On my blogpost "There's no more money" I stated that one reason for the Bank of England's QE programme was to stave off deflation. There has been one comment in response:
"Why is deflation bad?"
It's an amazing question.
My immediate reaction was "well, obviously it is". And then I thought, "well, actually it's not obvious at all, and I don't know the answer". So I did some research to find out what economists say about whether deflation is a good or bad thing. I found Krugman's article on this, and several others as well. As I expected, Krugman's article was accurate in description but uniformly negative in opinion about deflation. But the others were more balanced. And one, ElliotWave, pointed out that deflation was not bad unless you were unprepared for it.
Now, according to ElliotWave's description, the UK is pretty unprepared for a period of deflation. Households, businesses and government are all carrying exceptionally high levels of debt. Government debt is heading for 70% of GDP. Individual debt is over 100% of GDP. And corporate debt is higher still. But deflation seems to be what everyone wants. The Government is putting in place measures designed to reduce the rate at which government debt is growing, which generally reduce the amount of money available, to households in particular. Banks are not lending anything like the amounts they were prior to the financial crisis. And individuals and businesses are choosing to pay down debt rather than spend money. All of this adds up to a severe and rapid contraction. Deflation is not just a risk, it is inevitable.
But my questioner wants to know whether deflation is a bad thing. And after reading all those articles and papers, I don't know any more than I did before, except that this is another subject on which economists don't agree. But of one thing I am certain. Whether deflation is a bad thing depends on the circumstances. And in the present economic circumstances I don't think it is a bad thing at all. I think it is essential. The only debate should be over how fast the economy should deflate.
Let me explain my thinking.
The prosperity of the ten years to the financial crash in 2008 was built upon a credit bubble, not on real economic growth. There was no sound economic foundation to this prosperity. In effect, the UK was living beyond its means. As a consequence of this, many businesses and individuals are carrying historically unprecedented and unsustainable levels of debt. This debt is now much more expensive than it was a few years back, and tighter lending conditions mean refinancing it is no longer an option for most people and businesses. The only other option is to reduce it, and that is what people and businesses are doing.
Debt reduction causes shrinkage in the money supply, which increases the value of monetary units and therefore tends to reduce prices. This is deflation. Under normal circumstances this shrinkage would be offset by expansion in the money supply due to new bank lending. But at present the banks aren't lending at anything like the levels required to offset private sector debt repayment. Nor should they be. After all, the private sector wants to reduce its debt, not take on more. So deflation is necessary if the private sector debt burden is to be reduced - unless, of course, the reduction in private sector debt is offset by increases in public debt.
Officially, we don't have deflation as such at the moment - we have inflation, mainly due to a VAT increase coupled with rising world prices for fuel and food prices. But the pattern of behaviour in the domestic economy is definitely deflationary. House prices, which have been inflated due to the credit bubble, are falling, and the retail sector is turning in awful results. People and businesses are reducing their spending across the board, and rising prices in some sectors are simply encouraging people to make even deeper cuts. Were this not the case, external factors would mean that inflation might well be quite a bit higher than it is at present.
Government policy so far has ignored the drive to deleveraging in the private sector and concentrated on controlling public sector spending while stimulating the economy in various ways to promote growth. These measures include a failed attempt at demand stimulus through quantitative easing; corporate tax reduction; measures to improve lending to businesses, both through the banks and directly from government; light-touch regulation of tax avoidance measures such as offshoring. All of these are bound to be ineffective if the private sector prefers to pay its debts and sit on its cash, which is what is happening. Near-zero economic growth is here to stay while the private sector isn't spending.
The question is, do we really need to push for economic growth at the moment? Or should we accept that the UK economy is rebalancing itself, deflating the unsustainable credit bubble and returning to a more stable, if smaller, base? If we interfere with this so as to slow down the rate of contraction or delay its effects - for example by encouraging more bank lending to businesses, or increasing debt-financed public spending - do we make the necessary adjustment easier to bear, or do we simply turn an excruciating but mercifully short adjustment into a long-drawn-out agony?
I don't know the answer to this. But I know how I prefer to take off sticking plaster.