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Cooking the Books: Fighting Against Falling Prices

‘Draghi holds QE in reserve as he wheels out the big guns for the fight against deflation’ read the headline in the Times (6 June) reporting an announcement by the president of the European Central Bank of a package of measures aimed at increasing inflation in the Eurozone.

Deflation is the opposite of inflation whatever the definition of the latter. These days ‘inflation’ means rising prices, so deflation means falling prices. So what’s wrong with that? Aren’t supermarkets, furniture stores and the like always boasting about how they have cut, slashed or even massacred prices? If things cost less to buy shouldn’t that mean that we are better off as we don’t have to spend so much on what we need? That the pound in our pocket has expanded not shrunk?

‘Inflation’ originally meant a rise in the general price level caused by issuing too much currency, i.e., by inflating the amount of it put into circulation. But a general rise in prices can be caused by another factor – the level of economic activity in a boom which leads to paying demand coming to rise faster than industry can supply it. In a slump the opposite tends to happen with supply coming to exceed demand, so driving prices down.

In between the two world wars falls in the general price level, some quite severe, were not uncommon. Not that this made people better off, at least not for long as wages too are a price and, despite rearguard trade union action, fell along with prices generally. In that period inflation, as increasing the amount of money in circulation, was seen by some as a way-out of a slump in the belief that rising prices would encourage capitalist firms to invest. Keynes, without putting it so crudely, lent some support to this by arguing that what was important were the government’s tax and borrowing policies while the amount of currency put into circulation (by then not linked to gold but ‘managed’ by the central bank) could be left to follow suit.

The first Keynesian budget in Britain was in 1940 and it is no coincidence that ever since the general price level has risen steadily. It continued to rise even during a severe economic downturn in the mid-70s when, between the wars, this would have resulted in a fall. In fact a new phenomenon emerged – a rising price level during a slump – which was dubbed ‘stagflation’. What had happened was that the upward pressure on the price level exerted by the government inflating the currency had countered the downward pressure that occurs during a slump.

This discredited Keynesianism and governments tried to reduce inflation by reducing the money supply. The rise in the genera price level was eventually steadied at about 2 percent a year, which is now the level at which it is government policy in all developed capitalist countries to aim to maintain it. But the present slump has been so severe that central banks and governments are afraid that this time the downward pressures might overcome the upward pressures, resulting in a fall in the general price level, or deflation.

In April the rise in the price level in the Eurozone fell to a mere 0.5 percent from 0.7 percent the previous month. That’s not yet deflation but Draghi said that the ECB’s measures were a reaction ‘to the risks of a too prolonged period of low inflation’. We always used to be told that inflation was a bad thing but now they are telling us that it’s too low inflation that’s bad and that falling prices are even worse. It seems they want the pound in our pocket to shrink.