Inflation … stagflation … deflation or will it be …

In recent months we have continually been bombarded with the threat of deflation. As though this is a bogeyman to be avoided at “all costs”. Deflation “per se” is not necessarily a consequence of not printing money, however, it might well be a stage that one needs to go through to correct past excesses. Deflation is that time during an economic cycle when prices start falling, because demand for goods has dried up. Until prices have fallen below cost of production, without allowing profit as a cost, we are simply in a correction phase … once they fall below that point we are entering a full scale depression.

As a young economics student in the 1960’s I started recognising that the economic policies being adopted by the government in South Africa were inflationary and could only lead to future pain. My Dad was fairly blunt in criticising one of the essays I wrote, claiming that he would always choose inflation instead of the alternative … depression. He described to me the 1930’s when as a farmer the point was reached where the tomatoes, which he was always exceptional at growing would only realise two pence a box on the market, but he had already spent three pence on making the boxes in which they were packed. He told me of how he drove the pigs into the fields and allowed then to feast on that which fellow humans were not prepared to even pay the cost of the packaging. He told me of giving away his livestock, mainly cattle and pigs so that the bankers who were foreclosing his mortgage would not get them. He told me of simply deserting his farm and accepting a job with one the public works programs that was undertaken by the South African Government. He never told me, but I learnt later how Mum had left him at this time, that it was only her father forcing her to go back to her man in his time of need, that resulted in our family growing. Yes, the end results of true deflation are horrifying beyond our imagination.

It was little wonder that I accepted the Keynesian attitude of Government control of the economy, even though my thought process was telling me that this had failed too often in the past for it to be universally true. The 1970’s started exposing the horrors of pure Keynesian economics as we faced our first serious inflationary shock since the German experiment of printing money to maintain the level of currency in the economy at a relationship with economic activity. Still, inflation was better than deflation it made starting new businesses easier and it was easy to make profit, or was it? Once we thought of producing inflation adjusted financial statements for companies we started seeing that most of what we called profit was an illusion … our borrowings were growing. Yes the property speculators score during inflation but not the economy as a whole.

Deflation, only to the extent that it can lead to depression is always a threat.
Deflation to the extent that it squeezes margins, without dropping prices below cost of production, is simply a process of correction. Deflation resulting from a drop in demand for goods is best countered by companies diversifying their product lines, seeking new markets and/or increasing their manufacturing efficiency. Depression will only result from deflation if companies, instead of adapting to changed market circumstances, choose to lay off workers and create unemployment thus reducing the overall amount of disposable income in the market.

Why have we had so much talk about the threat of deflation if it is only a normal correction to market excesses?

Well, inflation has always been the friend of the Exchequer. Inflation has always made things a bit easier … rising prices mean increased tax revenues both by way of VAT collections and from increased corporate profits. The Exchequer has always paid lip service to holding inflation in check, as long as it can run an economy with a higher real rate of inflation than the “statistically derived rate” the pressure on increasing taxes is far less, and statistically the economy will appear to be growing when in truth it is stagnant.
Deflation terrifies the Exchequer, as all those untruths it has been telling are suddenly laid out in the open. In true political fashion, the way must be prepared, talk about the horror of deflation, because then people will more readily accept the next step … printing money … oh what a lovely word “quantitative easing” it sounds so sensible.

There are two paths open after the sequence Inflation, stagflation …
it is either;

inflation … stagflation … deflation … which could lead to depression (if fiscal stimulus for business start ups and maintained employment and wage levels are not applied)


inflation … stagflation … hyperinflation

There is no doubt in my mind that deflation is a far happier course than hyperinflation. Japan has shown us that it can survive deflation without descending into depression, it is still producing a balance of trade surplus in spite of all the things we say in the western press. Yes, housing prices fell to less than 50% from their peak, wage increases became minimal, housing prices are now increasing but very sedately.
Politically deflation might be intolerable, as the population at large will become very dissatisfied when they don’t see their lot improving, and there is a history of governments being thrown out in these circumstances. Sometimes quite violently!

However the spectre of Hyperinflation is a far worse alternative. The pictures of German housewives burning currency notes in their fire places as the cost of buying coal was greater than the value of the notes, or taking a wheelbarrow load of currency to go and buy a loaf of bread, are too frightening to contemplate.

The German experiment post World War 1 started in 1919, they printed money to keep quantity of money in line with the level of economic activity, up until about 1921 it looked as though the experiment was working, their inflation rate was lower than those of other major economies but then things turned.

This is where “quantitative easing” will lead.
We have started with the £75 billion and will possibly increase that to £150 billion over the next three months.
Is that an all time stop?
or will it be increased again and again, as it will have little effect or no effect.

To be rational, if this is a viable choice, why do we have taxes?

Surely the government could do some “quantitative easing” … or so the Germans thought.


Most of us think we know what inflation is.
After all, the government publishes figures every month so show the rate at which prices are rising. Our instincts will often be telling us that these figures are not true, as we feel a different effect in our wallets when we do our regular shopping. What we need to understand is that statistics seldom tell the truth … as the saying goes “there are lies, lies and then there are damned statistics”. Statistics can be designed to tell almost any story you want, I always take a statistical argument with a pinch of salt.

If inflation is not that number they publish every month, then what is it?

By definition inflation is the rate at which our money is depreciating.

Why does money depreciate?

Usually because we are fairly creative about finding ways to print it!
A Government deficit is the most common way of printing money, quantitative easing is a more blatant way. The subtle way it has been done in the UK, has been for our Banks to be taking deposits from foreigners and then lending out a portion of that money in the local market. In simple terms we have been printing money out of money we need to repay!
As we are operating with a trade deficit repayment becomes difficult.

About 30 years ago I started creating economic models that did not follow the conventional lines. I was interested in predicting both inflation and exchange rates.

The key was in what I called a countries cost equation

Cost = Imports + NonGovtWages + Interest + Rent + Profit + GovtExp
(The figures for Imports, Interest, Rent and Profits relate to the business sector)

To compare with previous years I used a productivity factor.

Productivity = NonGovtWages / NonGovtEmployment.

When comparing Cost divided by Productivity with the previous year we get a fairly reliable figure for the true inflation that has taken place in the economy.

We are also able to take the budget figures and make a few assumptions on the other numbers to get a good idea of what lies ahead.

This inflation may not appear in the consumer price index but it will manifest itself in the economy be it in property price increases, stock exchange increases or devaluation of the currency. The currency devaluation, as distinct from the inflation factor would depend on the extent to which the imbalances related to the foreign trade account.

In South Africa, where I knew my way around the national accounts and could readily pick up the figures I was looking for, this proved a reliable predictor.
In the UK, I am not confident of my extrapolations from the blue and pink books but my figures suggest that during 2005/2008 period we have been running an inflation rate in the region of 6/7% suggesting that over this period, the real economy by which I mean non government, was actually in recession.
The imbalance in our external trade account has been growing since 2004 and suggests that the £ should devalue to somewhere between £=$1.25/1.35. At the moment it is still propped up by foreign deposits in our banking system.

Markets are a funny thing, and usually over react one way or another, I anticipate therefore that, when the run on the £ begins it will go through the $ parity mark before coming back to settle at its natural level.
The quantitative easing, which at this stage has no limit, makes these figures look optimistic.

The government is determined that we do not go through the pain of a correction … so called deflation.

This means the odds are now 60/40 that we are on course for;

Inflation … stagflation … hyperinflation!

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