When inflation could be good for you

  • 7 January 2012
  • From the section Scotland
Image copyright PA
Image caption Could a little inflation be good for the economy?

It's a theory that works in medicine - use some of the disease to protect against much more of the disease.

So could an inflationary inoculation work in economics, providing strong medicine for a serious economic ailment?

With our economics strongly influenced by the experiences of the 1970s, the answer tends to be 'no'. Inflation feeds on itself, workers chase higher wages to keep up with prices, costs spiral, companies lose the confidence to invest, and anyone on a fixed income - notably, pensioners - are the ones who suffer most.

But where workers are too dispirited and fearful about their job security to use their muscle to push for higher wages - indeed, when their attention is focussed on erosion to their pensions, as it currently is - inflation is much less dangerous.

And it's being suggested as one answer to the economic malaise by, among others, Professor Brian Ashcroft, emeritus professor of economics at Strathclyde University, and a contributor to this weekend's Business Scotland radio discussion on the year ahead for the economy.

Saving or hoarding?

The idea goes like this... the Bank of England could be told that it should target an inflation rate of, say, 4% instead of the 2% it has followed since Gordon Brown offloaded monetary policy to the central bank in 1997.

While interest rates remain at a historic low, with the base rate still at 0.5% and expected to stay there for a while yet, that means a negative real interest rate.

To put it simply, the interest you get on holding money in a savings account is not enough to stop the value of your savings eroding.

If inflation is officially encouraged to go a bit higher, real interest rates would fall, and people's expectations of falling value of their savings could encourage them not to save but to get consuming again.

Unorthodox monetary policy has already seen quantitative easing pumping newly-created money into the economy. Its effect is unclear, but perhaps it is best measured by a guess at what would have happened without it.

The best analogy is that it has shored up foundations, by pumping money onto bank and corporates' balance sheets.

So the idea is to use another unorthodox lever of monetary policy, and penalise people and companies for hoarding money, when it's needed to boost demand.

To be honest, it's not like medical inoculation. It's accepting more of one bad thing in the hope that it avoids a much worse, long term alternative.

Lost decade

Anyone with savings is already painfully familiar with negative real interest rates. The Bank of England may still have a 2% inflation rate target, but it has failed to keep anywhere close to it for many months.

There's not a savings product on the mainstream market that matches the current rate of inflation.

That's perhaps because the Bank of England has implicitly shifted its target to limiting damage to the rest of the economy, in jobs and growth. Or perhaps it is implicitly already doing what Prof Ashcroft suggests, though without the longer-term expectations built in, to persuade people that negative real interest rates are here to stay.

Such a policy has to be implicit because any change to the target inflation rate from 2% - widely perceived as a safe and stable rate which allows for steady expectations and evens out the effect of growth, when we have it - would be a tough political sell for a Chancellor, and particularly a Tory one.

But inflation now looks like it's on a downward trajectory, and could even undershoot the 2% target before long. That's where real interest rates become positive again.

There are plenty possible objections to this. Inflation, as most workers are currently finding out, erodes spending power if wages aren't increasing to match it. The bigger the gap between wage growth and inflation, the more wages are eroded.

The counter-argument: those workers are becoming more internationally competitive.

Then, why-oh-why would we want to penalise thrift and savings, to encourage consumer demand, when excessive consumerism is precisely what got us into this mess?

The answer is that - to misuse a political slogan from 2010 - we're all in this together. Responsible behaviour may have to be penalised so that savers, alongside everyone else, can get out of the current economic predicament.

The alternative to stimulating demand like this, suggest those behind the idea, is the Japanese scenario of a 'lost decade' - or perhaps two lost decades, as the economy risks see-sawing between deflation and stagnation. And that's in no-one's interests.

Business Scotland is on BBC Radio Scotland at 10.05 on Sunday 8 January, and after then on BBC iPlayer and by free download.