk price deflation? Assuming it was down to higher productivity, and profit margins along the line from farmer to retailer stayed the same, then nothing. In fact, it would be a good thing. If you need to spend less on milk, that means you can spend more on something else. Or heaven forbid, you might even want to save some of that money.

All the stuff we get from Asia has been getting cheaper anyway. Computers are undoubtedly cheaper. I remember that when I bought my first laptop in 2001, the cheapest entry level PC I could find was around £700. Now you can get a far more advanced laptop for about half that price. Does this rampant price deflation stop people from buying computers? Not that I've noticed.

So the real problem is in the way that we measure inflation and deflation. Price changes happen for lots of reasons. Oil demand is up, supply is stable or falling, so the price goes up. Computers get cheaper to make, there are lots of factories competing to make them, so the price goes down.

But none of this is about inflation. What inflation really is, is an increase in the money supply. Deflation is a decrease in the money supply.

When the amount of money available to the economy is rising, it's got to go somewhere. In this case, it largely went into chasing house prices higher. Now that the supply of money has been cut off, as banks stop lending, house prices are falling.

And the real problem with deflation like this, is that as people get more and more concerned about the availability of money, they start to hoard it. That means that not only does no one spend money, they don't invest it either. They don't take the sorts of entrepreneurial risks with their money that are necessary to make an economy grow, because they are too scared of losing their scarce cash.

So the truth is that, even though prices are rising at a rate of knots just now, deflation is also a very genuine threat to Western economies. How it plays out remains to be seen, but a period of inflation followed later be a longer period of deflation does look quite possible.

But what does this mean for policy'? Well, arguably, if central banks are going to target anything, they should be looking at something objective like the money supply, rather than something subjective like a basket of goods that is believed to be representative of the average person's spending. Using the term average cost of living' when referring to the various price indices, rather than inflation, might help make the distinction clearer for everyone.

Better yet, we could just scrap central banks and let the market decide where interest rates should be. After all, that's pretty much what's happening now that everything's gone horribly wrong.

Turning to the wider markets

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In the UK on Friday, the FTSE 100 ended 11 points higher at 5,529 as high oil prices boosted the oil majors, while miners were also higher.

Over in Europe, the Paris CAC 40 fell 28 points to 4,397. Meanwhile, the German Xetra Dax was down 38 points at 6,421.

Over in the US, the Dow Jones Industrial Average continued to slide on Friday after its Thursday collapse, falling 106 points to 11,346. The wider S&P 500 fell 4 points to 1,278, while the tech-heavy Nasdaq Composite dropped 5 points to 2,315.

Overnight the Japanese market also incurred losses, with the Nikkei 225 losing 62 points to 13,481.

Brent spot was trading this morning at $142, and in New York, crude oil was at $142.43. Spot gold was at $933. Silver was trading at $17.76 and Platinum was at $2,071.

In the forex markets this morning, sterling was trading against the US dollar at 1.9944 and against the euro at 1.2607. The dollar was trading at 0.6324 against the euro and 105.14 against the Japanese yen.

And this morning, troubled house builder Taylor Wimpey has written down the value of its land by £660m. The group has renegotiated its loan covenants and is looking to raise as much as £500m from investors, according to press reports.


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