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Low or zero inflation is normal: competition keeps it that way

Posted by on September 23, 2014 in Economic Policy, Economic Theory, Euro-zone, GDP, Politics | 0 comments

Fears of deflation are rising across Europe.  Inflation keeps edging down to lower and lower rates.  Eurostat estimates the rate of inflation in the Euro zone in the year to August to be only 0.4 per cent, compared to 1.3 per cent in the year to August 2013.  Negative rates were observed in seven EU countries.  Remarkably, the rate of just 1.5 per cent in Austria and the UK is the highest in Europe.

The current inflation situation is perceived as being in some way abnormal.  Such a way of thinking is understandable for policy makers whose formative years were the 1970s and early 1980s, when inflation was in double digits in many countries.  But a longer historical perspective shows that inflation rates close to zero can persist for many years.  We have been here before.

During the late 19th and most of the 20th century, the leading world economies were America, the UK and Germany.  The general historical experiences and economic policies these three countries have followed over this period have been very diverse.  Not least, America remained physically untouched by war, and Germany was laid waste in the mid-1940s.  These two economies were devastated by the Great Depression of the 1930s, with unemployment rising above 20 per cent, whilst the UK escaped relatively unscathed in comparison.  Germany had fascism, Britain and the US had democracy.  The differences are huge.

But a striking feature is that their experiences of inflation have been very similar over the past 150 years.  The one exception was the very brief period in the early 1920s when political turmoil led German inflation into stratospheric rates of millions of per cent.  Those few years aside, the average rate in the US since the late 19th century has been 2.0 per cent, 2.9 per cent in Germany, and 3.0 per cent in the UK.  And a relatively small number of years push the averages up.  Inflation was high in the Second World War and after the quadrupling of the oil price in the early 1970s.  Apart from that, the typical rate of inflation is just above zero.

The one common feature across the three economies and across time is that markets have been allowed to function, and companies have had to operate in a competitive environment. Competition in the labour market restrains wages, and competition in goods and services markets makes it difficult to enforce price increases.  Of course, markets differ in practice from the competitive ideal of economic theory, but competition is the unifying theme.

The implication is that it is extremely difficult for the authorities to stimulate inflation.  This would be an effective way of eroding the value of debt.  It worked in the UK in the late 1940s and 1950s. Even modest rates of inflation, inherited from the Second World War and boosted by the Korean War, brought the public debt to GDP ratio of 250 per cent after the war back to sustainable levels.  But low or zero inflation is a perfectly normal state of affairs.

As published in City AM on Tuesday 23rd September

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