Can we prevent deflation?

Deflation may or may not happen. What are our options?

We discussed deflation a couple of weeks ago, what it means for us personally and our economies generally. And this year there has been much discussion about “good deflation” and “bad deflation”, as economists try to get to grips with the wider implications. So while oil price deflation might appear to be “good deflation” for net oil importing countries, it’s at the expense of “bad deflation” for oil exporting countries.

At a personal level, isn’t it clear what we will do if deflation happens in our economy? Most of us will hold off making major purchases until prices have fallen further, hurting the manufacturing sectors and causing a “deflationary spiral”. If land and house prices are falling too then this benefits first time buyers and those upsizing at the expense of those having to downsize or sell. The younger generation might feel this is justice done, having spent the last few years paying rent to property owners. Indeed house price deflation is not unusual in such a cyclical market as this.

Can we control deflation?

Just as national governments have ways of controlling inflation, so too do they have ways of controlling deflation. To tackle inflation, the usual strategy is to raise interest rates. This makes it less desirable to borrow money, thus reducing demand for goods and making price rises less likely. In fact any way of removing money supply should, in theory, be anti-inflationary. In which case, controlling deflation is the same, but opposite, no?

Correct, no. The opposite of an interest rate would be, well, a dis-interest rate. A negative rate whereby we have to pay a bank to deposit our money or, indeed, pay a government to take on its debt. It doesn’t make sense, because in the end we can beat the system simply by withdrawing our money and metaphorically hiding it under the mattress.

Another way of increasing the supply of money is to make more of it. Quantitative Easing (QE) has been used for some years already in a number of economies. Originally it was intended to free up assets held by banks so they could lend money again, after the “credit crunch” of 2007/2008. It had a mixed reception by economists (most things do – they never agree) and there were fears it would lead to inflation. It didn’t, and now the ECB has joined the UK, USA, Japan and others in creating more money. If deflation becomes a problem, we can expect more QE to get us spending again. In fact, QE is a bit like having a negative interest rate. It means the value of the money we have, as a share of that national wealth, goes down as if we are being charged for owning our currency.

Should we control deflation?

It’s interesting how, in a capitalist economy, just how much intervention there is by central government. Some will say that the market is always right, and if deflation happens then it happens. Others say that intervention is necessary to keep markets functioning in the way we would like them to.

When interest rates are lowered, savers are penalised. Retirees will tell you how their pensions have been eroded by falling annuity rates, and companies running final salary schemes will tell you how much extra funding they have had to provide in order to keep their pension schemes solvent. The beneficiaries are those enjoying a final salary pension, or with an annuity they bought when rates were higher. This is all seen as a kind of secondary effect by national governments, whose priorities are to keep rates of inflation between certain limits.

Even with QE there have been discussions as to who has benefited. It seems to be the financial sector, mostly, as it was they who held the government bonds which the QE programme bought back. In theory that should have fed through to the wider economy, but demonstrating that is virtually impossible. Some critics suggest that QE should have been used for something more tangible to the general public, like increasing the housing stock.

So the “should” question remains unanswered. It was an experiment, and we can look forward to many years of analysis in hindsight.

What can we do in our personal fight against deflation?

In a deflationary environment, cash is the most powerful resource. Its value rises against goods. So our priority should be to secure as much cash as we can. This means a kind of siege mentality, so:

Reduce or pay off debts

If money is best, then negative money is worst. In times of deflation, the only thing guaranteed to at least keep its value is a loan or mortgage. Interest rates will never be zero, so make paying this off the priority.

Secure your income

Easier said than done. But if you have the choice of a permanent job over a short term contract, all other things being equal, go for the former. As deflationary pressures take effect, unemployment will likely increase and the chances of getting a new job or contract will lessen. In Japan, wages are actually falling.

Look for bargains

Deflation won’t last forever. There will come a time when you have to cash in your chips and buy that home, or upscale your business, or perhaps you want to buy hard assets such as antiques. Don’t get too cocky and hold out for the best deal, because you might miss it. But go for deals which are affordable and in which you have some expertise. These will protect you against any subsequent inflation.

Is deflation really going to happen?

Who knows? In Japan it’s very real, but globally, the jury is out. It’s hard to see prices of essentials like food falling, although with deflationary pressures on wages, it’s possible. But then again I didn’t expect to ever see an inflation rate of zero in my own country (the UK), so never say never.

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