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Deflation or inflation – what will happen in the UK?

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I’ve written in a previous article about the various concepts involved in economic inflation and how it can affect the value of your money, your wages and the things you buy.

The opposite of inflation is deflation, which I’ll explain in this article before going on to discuss the probable and possible situations in the UK for the next few years. The ‘deflation versus inflation’ argument is more important in the UK today than it has been at any time in the last 30 years, so it’s worth thinking about in some depth.

So, deflation. If inflation is a general increase in prices and/or wages driven by the greater availability of money (whether ‘real’ money or debt), then deflation is a general decrease in prices and/or wages driven by the much reduced availability of money. This is widely considered to be a bad thing.

But isn’t a reduction in prices a good thing? At a simple level, yes it is. Your wages – assuming they aren’t cut at the same rate – go further, your savings buy more over time and there’s less of a ‘treadmill’ effect where people feel that they are working ever harder to chase money to buy the same purchases, as happens in inflationary environments.

But politicians and economists fear deflation for a good reason. Fundamentally it stops the economy dead in its tracks. Nobody will buy something today that they don’t really need if they know it’s going to be cheaper tomorrow. This applies to companies as much as to individuals, which means that investment stops, companies cut back their staffing levels and unemployment rises. We end up with a deflationary spiral that’s every bit as traumatic as a highly inflationary one.

Deflation also makes it harder to pay off the principle amount of any debts, because wages tend to go down in nominal terms but the amount owed remains the same. This, incidentally, is why some newspaper pundits are now calling for deliberate inflation in order to wipe out the value of many people’s (and the nation’s) ill-advised debts, though such pundits are ignoring several important points about the banking industry’s methods of counteracting inflation through charges and wider interest rate spreads.

  1. Rob Lewis says:

    Alex,

    Once again a brilliant piece of writing – makes a tricky subject easy to understand.

    It’s a shame you couldn’t come up with an answer to the inflation / deflation problem though ;>)

    Do you think the Government will start giving out more cash in some way? Is that what the US Government are trying to do with their stimulus cheques?

    Also, where do you think the Government will stop after bailing out the Banks and possibly now the car industry – how far can they go? Maybe an idea for a future post.

  2. Inflation & Deflation Explained / Money Watch says:

    If you’re interested in learning about the economic concepts of inflation and deflation then I recommend you read the following two articles at Economonkey:

    Deflation or inflation – what will happen in the UK?
    Inflation – blowing your money away
    These articles discuss how inflation is measured and how it has affected the UK economy in the past few years, and how deflation might soon begin to affect us.

    If inflation is a general increase in prices and/or wages driven by the greater availability of money (whether ‘real’ money or debt), then deflation is a general decrease in prices and/or wages driven by the much reduced availability of money. This is widely considered to be a bad thing.

    The threat of deflation is particularly scary, as it prevents investment and spending (subsequently people lose their jobs), and those in debt generally find it harder to pay it off.

    So what can be done? There are some suggestions that the Bank of England will start printing more money to distribute, which in effect causes inflation, but I’m not sure how this would be given out. I guess this could be in a similar way to the US Economic Stimulus Act, in which the US government gave tax rebates to lower income families to help prop up the economy.

  3. Thanks Rob. Yes, I do think there will be handouts to various groups under all sorts of auspices. Probably it’s already started. But much of that money will find its way back to the banks in debt paydown (and perhaps that’s the intention). As to where the government will stop… they’ve already gone further than I expected to prop up the Ponzi property market, so I hesitate to guess. Rationally I’m hoping they’ll get the balance right. Emotionally my mind is screaming “Zimbabwe!”

  4. JKA on Economics UK says:

    Hi Alex,
    Great piece.
    Deflation can refer to a fall in the general price level or a contraction of credit and available money. There is no doubt the UK faces a severe deleverage and contraction in credit. A deflationary tsunami is hitting the economy with a big impact on activity and employment.
    Price levels, the latest manufacturing price data demonstrates the obstinacy of price given the weakness of sterling and the strength of food and non speculative commodities. RPI headline will provoke drama in 2009 but the underlying CPI levels will show greater resistance.
    JKA

  5. Thanks JKA – I’ve just been perusing your site and am impressed with the level of detail you go into.

    I’ve been debating this topic on another site and I’m crystallising my opinion: I think we’ll have deflation for months, a year or perhaps more, after which the central banks’ attempts to reinflate will succeed… and exceed, leading to high inflation (though I don’t yet know where). Pendulum swings back the other way again.

    But really this is still only a guess. So much depends on the (in)competence and mendacity of politically-motivated bankers.

  6. harry porter says:

    It is nice explanaion. I think the best measure to do is buy a house. prices are down, and may go down more. but it is safer than gov bond, open shares, gold or banks. i may lose a bit if the prices drop more but my advice is chose a good house( location/ potentials). prices will come down sure ..yes .. however we need couple months to find and buy bthe correct house by the time when gov will turn the deflation to hyperinflation. because pound doe not worth more than 60% of what it was, so the cost of building will be soon 40% extra. even if house prices drop 30% over 2 years, this will be 40-50% increase in 3-5 years max. exact dates imposible to predict by anyone, so do not search for it just hide your money in a brick and do not trust share losers,gov. losers, banks or a matress under your wife…!
    good luck

  7. gerald harris says:

    An elegant and easily understood expalnation of theses two phenomena. At least I will now have some idea why I’ll be struggling to stay afloat

  8. Harry porter, while it’s possible that the housing bubble will be reinflated, all the evidence to date indicates to me that the next bout of inflation, if it occurs, will be somewhere else entirely.

  9. Striving to be like Zimbawe..oh Lord help us!!!