The Band-Aid Decision – Deflation Or Inflation?

Last night Lord Adair Turner, head of the UK’s regulatory body, the Financial Services Authority (FSA) questioned whether or not the Bank of England’s programme of QE was doing enough to promote a recovery. He called for a ‘willingness to employ still more innovative and unconventional policies’ as ‘quantitative easing alone may be subject to declining marginal impact.’

Central bankers and policy makers today are scared of this huge beastie known as ‘deflation’ and its effects on economic growth. Lord Turner is worried the current weapon of QE will not be enough to scare it away.

Whilst he didn’t say it explicitly, it is widely understood that the unorthodox policies which Lord Turner would like to see implemented in order to avoid deflation, would include the monetization of the debt issued to the Treasury from the Bank of England.

This monetization of the debt would be financed by the physical printing of money, not the pretend version which we see at the moment by just buying bank bonds. He argues that it would not involve ‘an increase in government debt and therefore no increase in future debt servicing’.

This is known as ‘Friedman’s helicopter’, named after the economist who famously quipped that debt price deflation can be fought by ‘dropping money out of a helicopter’.

The deflationary spiral

Proponents of debt monetization fear that reductions in public spending drives up the value of money and have a greater than proportional effect on economic activity. This negative multiplier effect helps fuel a deflationary spiral. For Bernanke, Lord Turner, Sir Mervyn and all other governments and bankers, deflation in the economy is the equivalent of a fat lady at an opera. They see it as something which creates a vicious spiral of negative events.

By monetizing the debt, they believe, this will leave public spending safe, and the value of debt and money ever falling, and therefore the economy risk free from deflation.

Deflation is usually defined as when inflation is less than 0%, i.e. there is a decline in prices. Keynesians and others of mainstream economic thought do not like deflation, they believe it is harder to control than inflation, and more damaging to the economy. Deflation means that the money held by everyone becomes more valuable so people are more likely to hold onto it. The holding onto money slows down the movement of capital which sees a decline in wages and therefore business activity. There is also a fall in borrowing as people realise that their debts become larger relative to the assets they own.

As we have said on these pages there is a misconstrued belief that more money equals greater wealth and prosperity. The opposite is true: more money reduces wealth and prosperity. The sooner the money supply is corrected the more people’s money will be worth and therefore see their wealth increase.

Deflation also, of course, increases the value of outstanding debt faced by all who have borrowed – the government, businesses and consumers. To show how far away we are from market equilibrium when it comes to how indebted we are just look at house prices. They have been increasing in double digit percentages for many years. This needs to be adjusted; this excess liquidity needs to be corrected and there are wider mountains of debt that also need to be reckoned with

Bring back to equilibrium

At the moment our economy is dramatically far away from equilibrium. The economic growth which everyone is so desperate to get back to has not been real for the last forty years; it has all been thanks to monetary and fiscal tools. And now Lord Turner wants to try out unorthodox tools. Well, what we’ve been going through for the past 4 decades has also been fairly unorthodox. We all now live in economies where growth is based upon manipulation of the money supply and outstanding credit. These practices have worked for a while but it is artificial success.

As explained by Adam Smith’s invisible hand, natural forces are desperately trying to get us back to equilibrium. We can’t do that by trying to inflate our way out. We have built this current mess on liquidity so we must now do the exact opposite and reduce the availability of liquidity. Governments not wanting to allow this are literally pursuing financial repression tactics.

Inflation tows the government line

Deflation is a tough gig, what’s more is, it makes the government look ‘bad’ according to the modern nanny-state view. Governments are inherently inflationary in both their election promises and their policies (financed by public borrowing). It makes them look good if they can spend more on schools, benefits and infrastructure. The hardship of deflation would not be forgotten in the average electoral term, therefore it doesn’t bode well for the next election. Lord Turner (who happens to be an applicant for the Governor of the Bank of England role) or any other banker’s approach to avoid deflation will be supported by an incumbent government.

The proposal of debt monetization is still seen as slightly controversial but only in a PR manner, it’s not as though it hasn’t been discussed behind closed doors. This may already be a decision in the making, with or without Lord Turner’s ascension to the top of the world’s oldest central bank. Some of the current £375bn of debt is due for repayment next year by which point those piloting the Old lady of Threadneedle Street need to decide whether or not to roll it over into a perpetual zero-interest debt. Effectively, writing off the debt.

I once heard someone liken deflation and inflation to taking off a plaster – deflation is ripping the plaster off, inflation is doing it slowly. Both end up with the same result but one makes it go on longer. But the sooner the plaster is off, the sooner you can let the wound get on with healing.

The deflationary process is one which is almost guaranteed in the way in which it will play out. The effects begin to touch the economy almost immediately. However, with inflationary policies – such as upping the liquidity by monetizing the debt, we have no idea how long they will last, or what policies to pursue. Particularly as there is a time lag between inflationary policies and the effect of inflation kicking in.

Social unrest

Last week, Dylan Grice quoted Keynes himself: ‘by a continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate arbitrarily; and, while the process impoverishes many, it actually enriches some.’

Grice refers us to history to show the damage which sharply devalued currencies have done to societies. The fall of the Roman Empire, the French Revolution at the end of the 18th century and Weimar Germany – all thanks to currency debasement leading to the breakdown of society.

David Cameron spoke this week of wishing to spread privilege across the nation, he also told us that you couldn’t borrow your way out of a liquidity crisis. Let’s hope he wasn’t paying too much attention to Lord Turner last night, and that Lord Turner’s application to govern the Bank of England has been put firmly on the ‘reject pile’.

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