The debt problems which the UK and Europe currently face are essentially ones of political economy. Basically, there is a lot of debt around and the simple question is: who is going to pay for it? All the economic theory in the world does not get around this fundamental issue.
Traditionally, bondholders paid. The real value of their debt was eroded by inflation. In 1945, for example, the UK’s public sector debt to GDP ratio stood at a massive 250 per cent. But slow but steady inflation ensured that by 1970 this had fallen to 67 per cent, lower than it is today. This was before the inflationary surge of the 1970s, but the 3 to 4 per cent inflation which was experienced each year doubled the price level in 20 years. So this on its own halved the real value of the debt.
The case of Japan is instructive. In the crash of the late 1980s, the Nikkei share index fell 80 per cent – imagine the FTSE at just 1400! – and land values dropped a stunning 90 per cent. The country was awash with debt, accumulated to buy these assets at their peak prices.
Japan has followed an expansionary monetary policy, with interest rates close to zero almost ever since. They have carried out quantitative easing on a huge scale, ever since three big banks collapsed in the late 1990s. Yet since 1990, inflation in Japan has been barely positive, averaging just 0.3 per cent a year. They needed 3 per cent and got just a tenth of it.
The evidence suggests very strongly that in general inflation is not purely a monetary phenomenon. We can identify special historical cases where it has been, such as civil wars and during sieges. But in developed economies, very lax monetary policy can go hand in hand with low inflation.
Inflation in the UK and the West in general fell in the early 1990s and had remained low ever since, despite unemployment falling more or less continuously for over a decade prior to the crash in 2008.
Low inflation is not due to the brilliance of politicians or central bankers – after Gordon Brown and Mervyn King, who could believe this anyway? It exists for purely structural reasons. Globalisation has led to a flow of cheaper goods from emerging markets. It has restricted the ability of the labour force in industries which compete with this to enforce wage increases. This in turn enables companies to raise the profit share and hold real wages down.
In short, we are in a regime of low inflation which no amount of monetary expansion will overturn. We must look elsewhere for the answer to the question: who pays for the debt?
by Paul Ormerod, published in CityAM on Thursday 26th July 2012