Thursday, December 17, 2015

As three months of negative inflation come to an end: should we do this more often?

This week new ONS figures were published showing that prices in the year to November 2015 rose by 0.1% (on the CPI measure) compared with a fall of 0.1% in the year to October.

This ended a period of three months of very slightly negative inflation and continues a period of six months so far during which inflation has been very close to zero.


THE CONVENTIONAL ECONOMIC VIEW ON THE RISKS OF DEFLATION

Anyone who has studied economic history knows that in the past, negative inflation was usually associated with catastrophic slumps. In the 19th century in particular the economic cycle included regular depressions characterised by falling prices (and often wages), job losses, business failures and hard times.

For that reason the received wisdom among economists such as myself is that although inflation in even the high single figures is damaging, double-digit inflation is generally disastrous, and control of inflation is therefore essential, one should be very cautious about bearing down so hard on it that inflation actually goes negative.

A related opinion held by many economists is that the optimum rate of increase in demand is about 2% above expected growth, accepting inflation at about 2% to ensure that any slack in the economy is taken up and making slumps less likely.

To the best of my understanding, the basis for Gordon Brown's belief that he had abolished Boom and Bust was that by devolving control of interest rates and monetary growth to the Bank of England and its' Monetary Policy Committee and writing the principle of aiming for inflation within the band of 0% to 4% and as close as possible to the centre of the band, he had eliminated the major causes of past recessions. Unfortunately, as we all know to our cost, there were more possible causes of recession than he had considered ...

Incidentally, Gordon Brown subsequently denied having said that he had abolished Boom and Bust, so here is a reminder  that he did indeed say this ...



Can we learn anything from the experience of the last six months? Actually yes, I believe we can.


THOSE WHO IGNORE HISTORY MAY FIND THEMSELVES REPEATING IT

I included the clip above, not to rub people's noses in the incompetence of the last Labour government - well, mainly not for that reason - but to make the point that people who assume that the previous facts of economic life have gone away have a sad record of proving to be disastrously mistaken.

We ignore at our peril the economic lessons of past centuries: if prices were to fall consistently and significantly, there is a strong probability that the disastrous cycle of deflation which occurred most recently in the 1930's and repeatedly in the 19th century could recur.


BUT THE RECENT PAST CAN ALSO TEACH US NEW IDEAS

However, given that Britain has managed to maintain positive economic growth and falling unemployment - and indeed record employment - during a period of inflation which for all practical purposes has been zero, and for three months very marginally negative, this has conclusively proved two important things:

1) a negative sign on the inflation rate is not a tipping point which automatically plunges you into recession.

2) it is possible for an economy to continue to grow for at least a few months without inflation.

Now, let's be clear about why inflation has been so low. It is a temporary situation brought about by substantial one-off falls in the price of certain primary products, particularly energy and food.

Under normal circumstances including present monetary policies I would expect inflation to return to about 2% within a year. One reason for this is that the Bank of England's current terms of reference task them with making inflation do precisely that.

But I think it is time to ask - are we instructing the Bank to plan for more inflation than is actually necessary?

At present they are tasked to keep inflation within a band of 0% to 4% and if the inflation rate diverges from the centre of that band by more than one percentage point, the Bank of England Governor has had to write to the Chancellor and explain why.

This has meant the delightful spectacle in the last year of Mark Carney having to write to George and explain why inflation was under 1%, and more recently why prices were falling.

TIME TO REVIEW THE BANK OF ENGLAND'S TARGETS.

I would like to see the Chancellor commission a study of a balanced panel of independent experts, including some business people as well as economists, on whether some or all of those target figures should be reduced by one percentage point.

Perhaps instead of having a target range of 0 to 4%, the target range should be 0% to 3%, or maybe even -1% to 3%, and instead of having to write a letter if inflation is over 3% or under 1%, Mr Carney should have to explain what has happened if inflation goes over 2% or goes negative.

We cannot abolish boom and bust, and we cannot squeeze inflation totally out of any real-world economic system. But maybe, just maybe, we can ratchet it down a notch and further embed the low inflation we have enjoyed for the past few years as the most common state of the British economy.

And if we could do that, the long term gains in terms of more incentives to save, greater security for savers in general and pensioners in particular, more certainty for businesses looking to invest, of even a one percentage point drop in the inflation trend could be very much worth having.

3 comments:

Jim said...

97% of the money we use is not "money" as such, its just numbers typed into a computer by a high street bank. This is the money you have "in" your bank account. Its not actually money at all, what your bank balance is, is a promise by your bank to pay you a certain amount at some point in the future.
These figures are created when banks make loans, they just enter 2 lines into the books, well more accurately on to the balance sheet. its a system of double entry book keeping. then charge interest on it.

so i take out a loan for £1000 at 5%,

the bank records £1000 into my bank account (which is not money, just a promise to pay me some money) this is recorded as a Liability of the bank.
At the same time they create an asset (this is my loan as i have promised to pay the bank £1000 + £50 in interest).

At the end of the loan term when I have paid £1050 to the bank then the £1000 is "destroyed".

its a very important concept to grasp that banks are not middle men, loaning money from savers to borrowers, they don't.


Thing is, if we have £1 it means some one somewhere owes £1. So the only way we can get money is to borrow it, that is go into debt. Though we end up with a lot of money in the overall economy, it also means we have a lot of debt (the boom). Though then, because there is way too much debt, people start to default on it, others then get a bit panicky and "repay their loans" or destroy the money. the bank is reluctent to lend more, as there is more chance of a default, and those who have defaulted leave the bank in a hard place. (the bust)

Unfortunatly the government "bail out the banks" in order to keep this mad system working. so quite simply, when things are going well the banks cream a lot of money from the productive section of the economy, when it all goes tits up, then the government bail out the banks which puts the debt (via taxes and government borrowing) onto the productive section of the economy.

This is why under the current system there can never be any removal from boom and bust. And any politician who ever tells you there can is either Ignorant, being economic with the actualite, or is plain simple telling porkies.

Jim said...

Also how on Earth can HWSNBN say that he never said no return to boom and bust and expect people not to call him out for telling porkies.

I mean the evidence he showing he did is pretty overwhelming.

Chris Whiteside said...

Economists have, as you probably know, several different definitions of money. But the general principle is that, if you can use it to settle a debt or buy something, it's money.

Debt is not inevitably a problem per se, it becomes a problem if you do not have the assets to cover it.

I don't think it is a mad system, but I do agree that no chancellor is ever going to be able to "abolish boom and bust" while we have it - I doubt they could do so under any other system either.

And yes, it was a silly thing to say and an even sillier thing to deny having said.