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Britain faces dangerous deflation

Image: Steve McNicholas

In addition to his famous ‘hierarchy of needs,’ psychologist Abraham Maslow had a hammer:

“I suppose it is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail.”

In central banking, that hammer is the rate of interest on overnight lending – currently 0.25 percent in the UK.  The nail, of course, is inflation.  And just at the moment inflation is rising.  As the BBC report:

“The UK’s inflation rate climbed to its joint highest in more than five years in August as the price of petrol and clothing rose…  August’s inflation rate is far above the Bank of England’s target of 2%. The Bank has said it expects inflation to reach 3% in October.”

The apparent result of the rise in inflation is that the Monetary Policy Committee – which sets interest rates – will raise interest rates sooner rather than later.  The more or less immediate result of this announcement was that the Pound climbed to its highest rate since the Brexit referendum result sent it plummeting last summer.

Anyone familiar with the machinations of the US Federal Reserve Bank during the Obama years might have a sense of déjà vu at this point.  After all, for almost eight years the Fed bolstered the value of the US Dollar by hinting at the possibility of an interest rate rise, only to conveniently discover some negative economic  indicator in the data that meant that ‘now is not quite the time.’  Bolstering the Pound in this way (so long as that is all they do) is a smart move by the Bank of England.  This is because the recent rise in inflation has a disturbing primary cause – the decline in the value of the Pound.

The UK economy is dangerously unbalanced, with consumer spending accounting for two-thirds of its economic growth.  Since consumer spending goes disproportionately to imported goods, a fall in the value of the Pound translates into higher import prices – which are what the inflation statistics have picked up.  In Maslow’s terms, this is a screw rather than a nail; the wrong kind of inflation.

All of the mechanisms that governments have put in place to combat inflation stem from the response to the inflationary crisis of the 1970s.  Indeed, the very fact that so many politicians and economists fear inflation more than any of the other (inequality, social unrest, unemployment, etc.) economic problems facing us, is due to a collective folk-memory of the 25 percent inflation of the mid-1970s.  That particular nail, however, was hammered into oblivion by the Thatcher and Reagan administrations in the 1980s.  Today, the economic conditions are reversed:

  • Interest rates are low
  • Inflation is (relatively) low
  • Debt is at an all-time high
  • Capital controls don’t exist
  • Labour markets are ‘flexible’
  • Governments no longer print currency
  • Social security and public services are starved of cash
  • Nationalised industries were sold off decades ago
  • Trade unions are a shadow of their former selves
  • Productivity has collapsed
  • Wages are stagnating.

This last difference is the most telling.  The reason central banks (and before them, governments themselves) used interest rates to control inflation in the 1980s and 1990s was because they acted like an additional tax that could be levied without the need to go through Parliament.  Every time the interest rate rose, households were obliged to set aside an additional sum from their income to service the interest on their debts.  This weapon became increasingly powerful as social housing was sold off and more and more ordinary people were obliged to take on mortgage debt to meet their housing needs.

The result of a rise in interest rates is a fall in consumer demand as millions of workers pay this additional ‘tax.’  The ultimate result is that the least competitive firms and sectors experience a fall in demand that either bankrupts them or at best forces them to ‘downsize’ and ‘restructure.’  The additional unemployment that this creates serves to ‘discipline’ workers into accepting lower wages and/or increases in productivity.

According to the headline employment figures, Britain’s inflation rate should be far greater than it is.  At little more than four percent, Britain’s unemployment is at a level last seen in the heady days of the early 1970s.  If this really were the case, then employers would be so desperate to fill vacancies that they would be competing with each other by offering higher wages, fringe benefits and better working conditions.  Firms would be relocating from London (where four-fifths of the new jobs have been created since 2008) to the depressed, Brexit-voting regions of Northeast England or the South Wales valleys; where labour is still plentiful and cheap.

To the astonishment of most economists, this process of wage-driven inflation has not materialised.  Indeed, the 1860s were the last time wages stagnated for as long as they have since the crash of 2008.  The reason for the contradiction was set out by Jim Edwards in Business Insider:

“The problem with this record is that the statistical definition of “unemployment” relies on a fiction that economists tell themselves about the nature of work. As the rate gets lower and lower, it tests that lie. Because — as anyone who has studied basic economics knows — the official definition of unemployment disguises the true rate. In reality, about 21.5% of all working-age people (defined as ages 16 to 64) are without jobs, or 8.83 million people, according to the Office for National Statistics.”

