How to accelerate 'good deflation'

A little deflation can, in fact, boost living standards. Matthew Lynn explains why, and how we can encourage a bit more of it.

Well, that wasn't so bad was it? Last week, the UK fell into deflation for the first time in half a century. Despite the dire warnings from some economists that falling prices would create economic chaos and plunge us back into a fresh recession, it turns out that rather like a trip to the dentist the reality isnot nearly as bad as the anticipation.

In fact surprise, surprise it turns out that we quite like stuff getting cheaper. So while it might sound odd, if deflation is not actually so bad, and may in fact boost living standards, perhaps we should encourage a bit more of it?

Back to the 1960s

It was way back in 1960 that the UK last experienced an absolute fall in the level of prices. Now, after stagnating for a few months, we learned that in April prices actually fell by 0.1%, according to the Office for National Statistics.

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For years, economists and central bankers have worried that deflation would be a disaster. People would be put off buying anything because they thought it would be cheaper in a few weeks' time. That would depress demand. In Japan, deflation has been a feature of an economy that has been stuck in a rut for a couple of decades. Central bankers worried that it could happen here too.

Sometimes that might be true. If prices are falling because demand has collapsed, and soaring unemployment means wages are being cut, then obviously that's bad for everyone. That is roughly what is happening in Greece right now,where deflation is running at 2%.No one wants that to happen here.

But there is also what some economists are labelling "good deflation". That is where prices are falling because there is more competition, and companies are working out smarter ways to make things. That has been under way in sectors such as electronics and computing for years your smartphone is a lot better than the desktop computer you bought a decade ago, and it costs a lot less too.

The supermarkets are slashing prices

In reality, in an economy where wages are struggling to grow, deflation is one of the best ways to boost living standards. There is not much sign of workers being paid significantly more in the UK right now wage growth is running at 2.2% a year.

If the Bank of England was hitting its 2% inflation target, that would not be great. But with 0.1% deflation, it is actually pretty good. In real terms, the average person is now 2.3% better off than a year ago not bad for a mature economy, with low productivity growth, and still recovering from a financial crash. Deflation is already starting to boost living standards. So how could we encourage more of it?

The fall in prices can partly be explained by the big drop in the oil price over the last year. There is not much we can do to influence that (and since the UK still pumps a lot of oil out of the North Sea, perhaps we wouldn't want to).

But that aside, the biggest driver of deflation has been the arrival of the hard discounters in groceries, such as Aldi and Lidl, both of which have slashed prices and forced the bigger supermarkets to do the same. The contribution of the grocery trade to the overall deflation figure is striking.

In the year to April, food prices fell by 3% overall. Some of that might be global commodity prices, but most of it is the result of fierce price competition between the big supermarket chains. That might be terrible for shareholders, but it has been great for consumers and great for the overall standard of living.

Time to encourage price wars

But there are plenty of other sectors where new players could be allowed to come in and drive down prices, just as Aldi and Lidl have done in groceries.In banking and insurance, there is lots of space for new entrants to provide better products at lower prices. Likewise, in the leisure and eating-out industries, where prices are still rising by slightly more than 2% a year, there is a lot of scope for competition to bring prices down.

Look at coffee chains Costa Coffee and Starbucks could surely charge a bit less than £2.50 for a latte and remain in business. The cost of education, likewise, is rising at a relatively high rate more space for new private schools and training centres would drive down costs. And some sectors of retailing have also been relatively immune from competition.

To make this happen requires relaxing regulations. Aldi and Lidl managed to expand so fast because local councils allowed them to acquire the space needed to open new shops, often very close to the existing supermarkets. If that hadn't happened, there would never have been a price war. The same should happen in other sectors.

The Bank of England should allow many more companies to provide bank accounts encouraging the likes of Apple, Facebook and Google to muscle their way into the finance market. Councils should allow boarded-up shops on high streets to be turned into coffee bars, pizza restaurants, or training centres, all of which would allow new players to take on established leaders and provide them with some competition.

After all, if a few more sectors were as hyper-competitive as grocery retailing has been in the last couple of years, we might see deflation down to -1% or so and if that happened, and wages kept rising, we'd all be a bit better off.

Matthew Lynn

Matthew Lynn is a columnist for Bloomberg, and writes weekly commentary syndicated in papers such as the Daily Telegraph, Die Welt, the Sydney Morning Herald, the South China Morning Post and the Miami Herald. He is also an associate editor of Spectator Business, and a regular contributor to The Spectator. Before that, he worked for the business section of the Sunday Times for ten years. 

He has written books on finance and financial topics, including Bust: Greece, The Euro and The Sovereign Debt Crisis and The Long Depression: The Slump of 2008 to 2031. Matthew is also the author of the Death Force series of military thrillers and the founder of Lume Books, an independent publisher.