Low inflation is here again and should be hung on to this time, says David Smith.
Most economists believe, correctly in my view, that the boom of the late 1980s, while enjoyable in its short-term effects, wasted a wonderful opportunity for the British economy. There was a chance, back in 1986 and 1987, to establish a pattern of sustainably low inflation for Britain, last seen in the fifties and sixties. Instead the cat was let out of the bag, inflation and pay increases moved back above 10% and the whole process had to begin again.
Since that inflation peak of autumn 1990, when the rate reached 10.9%, there has been a sharp fall in the headline rate of inflation (partly due to mortgage rate cuts and lower community charge bills) and a smaller, but still significant, drop in underlying inflation. Given the mistakes of policy of the past few years, and thanks to an unnecessary recession, that low inflation opportunity has come round again sooner than it was reasonable to expect.
Britain, as the newest member of the European exchange rate mechanism (ERM), also appears to have undergone the most rapid adjustment on record to the low inflation requirements of the system. France took several years, and many painful episodes, to close its inflation gap with Germany. Britain has done so in a year, admittedly from an artificially high starting point.
The gap has been closed, of course, in rather special circumstances and some economists do not expect it to be maintained. The economic boom which accompanied and followed German unification has pushed inflation up to around the 4% level, which by Bundesbank standards is somewhere up in the stratosphere.
Meanwhile, Britain's economy has been doing precisely the opposite, the second worst recession since the war having the desired, if highly uncomfortable, effect on inflation. Old habits die hard and one suspects that, were growth conditions similar in the two economies, Britain would have significantly higher inflation. Similarly, the narrowing of the interest rate gap between Britain and Germany to less than two percentage points - its lowest since the early eighties - is explained both by the additional credibility that sterling has gained since ERM entry and the fact that domestic economic conditions in Britain have clearly warranted lower interest rates. In Germany the opposite has been true.
Nevertheless, however achieved, the existence once more of low inflation has created the opportunity to hold it there. Indeed, the Government's view is that this is not so much an opportunity as a necessity, in that failure to keep inflation down cannot be countenanced in the context of ERM membership. A significant upturn in inflation, it is argued, would blow a hole in the credibility of Britain's commitment to the system, bringing about sterling crises and punishingly high interest rates.
The argument is not as clear-cut as it seems to be. Under the Bretton Woods discipline of fixed exchange rates of the fifties and sixties, Britain's inflation, while low, was often above that of competitor countries for years on end. Yet the pressures on the pound took years to build up. And, after all, there was, and is, the option of devaluation. More recently, in the ERM itself, we have seen the paradox of high inflation currencies, particularly the Spanish peseta and the Italian lire, being the strongest in the system, on the view that, as long as no realignment of parities is likely, international investors might as well put their money where interest rates are highest.
If one accepts the view that long-run inflation convergence is a necessary requirement of ERM membership, is it sound enough? Long-term inflation of 3 to 4% a year sounds very good indeed. Certainly in the eighties the public's appetite for getting from 5% inflation to zero, or stable prices, proved wanting. Public concern about inflation vanished as soon as the rate dropped below 5%. And there is the argument, popular at one time, that a little bit of inflation does a lot of good. It allows relative prices and wages to adjust more easily. Gently rising wages and prices, thanks to the money illusion to which we are all subject, have the effect of making us feel better off.
The counter-argument is that even a little bit of inflation is a bad thing. A sustained inflation rate of 4%, after all, produces a doubling of prices every 15 years. There is the ever present danger of low inflation rates spawning higher ones. Tim Congdon, economic adviser to Gerrard and National, suggests that the only truly stable long-term inflation rate is zero.
Price stability would mean that the only pay increases that were justified would be those that reflected higher productivity. It would act as the most powerful and workable form of incomes policy. Price stability would also make economic policy less subject to errors - interest rates could be set at a level which did not have to take into account varying inflation expectations.
Given Britain's past record, the idea of price stability may seem fanciful. Inflation did, however, touch a temporary low of 2.4% in the summer of 1986. International factors, unhelpful in the seventies and eighties, may provide more assistance over the remainder of the present decade. Achieving a lower inflation rate than the rest, as Germany proved in the eighties, is the key to successful membership of the ERM. The system prevents the relevant currency from rising too much against the others, so the competitive benefits can be taken in increased exports.
The potential gains are many, and would outweigh the short-term costs. The difficulty is that, for politicians and the public alike in Britain, the will to eliminate inflation may be lacking. Despite three separate periods of high inflation in the past 20 years, Britain has nothing like the ingrained aversion to it of, most notably, Germany. But it is still worth a try.
(David Smith is economics editor of The Sunday Times.)