This time it’s different

The Duncan Weldon Economics Matters Column

In all the political posturing over the economy I believe a vital point is being missed, one that the Government should be more up-front about and the opposition, I fear, has failed to grasp. The current debate over the recession (‘Britain is best prepared’, ‘you didn’t mend the roof when the sun was shining’, etc) often consists of little more than point scoring and fails to tackle the most important issue; the nature of the recession itself. This issue is key, as this recession is different from any Britain has faced since the War.

Whilst there has been acknowledgement that this crisis is strangely global in nature, there has been little talk of the core difference – deflation. Recessions in Britain (and indeed around the world) have tended in the past to be associated with inflation. The standard textbook account of what causes a recession is a situation in which the economy has become overheated and prices are rising more quickly than is seen as desirable so the central bank raises interest rates to squeeze the inflation out the system. The cost of lower inflation is usually felt through higher unemployment and a declining economy – this was often seen as necessary, as John Major said in the early 1990s “If it’s not hurting, it’s not working”. Rising inflation, and the perceived need to control it, characterised the recessions of the early 1990s, the 1980s and the varied recessions of the 1970s.

The causes of this recession however, are different, and, crucially, it is characterised by falling prices: deflation. Any measure of inflation is imprecise, as different people spent their incomes in different ways (and I’ve blogged on how inflation is higher for the worst off) but whatever measure we use inflation is falling. There is a lot talk about how the policies of the Government and the Bank of England might lead to high inflation in the future, but no one is claiming this recession was necessary to deal with inflation. This is highly unusual.

Deflationary recessions are rare but dangerous (historical examples include the Great Depression and Japan’s decade long slump in the 1990s), the real worry is a slide into a deflationary spiral. At first glance deflation sounds like something to be welcomed: lower prices. But the reality of continually falling prices is far less pleasant. As goods become cheaper, consumers (entirely rationally) delay purchase of non-essentials (why buy today when it’ll be cheaper next month?), and as a result demand in the economy can rapidly fall away. Faced with falling sales, companies try to attract customers by cutting prices further. Corporates start to lay people off, and as unemployment rises, demand falls further. A whole set of negative feedback loops start to kick in: as unemployment rises, people default on loans and banks take losses, leading to lending being cut; as lending falls, there is less money spend in the economy, causing demand to fall further; falling demand leads to higher unemployment, and so on. As deflation sets in the real value of debt rises, especially perilous to over borrowed corporates and households.

My concern about a deflationary recession is not idle hand wringing. At present the USA, Japan, China, Switzerland, Korea, Taiwan, Spain and Ireland are all actually in deflation. Across the Eurozone as a whole inflation has fallen to 0.5% and is expected to go negative in the next few months.

Pretty much alone of the developed economies, Britain has so far escaped deflation (CPI has fallen from 5.2% last summer to 2.9% in March). The main reason Britain has escaped this threat thus far is the fall in Sterling: as the pound has fallen the cost of imported goods has risen and helped keep inflation positive. When the opposition decry the fall in Sterling, one has to wonder whether they would rather embrace deflation and all that entails.

So, what should the Government do? Thankfully the answer is pretty much what it is already doing – the central bank should slash interest rates and embark on a policy of quantitative easing, whilst the government should loosen fiscal policy and increase spending to try to keep demand intact. I would argue that the Government could be doing more, an infrastructure-focussed stimulus plan would be my preferred option but no matter, they are at least moving in the right direction.

The Tories who fret over the fall in Sterling and call for the government to ‘rebalance the books now’ are at best seriously misguided in their understanding the current recession and at worst, simply dangerous. Ireland (facing the same banking crisis and property market crash as us) is trying the Tory route of aiming to ‘rebalance the books’. Unemployment is at 11% and heading higher whilst the economy is expected to contract around 9.5% this year. That’s not simply a recession, that’s a depression.