Why a little bit of inflation might be good for us

The prices of food and household goods are actually falling, with clothing and footwear prices down by 4%
The prices of food and household goods are actually falling, with clothing and footwear prices down by 4%

While inflation has always been a dirty word, Dan White explains why it is in fact a necessary evil

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18 February 2014

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For decades central bankers and finance ministers have lectured us on the supposed evils of inflation. Now, with Ireland and the rest of the Eurozone teetering on the brink of deflation, we may be about to find out that falling prices are much, much worse.

According to the latest figures from the EU’s statistics agency Eurostat, Eurozone prices rose by an average of just 0.7% during the 12 months to January 2014. This was less than half of the ECB’s 2% target inflation rate. It was this very low rate of inflation that panicked the ECB into defying fierce German opposition and cutting official Eurozone interest rates to an all-time low of just 0.25% in November.

Prices are rising at an even slower pace in this country with the CSO recording an inflation rate of just 0.2% for the year to December 2013. Irish prices are to all intents and purposes now flat. In fact, when the CSO figures are examined more closely, an even more disturbing picture emerges.

The main contributors to higher Irish prices over the past 12 months have been dearer tobacco and alcohol (up 5.7%), education (up 4.4%), restaurants and hotels (up 2.8%) and health (up 1.2%). With the exception of restaurants and hotels these higher prices are almost exclusively the result of higher government taxes and charges. These range from increased excise duties (tobacco and alcohol), dearer VHI (health) and higher student registration fees (education).

Food and household goods falling

A very different story emerges when one examines most of those prices whose level is determined by the market rather than by government diktat. These include clothing and footwear prices (down 4%), furniture and household goods (down 3.7%), communications (down 2.4%) and food (down 1.1%).

The reality is that, when the impact of government actions is filtered out, Ireland has now entered a sustained period of deflation or falling prices. This is the first time this has happened since the early 1930s when average Irish prices fell by approximately a third.

So now that the dragon of inflation has been finally slayed should we rejoice? For more years than I care to remember financial experts have been warning us of the alleged evils of inflation. If, or so we were told, we didn’t mend our ways we would soon end up like the unfortunate Germans in 1923, when it took a wheelbarrow full of banknotes to buy a loaf of bread. This would quickly be followed by men with funny moustaches, and well you know the rest.

Learn from Japan’s mistake

Be careful what you wish for. While most developed countries haven’t experienced a lengthy period of deflation or falling prices since the Great Depression, Japan is only just emerging from two decades of deflation. It wasn’t a pretty picture.
As prices kept falling consumers stopped spending – why buy something today when you can get it for less tomorrow? Deflation pushes up the real value of money, including bank loans. With Japanese property prices having fallen by over two-thirds when the bubble economy burst in the early 1990s, this effectively bankrupted most of the country’s banks. The result was "zombie" banks with huge unrecognised bad loans on their books unable to make new loans.

Sounds kind of familiar doesn’t it.

The existing deflationary tendencies in the Irish and other Eurozone economies may be about to receive a further strong boost. If last November’s nuclear deal between Iran and the west sticks then several million barrels more oil a day will be added to global supply. This comes at the same time as the US Energy Department is forecasting a one million barrel a day increase in US oil output for each of the next three years while Libya is also cranking up production after a disastrous 2013.
With several of the developing economies running out of steam all of the ingredients for a major collapse in oil prices are now in place. While lower oil prices might normally be no bad thing, coming at a time when the Eurozone is already flirting with deflation, an oil price collapse might fire the starting gun on a sustained period of falling prices. As the Japanese experience demonstrates, once a country falls into the deflation trap, it can be extremely difficult to escape.

The IMF is clearly very worried about the possible impact of an oil price collapse. "It raises the likelihood of deflation in the event of adverse shocks to activity," the organisation warns in its latest World Economic Outlook published last month.
With most of the developed world teetering on the brink of deflation it is becoming increasingly clear that, contrary to what we have been told by generations of central bankers and finance ministers, inflation isn’t necessarily a bad thing. In fact a little bit of inflation can be good for an economy.

1979 property crash 

The post-Celtic Tiger bust wasn’t the first property price crash experienced by most Irish people. In 1979 Irish property prices peaked. They then fell sharply with agricultural land prices falling by 70% in real terms and most other types of properties losing almost as much of their value.

In proportionate terms the post-1979 property crash was just as severe as the one which we have recently experienced. So why didn’t the earlier property crash bankrupt the banks?

There is a simple answer: Inflation. Irish prices were rising by over 20% a year in the early 1980s. While the high inflation of those years may have been bad news for savers or those on fixed incomes, it came to the rescue of the banks and their borrowers. High inflation in the early 1980s meant that while property lost over two-thirds of its value in real terms, rapidly rising prices meant that the fall was much less severe in nominal terms. This is what kept the banks and most of their customers solvent.

So whisper it loudly: far from being a bad thing a little bit of inflation might actually be good for us.

 

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