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Supply-side growth, not inflation, is the cure to the debt overhang problem

In the year to March 2014, consumer prices in Sweden fell by 0.4 per cent. This has prompted the central bank, the Riksbank, to abandon the normally cautious language used by such institutions. Over the same period, inflation was negative in a further seven European countries, such as Greece, Portugal and Spain. In eight other countries, inflation was still positive but very low, running at an annual rate of less than 0.5 per cent.

The Riksbank argues that these very low, often negative, rates of inflation are caused by a ‘very dramatic tightening’ of monetary policy. There is a definite risk of a slide into a prolonged depression similar to that of the 1930s.

Surely low inflation is a good thing? Well, up to a point, Lord Copper. The current batch of policy makers, scarred by the double digit inflation rates of their formative years in the 1970s and early 1980s, have been obsessed with controlling inflation for at least the past twenty years. They seem to have succeeded. The highest rate of inflation in Europe is currently that of the UK, at a mere 1.6 per cent a year. Thirty years ago, it was well in excess of 20 per cent a year.

The problem with low inflation is that debts, both public and private, retain their real value. A classic way in the past to cure a large debt overhang was to allow inflation to erode its value. Immediately after the Second World War, for example, the British government appeared virtually bankrupt. Public sector debt was 250 per cent of GDP, compared to its current level of around 80 per cent, a figure which still gives cause for concern. But the debt was fixed in nominal terms. Anyone who bought a government bond for £100 and held it to maturity would get £100 back. Inflation ensured that £100 was not worth what it used to be.

Under the long period of Conservative rule from 1951-64, inflation was low, with an annual average of 3.3 per cent. Even this was sufficient for prices to rise nearly 60 per cent. £100 in 1951 was only worth £64 in 1964. Inflation plus strong real economic growth, which expanded GDP considerably, wiped out the problem of public debt.

The real question is whether policy makers can do anything to increase inflation. The fact is that they did not collectively, across the developed world, suddenly become geniuses over the past two decades and learn the secret of inflation control. Inflation fell everywhere, despite, until the crash at least, steadily falling unemployment. The single most important reason for this was the integration of India and China into the world economy, and the huge increase in competitive pressure which this brought. This has not gone away.

We seem to be stuck with very low inflation for a considerable period. Instead of trying to put prices up, policy makers should encourage growth. Not by irresponsible increases in public spending, but by tax cuts and encouraging the entrepreneurial culture.

Paul Ormerod
As published in City AM on Wednesday 23rd April

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