Every era has its own demons. In the 1930s the great demon of the time was inflation. It ravaged people’s savings, and devalued their salaries. Hyperinflation was rampant in 1930s Germany, and was one of the main reasons for the Second World War.
Again, in the 1970s and 1980s inflation was endemic in much of the world. Finally beating inflation was perhaps Margaret Thatcher’s greatest achievement.
Inflation was the biggest economic threat of the past
It was seen as the biggest economic threat of the time. That is why we now have inflation targets, why so much emphasis in placed on the setting of interest rates, and why we have the Monetary Policy Committee.
So, what causes inflation? It is basically a mismatch between supply and demand. If there is insufficient supply and too much demand, inflation takes off. That’s why, in the relatively unindustrialised world of the past, inflation was so prevalent.
High inflation causes salaries to spiral, and, if this is not controlled, you get hyperinflation. To control this, central banks raise interest rates so that money is expensive to borrow, and this curbs the spending of companies and consumers. This is commonly known as monetarism.
So why has inflation fallen so much in recent years? The answer is quite simple: China. The world is now more educated and skilled, and more industrialised, which means its capacity for producing more goods and services is far greater. Suddenly the balance has tipped from too much demand to too much supply.
That is why inflation is now virtually zero. Staple goods such as clothes, food, TVs and computers are very cheap and the supply is almost limitless. Competition between retailers, and particularly the supermarkets, is fierce. So of course inflation is falling.
But, I hear you say, this is only a temporary phenomenon. Eventually, as the UK economy continues to strengthen, inflation will start to rise?
But now we need to worry about deflation
I disagree. The world now has too much production capacity. And this capacity is still increasing. After all, China is now industrialised, but what about India? This nation is still mostly based on farming. Soon, it will transition to a more industrial and service-based economy. And the world’s production capacity will expand by another billion workers.
It’s obvious, isn’t it? The days of high inflation are long past. This will be a century of permanently low inflation. Which means that interest and mortgage rates will also always remain low. Instead central banks will need to continually reflate their countries’ economies. Quantitative easing could be in place for decades to come.
Interest rate setting will soon be a thing of the past. Though that does not mean we should not have bodies such as the MPC. But their role will evolve. Instead of discussing how to control inflation, they will work on how to prevent deflation.
No-one is bothered about interest rates any more. Inflation is the battle of the past. Deflation, and the effect it can have on debt, is a new demon. You see, the world is changing, and always will. We just have to keep our eyes on the road, and not on the traffic behind us.