Don't panic about inflation - that can wait
First published in the Telegraph on 18 February 2010
Back in the good old days, economics used to be about numbers, charts and dweebs with calculators. These days, it turns out, it is all about letters. For while those of us in the real world have moved on to email, mobiles and Twitter, the economists of the world have belatedly discovered the joys of putting pen to paper.
First there were the 20 economists who wrote to The Sunday Times urging the next government to cut the deficit more quickly than either party has yet proposed. Then, on Tuesday, Mervyn King, the Bank of England Governor, was forced to write a letter of explanation to the Chancellor after inflation shot up above target to 3.5 per cent.
At first glance, the pair of epistles don’t have much in common. The first is about controlling government spending; the second about keeping prices under control. In reality, however, they both underscore a simple but terrifying point: the credibility of Britain’s economic policy is under greater scrutiny, and in graver doubt, than at any time for decades. You might have assumed that the all-time low came a year and a half ago, when the Government was forced to nationalise large chunks of the banking system. In fact, for better or for worse, most investors consider those events, mirrored as they were throughout the Anglo-Saxon world, as an aberration.
Only now, in the shadow of the wreckage, can one ask whether Britain can maintain its reputation as a stable, predictable place to do business for the next few decades. In retrospect, the great achievement of successive governments over the past 30 years or so was to have convinced investors that Britain was precisely this kind of place. Leaving aside the brief dalliance with the Exchange Rate Mechanism in the early 1990s, in the UK inflation and interest rates were more or less predictable, as was tax policy, and the rule of law could be relied on.
These foundations, which helped Britain become one of the prime destinations for money and investment from around the world, cannot be bulldozed overnight. But a good way to start would be a bout of fiscal incontinence and a sudden uncontrollable spurt of inflation.
People are already fearing the worst. Markets are charging the Government higher interest rates on its debt than for Spain or Italy, something that says as much about their concerns over Britain’s escape plans as it does about their hopes that Spain and Italy get bailed out by Germany.
But this is a mere tremor set against what might come thereafter. Interest rates will more than double again in the next decade or so, according to the extremely well-regarded Equity Gilt Study from Barclays. It bases this forecast not on the side-effects of the financial crisis but on the effects of the ageing population, which, left unchecked, will push up the national debt for almost all major Western economies to many multiples of their current levels.
When faced with a national debt of uncontrollable proportions, governments will try to find a way to erode the debt through inflation – the “acceptable” face of default. Another argument has it that higher inflation would shift wealth from the older generation of asset holders to the younger, indebted generation – just as the credit bubble of the previous decades channelled wealth into the hands of the old, rather than the young. And you can see economists attempting to lay the groundwork today. The IMF’s chief economist has suggested raising the inflation target from 2 per cent to 4 per cent.
This rather naively overlooks the problem that inflation, in the words of German central banker Karl Otto Pöhl, is like toothpaste: very easy to squeeze out of the tube, almost impossible to put back in. As simple as it sounds in theory to create a world of slightly higher inflation, the upshot is almost invariably that politicians lose control of prices altogether, creating high 1970s-style inflation that is socially and economically destructive, cruelly disrupting the lives of millions of savers, pensioners, businesses and investors.
Having said that, the big threat for the next couple of years is still deflation. To extend Pöhl’s analogy, there is more than one flavour of toothpaste. The kind we’re tasting at the moment is the mild inflation caused by short-lived shocks – higher petrol prices, rising VAT, the weaker pound. That is quite different from the sharper variety brought on when wider faith in a government’s economic credibility is lost.
This week’s 3.5 per cent inflation, and the likely increases in the next few months, are rather like the temporary price rises in 2008 (remember the inflation hysteria then?), in that they disguise the recessionary forces still hammering down on the economy. Households are suffering wage cuts, businesses are still incapable of borrowing, and the country is about to endure its biggest set of tax rises and spending cuts in a generation. Now is not the time to panic about inflation. That can wait for another couple of years.