Bill Emmott - International Author & Adviser

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Been Good? Ask Santa to bring us inflation
The Times - December 20th 2010

It is the time of year when people are at their least price-sensitive. Grumble though they might at the cost of turkeys or of record prices for petrol and for heating oil, most will not really worry until the credit card bills arrive in January. Nevertheless, ever public-spirited, economists and monetary-policy-makers are doing the worrying for them, wringing their hands at Britain´s stubbornly high rate of inflation (3.3% in November) and concerned that the hike in VAT on January 1st to 20% is about to make it even higher. Stagflation has joined Slade´s Christmas song as one of the most unwanted reminders of the 1970s.

            So here´s a prediction. Of those two reminders, only Slade will still be with us in twelve months´ time. Though it would be nice to think that we won´t be worrying at all, given that recent economic numbers have brought a glow to George Osborne´s cheeks, if we are worrying it is most likely that it will be deflation that rings in our ears, not inflation. I never thought I would say this, but if inflation remains above the official 2% target, that will count as good news.

            Two clues as to why came in the past week. One was when poor Nick Clegg tried to change the subject by attacking banks for not lending enough and, of course, for even thinking about handing out big bonuses to their staff. The other came from the dramatic downgrading by the Moody´s credit rating agency of Ireland´s sovereign debt.

            Lest we forget, the most popular slogan during the election campaign was "I agree with Nick". No doubt he would like to take us back to that fleeting moment of fame with his bonus-bashing, but on bank lending he is on to something. There isn´t enough of it, though not mainly for the reasons he cites.

            Under pressure from the government of which he is deputy leader, banks are working to raise their profits, take fewer risks and build up their capital. This makes them more cautious about lending than in the free-and-easy days of the credit boom, and some deserving borrowers get snubbed along with the undeserving ones, as Mr Clegg laments. But there is something else going on too. It is that companies are cutting their debts and borrowing less.

            Given that the boom was characterised by excessive dependence by households and companies on debt, this reduction in borrowing is a healthy sign. Households have been reducing debt too, though their ability to do so is a trifle constrained by the fact that incomes have been flat or falling at the same time. That is what makes higher prices for energy feel painful, as will be the rise in VAT. Unless millions of jobs are suddenly created, it is hard to imagine that incomes will start rising strongly again, soon.

            It is hard, too, to see how inflation can stay high in those circumstances. The government is cutting its borrowing, households are cutting debts or having their incomes squeezed, and companies are, at best, reluctant to borrow. That only leaves exporters as potential indicators of the sort of galloping demand or job creation that are associated with inflation, and although they are doing well, they are too small a part of the economy to have a big overall impact.

            Then there is an awkward trinity: Moody´s, the euro-zone´s recurrent debt troubles, and slow euro-zone growth. It is possible that credit-rating agencies are acting like weather forecasters of yore, eager to predict danger at all times to avoid getting caught out. But like weather forecasters they are also sometimes right that snow is on the way. And, unfortunately for Ireland, it is quite reasonable for Moody´s to question whether that country´s economic growth rate is going to revive sufficiently to cover its debt-service costs and ultimately to reduce its debts.

            Germany, whose GDP amounts to a third of the euro-zone´s, is a ray of sunshine in an otherwise dark picture. Its growth and the fall in its unemployment rate are proving the most remarkable success-story of the post-Lehman period, more remarkable even than China´s boom. There are good prospects that the combination of job creation and rising confidence will boost German consumption and with it imports next year, helping the rest of Europe too. But still, whether it (and the strong growth also being seen in Scandinavia) will be enough to lift Ireland, Greece and Portugal out of their debt-trap must be doubtful, especially with markets also eyeing Spain and its still-falling property market with concern.

            This dents the chances of a British export boom but also, more pertinently, casts a shadow over the very British banking system whose behaviour Mr Clegg was complaining about. If Moody´s fears are borne out, then at some point during 2011 Ireland´s biggest creditors should expect to have to take some losses amid some sort of debt restructuring. The European Council last week thought no restructuring mechanism would be needed until 2013, but it was thinking wishfully. The biggest creditors for Ireland are British banks, who also have hefty exposures in Portugal, Greece and Spain too. Such losses will dent profitability, tax revenues and the banks´ ability to lend to others.

            Contrary to eurosceptics´ claims, Mr Osborne´s willingness to take part in the recent rescue package for Ireland was neither a betrayal of anti-euro feelings nor was it a once-and-only gesture by Scrooge to Tiny Tim. It was a taste of things to come. For Britain will be part of any European debt restructuring agreement, whether it likes it or not. We may not be in the euro, but our banks are firmly part of the European financial market. Mr Osborne´s rescue loan was part of an effort to avoid having to bail out British banks yet again.

            Perhaps, to grab for another Dickensian cliché, something will turn up. But as things stand, the economic prospects look decidedly mixed, fully justifying the Cabinet Secretary´s much-criticised drafting of a "plan B" in case of a new downturn.

            Reductions in borrowing, fiscal austerity and even a euro-zone debt restructuring do not inevitably presage disaster: the economy should still be able to chug along despite that. But they do mean that there is a risk that things could get worse. And anyone who is currently worrying about inflation for next year, rather than deflation, is the true optimist of this icy December season, for that would require not chugging but sprinting. Look to the future now. The aftermath of the debt crisis has only just begun.


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