UK: The low-inflation tiger.

UK: The low-inflation tiger. - Habits have changed but too much low inflation can be bad for you.

by David Smith is economics editor of The Sunday Times.
Last Updated: 31 Aug 2010

Habits have changed but too much low inflation can be bad for you.

Two years ago, certainly, a year ago probably, and even six months ago possibly, there was widespread scepticism about Britain's ability to achieve low inflation. The doubters, and I counted myself among them, questioned the capacity of pay negotiators to deliver wage settlements compatible with suitably small increases in unit labour costs. Monetary policy, spectacularly off course in the second half of the '80s, was surely still prone to major errors. Had the inflationary leopard really changed its spots? We waited for the downward drift in inflation to reach its nadir.

But no. Alongside every disappointing statistic for demand and output there has been good news on inflation. In the short-run at least, there has been a trade-off between growth and inflation. Pay increases of 3% or 4% are commonplace now, as are pay freezes. Average earnings growth is 6% and falling, having dropped well below the 7.5% floor which was the best that could be achieved in the '80s. With hindsight, we can see why. Unemployment is below the peaks of the mid-'80s but its structure has changed. It has reached into virtually every occupational group, including previously sheltered service industries. Greater labour market flexibility, more realism among pay negotiators, has also helped.

As for monetary policy, there is no longer the constraint of European exchange rate mechanism membership. Yet lenders and borrowers are still in the "burnt fingers" phase of adjustment to the excesses of the '80s. Having gone too far then, they may take years to return to normal. Monetary policy, far from being too loose, is too tight. Credit growth, having been excessive, is now inadequate. That inflationary leopard is now a low-inflation tiger.

Under Margaret Thatcher, the goal was stated in stark and simple terms - zero inflation, or stable prices. It was never achieved. Under John Major, the ambition is expressed in a slightly more subtle way. It is, in a definition borrowed from Alan Greenspan, chairman of America's Federal Reserve Board, that of achieving, year-in, year-out, rates of inflation which cease to have an adverse or distorting effect on economic decision-makers. In other words, people and companies will stop taking actions which have as a central aim that of protecting themselves from the effects of inflation.

This is clearly highly laudable. The problem is that Britain, according to a recent description by the Paris-based Organisation for Economic Co-operation and Development, has been inflation-prone since the '60s. But expectations of inflation are now low. Many companies will now be feeding in five-year inflation projections of no more than 2% or 3% a year into their corporate plans. Individuals no longer anticipate generous salary increases, not this year or for several years.

The difficulty is one of adjustment. It is here and we have to learn how to cope with it. There is no doubt that the bigger pay increases of the past, even if ultimately eaten up by higher prices, created a "money illusion". People getting a 10% wage rise were likely to boost their spending, initially at least, whereas a 3% increase now, even if worth as much in real terms, will most likely be thought insignificant. Large pay rises provided a repeated stimulus for consumer spending which we have lost.

Another area where the slate cannot be wiped clean concerns debt. The great personal and corporate debt build-up of the '80s was based on the implicit assumption that inflation would erode its real value. Instead, the unexpected achievement of low inflation and the increasing likelihood that it will be sustained, has left many high and dry. Without inflation's helping hand, people and companies reduce their debt in a direct and active way - foregoing spending.

The other side of this coin is that low inflation means that the real value of people's savings has risen. In other words, it takes a smaller amount of saving to guarantee a nest egg at some time in the future. But, apart from the fact that there are a range of incentives to encourage savers to lock up their funds for long periods, the attitude change required to make people unlock their savings because of a shift in inflation expectations is a substantial one. It may happen but it will take time.

The point is that, while we may be heading for a state in which inflation ceases to distort economic decisions, the road is strewn with dangers. The most dramatic case of disinflation, for example, has been the housing market. Falling house prices have had a major adverse impact on decisions, and continue to provide a significant distortion. Bank of England estimates suggest around a million people have "negative equity", where the value of their home is less than their mortgage, and are effectively stuck. The distorting effects of sharply falling prices can be as bad as those of excessive rises.

So far, significant price falls have not been extended into other sectors. If they were, the distorting effects could be equally as bad. People would delay purchases in the expectation of yet lower prices, contributing to the depressed demand condition that would bring about further price falls. Low inflation is undoubtedly a good thing. Too much of it can be bad for you.

Debt: The dangers of the borrowing habit.

British companies exacerbated the current economic mess by taking on too much debt - and yet they are likely to do exactly the same again. And why? Some would say the City is to blame. Lloyds Bank chief economist Patrick Foley points out that over the last 10 years British companies have made nil use of the stock market as a net source of funds - i.e. firms have put back into the market (through mergers, takeovers and share buy-backs) as much money as they have raised from it. Thus, as a group, their only source of new funds has been borrowings and profits. This unusual dependence on debt in Britain occurs because company chiefs find that every time they have a share issue, the market marks down their shares, thereby eroding the group's value and its ability to raise funds. Share issues are simply not worth this price. In the decade ahead it seems unlikely that this particularly British habit - forged by short-term minded institutions - will change. As recovery comes, debt will again rise as UK firms aim to grow and compete. The worst of it, says Foley, is that this reliance on debt makes UK firms highly "risk adverse". He believes this caution sparked the recession - at the first small downturn in spending, firms cut staff and spending, instigating the downward spiral. If Foley is right, it could happen again.

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