If you read online newspapers you’re more than likely to be clued up on economics, especially
when it impacts on your lifestyle but, just in case, I’d better clarify: Inflation means a sustained
increase in the price of goods and services, which leads to a fall in the value of money, so
borrowing appears to be cheap as the debt erodes over time. Deflation means a general decline in
the price of goods and services, usually the result of a reduction in the supply of money or credit,
often caused by a decrease in government, personal or investment spending, and borrowing
becomes more expensive as the debt grows over time.
Have you noticed that much of Europe is already starting to experience deflation? Look at the chart
above and you will see that the economies of Bulgaria, Greece, Spain and Poland are all deflating.
With zero inflation Estonia, Cyprus, Slovakia are also tottering on the rim of the deflationary vortex.
I use the word vortex deliberately because, as Japan has discovered in recent years, a deflating
economy is a horribly sticky state be in and, once in, it’s incredibly difficult to wriggle out of. On the
chart you can see that Hungary, Belgium, Portugal, Slovenia, Denmark, Ireland and Luxembourg are
also all hovering around the edge of the deflation vortex, as is the whole Euro area. This is an
extraordinary and unprecedented global situation. In the last six decades my generation has only
ever known economies that were inflating. As the last time deflation occurred was back in the
Great Depression in the early 1930s, there are only a few people alive today who have any first-
hand knowledge of what deflation really means. Younger generations have only been aware of
continual inflation although it has varied by degrees over the years. So, while most members of
society will remember prices always going up gradually, only the very elderly will recall steep price
rises that went into double figures for a time until draconian measures were taken on both sides of
The great reversal from inflation to deflation is astonishing because much of modern economic life
is predicated on the model that virtually everything that money can buy will be more expensive in
the future. It has been the driving force behind the bulk of consumer spending, as well, of course,
as the overwhelming amount of advertising shouting about the availability of apparently cheap
credit. This has led inexorably to people, particularly the young and gullible, to take on ever
increasing amounts of debt, albeit at obscured but punitive interest rates. The maxim has been:
buy what you want now and pay later (it will cost more in the future) and, as even inflation as low
as 2% gradually erodes the debt, as time passes, the amount owed seems to appear more
reasonable. But now the wheel has turned full circle and the opposite is starting to come true.
Debt will become far more expensive, not necessarily because of any threatened interest rate rise,
(that day keeps being pushed further away), but because of deflation.
There were multiple causes behind what became known as the Great Depression throughout the
early 1930s, although many in today's media seem to think the primary cause was simply the U.S.
stock market crash in October 1929. It wasn't, although it was a contributing factor. The origins of
the Great Depression lie in economic changes that happened during the First World War and
throughout the “roaring” 1920s and economists and historians still debate the complexity
surrounding the events that led up to it. One of the key reasons for the Great Depression was a
period of extreme income inequality, where the mass of people got poorer and the rich became
considerably richer. Sounds awfully familiar, doesn't it? The cruel fact is that the 1920s had only
been “roaring” if you were one of the privileged elite, because for the great majority it was a time of
shrinking incomes and an inferior quality of life which continued into the 1930s. There was also a
significant over-production of goods which the majority of people could never afford to buy on
their squeezed incomes. Does that also sound familiar? Whatever one’s political point of view,
income inequality and excess production were two major factors in the Western world during 1920
-1935 and they led inevitably to the Great Depression. And now? These twin factors, which usually
go hand in hand, were gaining momentum from the early 1970s and were then catapulted into the
Century by the financial crash of 2008.
Today one doesn’t have to look far for evidence of the shrinking of incomes for the majority of
people in the U.K. - it is everywhere. For the first time in living memory food sales have fallen and
once impregnable supermarkets are battling to stay profitable. In previous smaller recessionary
periods food retailing always managed to remain profitable – people always have to eat. But in
2014, the population of the U.K. is greater than it has ever been, yet demand for food has
decreased. When people have their financial backs to the wall they are forced to face the reality of
simply not being able to afford to pay the prices expected for many food items. They then have to
focus on simply getting the basic necessities to survive. This is why the demand for cheap
foodstuffs has radically increased at discount stores while declining nearly everywhere else. And
why even the comparably prosperous middle classes can be seen scrabbling for late-date reduced
items in supermarkets near closing time.
As for evidence of over-production, you only need to watch commercial television channels for a
short time. You may already have seen that car manufacturers are running advertisements
featuring zero interest car purchase spread over several years. But someone somewhere has to
pay that interest and, in this case, the buck stops with the car manufacturers. Obviously they are
only forced to do this when they have a glut of cars available which their dealers cannot shift. Talk
to a U.K dairy farmer and he will tell you about a global glut of milk production that has forced his
farm prices to drop by 20%. Around 14,000 dairy farmers in the U.K. produce 3.3 million litres of
milk a day at a production cost of just over 30 pence for each litre. Their problem is that they are
only paid 28 pence per litre by their main purchasers, the supermarkets, where most people get
their milk these days. This is because those supermarkets can buy milk from anywhere in the
European Union and, as production is now a global business, the price has been driven down.
