Why buy now if prices are plummeting? How deflation could drag us all down

Even as recently as August, we were being told by the Bank of England that the real economic risk was inflation, with oil touching $150 a barrel, energy and food bills hitting new heights and commodities charting a similar path. In his August report, Mervyn King, the Governor of the Bank of England, confidently declared that inflation would breach the 2.5 per cent barrier if he did not raise interest rates above 6 per cent.

Now, just a few months later, oil has dropped below $50, commodity prices have fallen by 40 per cent and, five weeks before Christmas, British retails stores are slashing their prices by anything from 20 to 40 per cent. UK and US interest rates have been cut sharply and will go even lower, and the Bank and the US Federal Reserve are now predicting inflation may go negative – perhaps as soon as the middle of next year. All talk is of recession, deflation and depression.

Unfortunately, this sense of impending doom is not without warrant. US stocks have plunged to a six- year low, while the number of US unemployed has hit a 16-year high. Most worryingly for America, consumer prices dropped by a full 1 per cent last month – the largest drop in 61 years. In Britain, the headline figure for retail prices may show only a 0.1 per cent drop, but this conceals far more drastic falls – household goods, for example, are down 3.4 per cent – and worse is expected. Meanwhile, house prices are down 15 per cent and everyone anticipates another 10 per cent fall. Similarly, the FTSE was touching 6,600 mid-December last year and now it hovers at less than 4,000 points. So extreme is the expected downturn that UK unemployment could hit three million in 2010.

Some see only a cyclical recession, albeit a severe variant. But an even worse outcome than that is possible. There are fears that given the scale of indebtedness (personal and corporate), the collapse in world house prices and the credit crunch, we could become a deflationary economy – and deflation is a prelude to a full-blown 1930s-style depression .

What does deflation mean? The classical definition is a protracted decrease in the price of goods and services. With sustained price falls, making it well-nigh impossible to earn a return on shares, investment collapses and growth flatlines or goes negative. While deflation in certain sectors of the economy might be good as prices fall because of increased productivity, a general decline is bad news for virtually everybody as trade itself ceases to be profitable. Just about the only winners in a deflationary environment are those who hold hard cash – because the purchasing power of the monetary unit (pound, yen, euro or dollar) expands as the price of goods fall.

Indeed it is the expansion of the purchasing power of hard cash that is one of deflation's most insidious aspects. Consider this: what would you buy now, basic needs apart, if you knew for certain that a particular good or service would be considerably less expensive in six months or a year? This bias-against-purchase effect is worse again for companies: if, in an attempt to offset deflation, interest rates are in effect zero but deflation is at an annual rate of 10 per cent, the real rate of interest to be charged against investment is 10 per cent. And in a truly deflationary environment, since rates can't go negative, this investment penalty persists – producing, for instance, a real three-year charge on investment of 28 per cent.

Thus everybody, consumers and producers alike, just hoards hard cash while the economy collapses around them. And while the Government may initiate stimulus after stimulus to try to get some activity and inflation back into the market, once deflation has set in, people expect it to continue. It can prove impossible to shift and all the county is left with is fruitless expenditure, negative growth and a vastly increased debt burden.

The great example of this is Japan, which has been battling deflation since 1990 and hasn't really emerged from it. The side-effects have been harmful too: at 171 per cent of GDP, the country now has the highest gross public debt in the developed world.

One of the best interpreters of the global financial crisis, Graham Turner of GFC Economics, says there are significant parallels between Japan's struggles and our current economic situation: "Japan's long slide into deflation began with a collapse in the property market, which spilled over into multiple banking failures. Repeated attempts to kickstart the economy with fiscal stimulus all failed. Not enough policy action was taken to stabilise house prices, and that fed into deflation for goods and services. By the time rates were cut to zero, monetary policy had lost much of its potency."

According to Turner, a widespread deflationary collapse is a likely for the US and the UK because "central banks have been too slow to act. Getting base rates down to zero may now not be enough. Even with last month's 1.5 per cent rate cut, corporate borrowing costs have soared, threatening a major escalation of corporate defaults that will cement the slide into a debt trap. Deflation is now going to be very difficult to avoid."

The most dangerous and least understood aspect of deflation is its relation to debt, and in this regard Britain is badly exposed: since 1997, personal debt has risen by 165 per cent to over £1.5 trillion and Britain now has a debt- to-income ratio for the personal sector of 173 per cent. Corporate sector borrowing has been at similarly extreme levels.

It is the confluence of debt and deflation that drives economies into depression. According to Irving Fisher, the economist who first crafted the debt-deflation theory in 1933, in a recession, asset disposal forces down prices, which in its turn causes personal and corporate balance sheets to deteriorate. This causes more liquidations as others rush to sell and so prices fall further and defaults and bankruptcies increase. Since the leverage in the system is unwinding, providers of credit are unwilling to lend on any security and that compounds the collapse in demand.

So extreme is the price fall that asset disposal can never catch up, and thus liquidation defeats itself as it leaves people in greater debt than before, since the amount of goods required to pay the debt increases faster than the repayment brings down the original sum. This produces the classic debt trap where the more debtors pay, the more they owe.

Given the current crisis and the failure to secure house prices as the base asset of the entire Western economy, this is the deflationary cliff edge on which the Western economies are teetering. In the current situation, fiscal stimulus will achieve nothing. Only a policy that secures assets, drives real interest rates down to zero and provides an inflationary floor can succeed in this downturn.

However, nobody seems to have learnt the lessons from Japan as such debt-initiated deflationary collapse is becoming more likely by the day.

The author is senior lecturer in philosophy at Cumbria University