Deflation or Inflation?
Robert Peston mentions “that the sum of consumer and corporate borrowing in the UK is equivalent to something like 240% of our annual economic output in the UK, while US household and business debt is closer to 300% of that country’s GDP.”
He appears to have a rather dim view on this matter, furthermore a hint of condemnation. This only shows part of the picture however, and we need more information to get the full idea of where we stand on the international stage.
1) What are the equivalent levels for our peers? What would the % debt levels be for other major economies such as Italy, Spain, France, Germany and Japan?
2) What about savings? Someone has lent all this money, which means that they have the savings to support it. Did this come from internal investors or external?
These additional pieces of information are critical to understanding the debt effect on the countries FX rate, GDP and standard of living, by telling us whether the country as a whole is in deficit, and by how much. They also change the optimal economic policies for fixing the problem, (which should always be the focus).
He follows by saying “In cash money, that’s about $45,000bn – or one of those big numbers that induces vertigo. Which is quite a burden, and – as far as I can tell – a record-breaking mountain of debt for us to pay off. The alarming and important point is that if deflation were to set in, if prices were to fall, the real burden of that debt would increase – thus prolonging and exacerbating the severe recessions that appear to be taking hold in both the US and the UK.
That’s why the US Federal Reserve has set its policy interest rate as so close to bupkes or zero as makes no difference.”
The logical extension of this is that; if deflation increases the real burden of debt, then inflation decreases it. Therefore, one could expect the CBs to review their inflation targets in the near future, as they might be more accepting of new levels of inflation, and intending to inflate their way out of debt. Given that the real IR for both US and UK is currently negative (i.e., IR – Inflation < 0), this seems to be a policy which they are in favour of.
However, this brings us back to the question of who lent the money in the first place?
If the money mostly came from internal investors, then inflation cuts two ways, as the investor ends up getting back less (in real terms) then their original investment. In the end, this is little different from simply writing off a portion of the debt. This is hardly a fair outcome for people who have saved responsibly while others were gorging themselves on debt to fuel artificially high demand.
If the money came from external investors, their investment loss would act as a positive net transfer of wealth into the domestic economy, and is therefore beneficial.
What are some alternatives to this? One is to accept that we had debt-fuelled high demand for a long time, that it is time to tighten our belts, stop spending and pay off (over a long, long period of time) our debt (the conservative party argument).
However, this is likely to result in (at best) a long period of sustained poor growth, high unemployment, and low standard of living. And this can end up becoming a vicious cycle; as the economy is producing less, there is less money to service debt. This results in less money being invested for the future, resulting in the economy producing less. A further, and very real, danger of this policy is the unemployment hysteresis effect. This is that when unemployment goes up sharply, and stays elevated for a long period of time (more than a couple of years), a significant portion of the unemployed forget skills, loss motivation and can become unemployable. This results in a decreased GDP growth for the rest of their working lives (maybe 25 years). And this is the reason why the BOE and FED have been taking drastic monetary and fiscal steps to stimulate demand, because the cost of doing so (although high) is still less than the cost of not doing so.
How do we fix this mess? The short term policy is to stimulate demand, which will also stimulate inflation. Not only would it help by devaluing domestic debt as it would, in the first instance, generate a boost in retail and industrial activity income and have as a knock-on effect the generation of more jobs (so long as their operating costs do not increase at the same rate as inflation). In order to generate a long-lasting growth to the economy, inflation would need to be controlled such that these effects do not back-fire, it will be a delicate balancing act of getting perfect timing of when to inflate the economy and when to control inflation. Ways to achieve this exist, such as stimulating specific industries, i.e. services, research, development, technology and education, industries that use little raw materials, processes, installations, transport, fuel, commodities, etc. These industries main resource is labour. They tend not to adjust wages at the same rate that their income varies. This will unfortunately mean that in the short term people’s cost of living will continue to suffer, as wages continue to not keep up with inflation. However this should stop unemployment rising to far or too fast, and allow for sustainable growth in the future. In the long term, this will create more dynamic labour markets in these industries, which will raise wages (and standard of living), and refuel inflation.
Andrea Graves and William Durham
10.01.2009