The reality of this is born out in those parts of the economy that depend upon people’s discretionary spending – the money we have left over when we have paid for essentials like mortgage/rent, utilities, transport, food and the interest on our debts.  If the headline unemployment figures were correct, consumer spending ought to be booming.  However, as Oscar Williams-Grut in Business Insider reports:

“Major UK retailers John Lewis and Next became the latest shops to warn of a slowdown in consumer spending on Thursday, in yet another sign of a serious slowdown in household spending that could be disastrous for the UK economy…

“Inflation is currently running at 2.9%, well above wage growth, meaning UK shoppers are feeling a squeeze on their incomes. As a result, they are cutting back on “discretionary” spending — anything non-essential.

“More evidence supporting this is the fact that one of the only areas that looks to be weathering the storm is the supermarket sector — Morrisons on Thursday reported 4.8% rise in revenues so far this year. Food prices are rising but people need to eat so cut back on things like going out to make sure they can afford the weekly shop.”

This, however, brings us back to that hammer that the Bank of England’s Monetary Policy Committee is waving around.  If too many of the esteemed economists on that committee swallow too much of the full-employment Kool-Aid, the likely result is that they will attempt to preemptively curb inflation by raising interest rates.

With this in mind, it is worth considering what happened the last time central banks decided to raise interest rates to ward off what they believed to be rising inflation.  The year was 2006.  The threat was the rise in oil prices.  The (erroneous) belief was that because everything in the modern economy is made from, produced with, or transported using oil, higher oil prices were guaranteed to result in higher prices across the economy.

This fallacy is nicely debunked by Frank Shostak in an article for the Mises Institute:

“If the price of oil goes up and if people continue to use the same amount of oil as before then this means that people are now forced to allocate more money for oil. If people’s money stock remains unchanged then this means that less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come off.”

All else being equal, the rise in the price of oil would not have fuelled generalised inflation simply because consumption would have to fall accordingly.  Although prices may have temporarily risen, left alone, they would soon fall back as consumers allocated a greater portion of their spending to oil.  Unfortunately, the central bankers acted as if increased oil prices were bound to lead to inflation.  They raised the interest rate.

It would be wrong to blame the rise in interest rates for the 2008 Great Financial Accident.  The fuel for that particular conflagration had been piled up over decades by rapacious banks printing money out of thin air every time they made loans to increasingly less credit-worthy borrowers.  It was the final act of that gluttony that left us with a mountain of sub-prime mortgages that depended upon low interest rates to service and a rising housing market to repay.  The rise in the interest rate was simply the spark that ignited all of that fuel.  For millions of people, it was the difference between just about managing to service their debt, and having to default.  On the other hand, it proved devastatingly effective at halting inflation in its tracks.

The parallel in the UK today is that we have far too many ‘zombie’ firms and households that are just about managing to service their debts provided that interest rates remain low.  Recently, however, this is being challenged because of the fall in the Pound and, to a lesser extent, by the gradual increase in oil prices (which may be back to $60 per barrel by the end of the year).  This is why UK companies like John Lewis, Next, Dunelm and Dixons Carphone that depend upon discretionary spending are struggling to stay afloat.

Why is inflation only hitting now when the Pound started falling last June?  Williams-Grut explains that:

“Most businesses agree on contracts for goods and services in advance to hedge against any currency fluctuations but these hedges have begun to expire, meaning the rising price of imports has begun to filter through to prices on shelves.”

In the same way, it will take time for that contracting process to adjust to the new reality of falling sales.  Ultimately, this will either force prices back down again or cause product lines to disappear altogether.  Either way, left to its own devices, the economic threat facing us is not inflation but deflation, as more and more households and firms are forced to cut back on their discretionary spending.

If, however, the Bank of England opts to force the issue by actually raising interest rates (rather than just taking about raising them) it risks generating a round of business failures and mortgage defaults similar to those seen in 2008.  If that happens, we had better hope that someone got around to fixing the banking system… although I wouldn’t put money on it.  If the banks go down, this time they are likely to be too big to save; and they are taking us down with them.

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