Inflation or deflation: a stress test for democracy
-Laurence Copeland is professor of finance at Cardiff University Business School. The opinions expressed are his own-
The policy debate is hotting up. On one side, we have the expansionists, arguing that it’s the Nineteen Thirties all over again, that Keynes is right now as he was then – we need more, not less government spending, we are digging our own graves by cutting back, especially as the fiscal retrenchment is continent-wide, covering thrifty North Europe as well as profligate ClubMed. According to this view, fiscal contraction will exacerbate the situation by magnifying the fall in the level of economic activity, leading to a downward spiral and, incidentally, making it harder than ever to repay our debts.
On the other side, the contractionists argue that comparison with the Nineteen Thirties is grossly misleading. Debt levels were far far lower for all the major economies in those days. Most important of all, in the Nineteen Thirties the threat (which duly materialised) was deflation, not inflation, so government spending financed by printing money was riskless.
The central question then is this: is inflation actually a risk today? Or is deflation the bigger risk?
On the one hand, falling prices could be catastrophic for two reasons.
First, ever since Keynes, economists have believed that deflation causes unemployment because wage levels rarely fall pro rata, so employers, squeezed between lower prices for the goods and services they sell and unchanged labour costs, are forced to lay off workers so as to protect their businesses.
Secondly, a falling price level implies a rising debt burden, or an increase in the real cost of repaying the country’s outstanding debts. If you think this is purely a matter of economic theory, just compare it with the situation facing a householder with a mortgage – inflation raises his wages and the price of everything he buys, making the burden of his mortgage lighter every year, while deflation does the opposite, meaning he has to struggle to repay a debt which remains unchanged while the value of everything else (including his house) is shrinking.
So give us back the inflation we all know and love – at least those of us who can remember the Nineteen Seventies, right?
With War Loan trading at less than a fifth of its face value, that decade’s inflation allowed Britain to pay off the last of its WWII debts – a default which was legally unimpeachable, but shameful nonetheless, and one which is going to be harder to pull off this time around, though one should never underestimate the shortness of memory of those who make a living mismanaging other people’s money. (Anyone in doubt on this point should read Reinhart and Rogoff’s history of sovereign defaults “This Time is Different”).
This escape route may seem attractive – indeed I am afraid it will in the end prove irresistible to UK and USA, and possibly the Eurozone too – but it has enormous drawbacks, as we well know. Inflation distorts relative prices and relative incomes, redistributing wealth from those who have to survive on fixed incomes to those who can be more nimble, so that in the end economic activity is reduced to nothing more than a race to keep one step ahead of rising prices. More and more wealth is ploughed into investment (and overinvestment) in projects which can be justified simply as refuges from paper money. Moreover, the flight from money itself prolongs and accelerates the rate of inflation, so that the process becomes self-sustaining.
The damage done by inflation lingers long after prices have stopped rising – for years, decades, generations. If you think I am exaggerating, consider the following: the global crisis we are in today has its roots in the inflation of the Nineteen Seventies. It has its origins in the deep-seated belief that “you can’t lose money on bricks and mortar”, the unshakable faith in housing as an investment rather than simply a consumer durable, which paid off so handsomely for the British and American middle class from the mid-Sixties to the late-Eighties, and which made the next generation so ready to mortgage themselves to the hilt in the mid-Noughties.
But today’s born-again Keynesians regard inflation as a straw man. Their argument is that there is so much spare capacity today that demand can be expanded almost indefinitely without any risk of reigniting inflation. Are they right? Is there really so much spare capacity – idle capital equipment, unused real estate and, critically, unemployed or underemployed labour waiting to be pressed into service as soon as demand picks up?
Leaving aside the many technical issues, the key point is that in a globalised economy spare capacity has to be measured globally. So is there excess supply at the global level?
By far the largest producer of manufactured consumer goods is China, where – far from underutilisation of resources – there is every sign of the opposite, and not surprisingly of price and wage inflation, real estate booms and barely controlled credit creation. The effects are being spilling over into the markets where the Chinese buy their inputs – not only raw materials (oil, base metals etc) and agricultural products, but also capital goods – which explains much of the boom in Germany, Europe’s largest economy and the world’s fourth largest.
So where is the spare capacity? Not really in Japan, where the unemployment rate is still low by global standards. Japan certainly suffers from ubiquitous and barely concealed underemployment, but there is little evidence that it has increased since 2007, or indeed for a decade or two.
If not in Japan or China or Germany, what about America and the Rest of Europe, basically UK, France and Italy? Europe has not so far seen any dramatic increase in unemployment. Even when it does, given the mess Europeans have made of their labour markets, we can hardly be sure that it will represent any genuine freeing up of productive labour, rather than simply a further fall in their already low participation rates – more early retirement, more long term disabled, more discouraged workers, more emigration.
That leaves America, where there has undoubtedly been a dramatic increase in genuine unemployment. It is no coincidence that in the USA the expansionists have so far remained in the driving seat, though they have been helped by the fact that the job of making the case for fiscal responsibility has fallen by default to a Republican Party which appears for the moment to be dominated by its most disreputable elements. As the source of the world’s premier reserve currency, Americans are also unconcerned about the effect of monetary incontinence on the Dollar – as a former US Treasury Secretary put it to his European opposite number: “Our currency, your problem”.
The problem of course is that printing dollars will do little or nothing to get unemployed Americans back to work. Indeed, it’s just more of the same folly that got us into the crisis. Homer and Marge can only carry on living beyond their means as long as their local Walmart (surely there must be one in Springfield?) is brimming with cheap clothes, electrical equipment and garden furniture made in China (and occasionally elsewhere in Asia). The expansionists want to make sure Homer can always get a loan on his credit card or from his overaccommodating bank – but that’s just storing up problems for the bank, because he can’t repay the loan, and in any case the shopping he and Marge bring home only provides work for the factories in China, India, Korea or Taiwan.
For the UK, the dishonest inflationary route would represent a decisive step on the road to national decline. On the other hand, as the Government seems to have recognised, taking the high road will require more than just sound fiscal and monetary policy, but reform of the welfare state too, as well as a change in the national psyche.
For the West as a whole, it’s as a stress test for democracy.