The common belief is that inflation has been permanently tamed but a number of economic factors indicate that its return is more than likely, reports Anthony Hilton.

The reason why the British savings industry is in such a mess, and the once trusted insurance companies are now subject to regular bouts of ridicule and abuse from politicians and the public, is that a decade ago it failed to see that inflation would be tamed.

Some industry players, most notably Equitable Life, sold policies with guaranteed rates of payout and has been put out of business as a result. Others have survived but have still paid hundreds of millions of pounds in compensation for failing to deliver promised returns.

The industry is in ruins yet the people who managed it in those still quite recent times were neither feckless nor irresponsible. They simply failed to anticipate how radically the economic climate could change. No-one predicted that inflation, which had been the one business certainty for a generation, would disappear in just a few years, thereby making toxic all marketing and investment strategies that assumed it would continue.

Popular belief

Now the pendulum has swung the other way. Not just in Britain, but across Asia, the US and above all in the eurozone, governments, bankers and investors all believe inflation has been tamed permanently. Looking at the Japanese experience since the bursting of its asset price bubble in 1989, they see deflation as the greater threat to global stability. Time and again economists, who should know better, say there are no circumstances under which inflation might return because central bankers now understand so much better how the economy works, and would therefore set policies that would kill the demon before it woke again.

There are so many flaws in this premise that it is hard to know where to begin – history is a good place. People have forgotten that what started the great inflation of the 1970s was the overnight quadrupling of the price of oil in 1973. This delivered a massive shock to the Western economies and resulted in a huge transfer of wealth to the Opec producers. When their petro dollars were recycled back into the global economy through the international banking system, it created a surge of liquidity that hit a world that was already awash with dollars printed to pay for the Vietnam war. This ignited global inflation and, although it was initially the dollar’s problem, every currency was contaminated.

Ignoring the facts

Economists who say central bankers would cope better now are ignoring the fact that a shock on that scale overwhelms all known defences. And they ignore, too, the current massive twin deficits of trade and government finances in the US, which are once again carpeting the world with devalued dollars. Equally, they ignore that the setting of interest rates at 1% by the US Federal Reserve is a huge inflationary engine that is already fuelling asset price bubbles in the housing, commodity and stock markets of most of the world’s leading industrial nations.

People have a touching belief in the accuracy of statistics, in spite of the fact that the consumer price indices in all nations correlate scarcely at all with what people spend.

Writing recently in Barron’s, the US financial weekly, Alan Abelson made this point: “When I got home I opened my gas bill and was astonished to find it had doubled in the past six months. On Sunday I bought some timber... and the salesman told me the price is up more than 40% in a year. My new automobile policy came in adorned by a 30% increase in premiums. When I queried my plumber’s bill, he replied that copper prices have doubled in the past year...”

And so it goes on and on. But the official statistics in every nation will tell you in every one of the world’s languages that prices are not rising.

Deceptive indices

Nowhere is this more evident than in the eurozone. The inflation index for all the countries in the single currency union reflects the conditions in none of them. It may appear relatively benign, but throughout the life of the currency, inflation rates have diverged widely, with countries on the edge, such as Ireland and Spain, having periods of much greater rates than countries in the centre, most notably Germany.

The fact that the Irish and even the Spanish economies make up only a small part of total GDP in Europe has made it possible for these difficulties to be ignored. But the warning is clear enough: inflationary pressures exist and in the countries just mentioned were significantly enhanced by the injection of development funds from Brussels.

Two things flow from this. First, this year is notable for the accession of 10 new nations to the EU, most of which have incomes lower than the EU average and which therefore can be expected to receive a massive economic stimulus in various forms from membership.

It is hoped that much of this will fuel lasting economic growth but some of it, inevitably because it will arrive so fast, will also fuel inflation. The point, though, is that while the primary effects from enlargement will be felt by the nations doing the joining, the inflationary effects will be felt reciprocally by old and new members alike.

Inflationary pressures

The additional demand from the new members will bring a significant inflationary pressure to the core eurozone economies – and just when increasing political pressure on the European Central Bank (ECB) may push the nominally independent institution into cutting rates to try to stimulate economic growth in France and Germany, the economies that set the tone for the bloc. The pressure on the ECB and its new head, Jean Claude Trichet, to be less remorseless in the focus on inflation and to consider much more the wider economic impact of interest rate policies must not be underestimated. It is one of the major drivers of change on the European scene.

Meanwhile, on the fiscal side, governments are still running big deficits and will continue to do so as long as overall economic growth disappoints. The potential exists, therefore, for an uncomfortable confluence of events: excess demand from the new nations, fiscal indiscipline from established countries grappling with high unemployment and low growth, and politically driven interest rate cuts and monetary loosening from the ECB. Any two of these factors could tip the scales towards inflation – the arrival of all three at the same time makes it a distinct possibility. It could happen without the need for a major recovery in the core economies, and it could arrive when governments that are facing elections will be unwilling to combat the threat with tax rises, whatever it may say in the small print of the Stability and Growth Pact.

Easy answer

All this is for the near term. However, there is one bigger, though more cynical reason, to believe that one day inflation will return. A lot of governments’ problems would be solved by a bit of inflation. Across Europe, governments labour under a mountain of debt and are reaching the limits of their borrowing capacity.

In the private sector, a potential time-bomb exists in the promises made for pensions to those who will soon retire. In almost every country of the Western world, the driver of economic growth is the willingness of the consumer to take on an ever-increasing burden of debt with which to pay for current consumption.

None of this is sustainable. All these factors are storing up huge problems for the future, and sooner or later there will have to be adjustment. The question is how painful that should be. Faced with the choice of a decade of austerity and belt tightening or the much less noticeable adjustment that can be achieved by inflation, society will almost certainly choose inflation. It is the seductively easy answer to so much. That is why one day it will return.

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