Over-indebtedness can be tough. Recession is grim. But deflation during a recession whilst people remain significantly over-indebted could be very grim indeed.
Imagine, for example, a scenario in which the price level is falling at 5% per year. In such a world, to retain their jobs most people would need to accept a nominal salary fall each year. If the economy is shrinking and profits were weak that might mean salaries falling at several percent, also - let's say 5%. If they have outstanding mortgages of 4 times their incomes with a fixed rate mortgage at +5%, then their mortgage payments will start at about 28% of their gross income or 44% of their post-tax income (if we assume income taxes constitute 35% of their income).
Now, if their incomes had been rising at 5% per year, their mortgages would have fallen, within three years, to about 38% of their post-tax incomes - so they would have 6% more income to spend on children, holidays, paying off debts, savings, whatever. In contrast, if their incomes fall at 5% per year in nominal terms but their debts remain unchanged, within three years the burden of their mortgages will have risen to 51% of post-tax income - 7% less to spend on other things.
The reality of such a situation would be large numbers of defaults on debts. And those that did not default would have to significantly curtail their other consumption and investment spending - each year by more and more. Massive over-gearing and deflation are a deadly combination.
So let's not go there, if we can help it. But can we? Inflation is currently 5% so deflation may seem unlikely, but that is an illusion. Even before recent events, the next figure gives what the Bank of England forecast as the future path of inflation in its August Inflation Report. Once inflation peaked, inflation was expected to drop like a stone - and that was assuming essentially zero growth over 2008-9 instead of quarter after quarter of intense recession (which is what will now happen); nothing like the fall in oil prices already witnessed and still to come (probably down to more like $50/barrel in the nearish future). Add to these the point that house prices are falling more rapidly than ever seen before in the UK and that the money supply (after adjusting for special factors) is now contracting significantly in real terms and for the private non-financial firms contracting even in nominal terms. Then chuck into the mix the problems in the finance sector and the consequent sustained squeeze on lending. I could add other factors, but you get the idea: inflation was already expected to fall down close to 1%, and we will now find it a considerable policy challenge to avoid inflation going negative.
If inflation goes materially negative, then even if the Bank of England should recover some control over interest rates (at the moment it has virtually none, as witnessed by the near-total unresponsiveness of interbank interest rates even to unexpected central bank interest rate movements) - even if the more normal relationships should re-assert themselves, the power of interest rate changes to slow the decline in prices and boost the economy will become very limited.
Let's distinguish between two kinds of scenario in which the ability to use interest rate cuts to manage the economy will be limited (there are others):
- If bank capital is seriously inadequate, then interest rate falls will not lead to additional lending (creation of more credit) because the dominant factor in determining lending will be banks' desire to rebuild their capital ratios to adequacy so as to avoid bankruptcy. This is the situation in which we have probably been since mid-2007.
- If nominal interest rates have reached zero, it is difficult to cut them further.
Scenario 2 can be a particular problem when there is deflation - because as prices fall further and further the real interest rate (the difference between interest rates and inflation) will be getting bigger and bigger, so the real cost of borrowing will become greater and greater and credit will tend to contract further.
No-one has ever devised a happy solution to this difficulty that was then tried in practice and worked. Plenty of us have devised schemes (here's mine), but no-one sane will be keen to have the opportunity to try them out.
Interest rates will be cut aggressively from here as part of the deflation-fighting strategy. They're unlikely to drop to 2% at one go. Apart from anything else, monetary policy isn't such a fine-bladed instrument that it makes that much difference, in a money-quantitative sense, whether rates are cut in one go or cut over four or five months. There would obviously be signalling power to a huge one-off cut, but it might just as easily be negative (inducing a sense of panic) as positive, and in any event doing the whole thing at one go would eliminate most of the scope for further signalling by rate changes. Finally, it's pretty likely that there will be further internationally-coordinated rate cuts. So my guess is that we will see the Bank in month after month of aggressive cuts over a period of perhaps six months, rather than one big heave. But either way rates are coming down.
Will that do it? It will do something - reducing the burden of debts for individuals with variable rate loans, perhaps giving the banks a bit of extra scope to make profits on existing loans. But the chances are that it won't be enough by itself. We are likely to need to try other methods to boost the money supply.
One of these will probably be the way that public expenditure is funded. Under reforms introduced in the 1990s by the Conservatives, the British government must cover all its expenditure through either taxation or borrowing. It is not allowed to print money to spend. We won't be changing this tomorrow, but those thinking about our plans for further ahead take note: this is another of those fiscal rules designed for another time that will be a burden to us shortly. We're going to need all the tools in the box, here, guys. Don't let past commitments - doubtless well-argued at the time - prevent us from taking the action necessary within what may soon be a completely different paradigm.