Firing up expectations of more financial chaos

In October, the 12-month inflation rate was 4.5 percent - a full 2.5 percentage points above the government’s target. In September, inflation hit 5.4 percent, marking a 16-year high. September capped off an extended period of dismal inflation numbers. Over the preceding 2 1/2 years, the Bank of England clocked up an almost 100 percent record of missing the 2 percent target.

Does inflation matter any more? There are people, including New Labour and the MPC who think it is yesterday's problem. According to the MPC, falling commodity prices and a flagging domestic economy will bring inflation below the 2 percent target. Instead, deflation is the thing to give us sleepless nights.

The fall in commodity prices is dramatic. After surging during the first half of this year, world commodity prices are falling back. Oil, for example, hit $147 in June; today it is around $50. Lower commodity prices will eventually feed into a lower UK inflation rate.

Presumably, this recession will also bring domestic inflation under control. As firms shake out unwanted workers, pay claims will moderate. As falling output and unemployment reduce demand, firms will find it difficult to pass on price increases. Taken together, these developments will put enormous downward pressure on domestic inflation.

Will the combined effect of collapsing commodity prices and domestic recession will push the UK into outright deflation; a rare economic disease when the inflation rate becomes negative? For that matter, how can falling prices be a bad thing?

Deflation would be very unpleasant. Negative inflation rates increase the real value of debt. This mounting debt burden might lock the UK into a semi permanent recession, as debtors realize that those home equity loans and mortgages will be much harder to pay off. This would depress consumption as households struggle to service an increasing debt burden.

There are, however, a couple of problems with the UK deflation story. First, although inflation is diminishing, prices are still increasing and we are still a long way from outright deflation. Second, during every UK recession since World War II, prices kept on rising. Finally, while credit growth has slowed, it hasn't actually stopped.

In any event, it would require a truly calamitous recession to generate a true deflation. To get some idea of the magnitudes needed to generate deflation, just look at the great depression. When the US suffered from falling prices during the 1930s, the accompanying recession was so great that one in four workers lost their jobs.

With this catastrophic scenario in mind, Brown and Darling are about to launch their anti-deflationary package on Monday. In an effort to hold off recession, they are going to cut taxes, boost public spending in a classic Keynesian fiscal stimulus. Like inflation, the government deficit does not matter; this is an emergency. As for public sector debt, the taxpayer will pay it down sometime in the distant future. Have Brown and Darling correctly diagnosed the problem? Are their fears of deflation justified? Will this spendfest work?

This brings us to the two major failings of New Labor. First, their time horizon is extremely short; Brown and Darling rarely examine the implications of a policy beyond a month. In turn, this provokes the second failing; the lack of foresight means that economic difficulties keep jumping out from behind the bush and catching them by surprise.

Here are three medium term problems that will arise directly from tomorrow’s package. First, UK households have an impressive capacity to import; therefore, most of this stimulus package will benefit firms in Shanghai and Beijing. Very little of this new spending is likely to sustain UK GDP.

Second, higher borrowing will eventually push up yields on government debt. This will distort credit markets, making it difficult for firms to borrow long term. After all, why would an investor buy a corporate bond with a significant risk of default when she can buy a high yielding government bond? The answer is she will, only if the return on the bond is sufficiently high.

Third, a tax cut this Monday, will mean a tax hike in the future. Both firms and households will discount the stimulus package as temporary. Households will use the temporary increase in income to pay down their debts. This is exactly what US households did when they received cheques from the Bush stimulus package. Likewise, firms will factor in higher tax rates in the future, and pull back investment plans accordingly.

What about inflation; have falling commodity prices and recession killed off it off? Inflation is process driven by expectations; in the short run, the upcoming recession might have temporarily anchored expectations. Over the medium term, the UK will experience years of high deficits, rising taxes , and financial chaos. The Bank of England is already trying to cover up this mess with negative real interest rates and huge amounts of liquidity.

That is just the thing to fire up expectations and a lengthy period of rapidly rising prices.