Yet another indicator of trouble looming is the excessive number of advertisements on television.
December is always a seasonal sales peak: for example, Amazon gets three quarters of its annual
revenue in the three month run-up to Xmas. Yet high levels of advertising have held up throughout
this year and UK commercial TV ad revenues are expected to show a year on year growth of 6% in
2014 when the figures get reported next February. As one would expect, profit levels have also
been maintained at most advertising agencies. All of this is natural at a time of over-production of
goods and services. A primary but not exclusive reason for advertising has always been to
stimulate demand in order to sell excess production. One of my own favourite sense checks to
determine over or under production and the general level of world trade is the Baltic Dry Index. It
takes a few years to build more shipping so that when world trade is buoyant because demand is
high, shipping rates climb very steeply. Conversely when trade is scarce and demand low, shipping
rates fall. The Baltic Dry Index is the shipping rate in US $ set daily at the Baltic Exchange in
London for 23 different global shipping lanes. At the moment the BDI rate is not far above recent
historic lows having fallen over 60 per cent this last year. Shipping rates show that global trade is
very depressed with many boats “awaiting orders.” Just bare these facts in mind next time you
hear a politician attempt to reassure you that the economy is growing.
So what does all this mean? As so often in the past, Japan is way ahead of Europe: Think of
robotics, high speed trains, care of the elderly and, perchance, how not to handle nuclear
disasters… Perhaps it’s par for the course then that in the 1990s Japan, even with its history of
personal financial prudence, experienced a property bubble followed by a bust and severe
deflation. Although it’s not as serious as what happened in the U.S. in the 1930s, the situation in
Japan in the 1990s shows remarkable similarities. In the 1930s the U.S. had a property boom
before experiencing a very sharp deflation which caused general prices to fall up to 27.9%, followed
by the collapse of house and land values. There was a run on the banks which responded by
curtailing lending with the effect that the U.S. GNP dropped 23.3%. And in both the U.S. and Japan,
deflation was a private disaster for the helpless masses while people with no debt and a reasonable
income became significantly more prosperous because of lower prices. And, of course, the
seriously rich became mega rich.
So what is happening in Europe now? And are there any lessons to be learned from the experience
of the U.S. and Japan? Look at the chart above and you can see that nearly half of the EU countries
are already in, or on the edge of, a deflationary catastrophe. Despite the obvious gravity of this
situation, the internal debate about economic policy in the E.U. is tragically polarised into two
opposite creeds, which are virtually tantamount to religions. And both creeds are championed by
two messianic historical figures. On one side there are those who would introduce strict austerity
and tight government spending based on the economic views of Friedrich Hayek. They say let the
free market rip unrestrained by government intervention. And on the other side are the followers
of John Maynard Keynes who, faced with such a slump, would have given impetus to the economy
by increasing government spending in useful areas like infrastructure as “the spender of last
resort”. The polarised views of these gods of economics and their followers were promoted and
debated endlessly throughout the 1930s.
It’s ironic that in 2014 the tenets of that debate have changed very little as the evil twins of income
inequality and over-production continue creating economic devastation, anguish and poverty. The
intense intellectual argument between Hayek and Keynes was accompanied by a mutual scholarly
respect. In fact in 1944 Keynes proposed that Hayek be elected to the British Academy. The ideas,
and not the man, were the cause of disagreement. This civilized attitude contrasts markedly with
the fixed positions taken on either side of the economic argument in Europe today, where
conflicting personalities are involved and there is no sign of any agreement about future European
economic strategy. The passions being aroused, and the immovable views being espoused,
threaten to tear the European Union apart. Meanwhile, in the absence of any European guidance,
and wavering political factions in each country, frightening levels of income inequality and over-
production can only increase, spreading the sticky glue of deflation ever wider.
The European Union did try to bring its members to attention: In July 2009 it published a report
entitled Economic Crisis in Europe: Causes, Consequences and Response. Part of that report
discussed the lessons supposedly learnt from the 1930s Great Depression. The first lesson, the EU
economists opined, was to avoid financial meltdown, and the second lesson, was to: “maintain
aggregate demand – avoid deflation.” It would seem these two instructions are incompatible. After
the debacle of 2008 the recalcitrant banks were bailed out to avoid financial meltdown, but the cost
to us all has been lower aggregate demand and hence over-production with the deflation that
history shows automatically follows. So the rich will continue to get richer and the wretched poor
will continue to get even poorer. And where will that lead?
...with analysis & insight...
The Great Reversal...