Deflation trap

Andrew Gamble - Professorial Fellow at SPERI

What does this imply? When the Keynesian political economy imploded in the 1970s accelerating inflation combined with a marked slowing down of growth came to be labelled ‘stagflation’.  The economy appeared stuck because any attempt to boost growth led to acceleration of prices.  The control of inflation gradually became the main priority of policy, with the post-war goal of full employment abandoned.

In our present crisis – this Crisis Without End, as I have described it – we face the opposite problem.  The economy is once again stagnant, the recovery is elusive, and the problem policy-makers face is not the overcoming of inflation but deflation.

Western economies are in danger of suffering the fate of Japan in the 1990s.  After its property and credit bubbles burst, Japan suffered persistent deflationary pressure and experienced low growth and falling prices for a decade.  The problem became ‘locked in’ because everyone came to expect that prices were on a downward trend and therefore postponed spending and investment decisions.  The Abe Government is now trying to break this deflationary psychology and has instructed the Bank of Japan to do whatever it can to push up the rate of inflation.  In the 1970s the idea that governments should aim for a higher rate of inflation would have seemed perverse.  Today it is what many dream about.

This deflation trap threatens all the western economies.  The extent of the deflationary pressure is shown by the historically low interest rates (close to zero in many countries) and the reliance of the financial sector on successive rounds of quantitative easing to maintain its liquidity and hold up asset prices.  These ‘emergency’ policies adopted in 2008-9 in the wake of the financial crash are still in force almost six years later.  This is unprecedented, and shows how far all the western economies are from a genuine sustained recovery.

The deflation trap is a symptom of the deeper crisis of neoliberal political economy, which has unravelled just as the Keynesian order did before it.  This has led to fears that we might be entering a new period of secular stagnation; that growth rates may not recover to pre-crisis levels; and that as a result productivity will remain low and wages will continue to be squeezed.  Some economies like the UK and Spain are now growing again, but public and private debt remains high in many countries, and there is little evidence of rising productivity or rising wages.  One of the side effects of quantitative easing was that it boosted the wealth of all holders of assets, widening inequality and pointing up the gulf between those with assets and those without.  This has reinforced tendencies established over the last three decades for rising inequality, reflecting the decline of the countervailing market power of labour against capital because of the weakening of trade unions, the rapid increase in financial flows and transnational investment, and the pursuit of policies to deregulate markets, privatise public assets and marketise public services.

As we know, the neoliberal growth model was at heart a financial growth model, which was only kept going through the ingenuity of the financial sector in persuading households to take on higher levels of debt to sustain their lifestyles.  When the financial sector crashed neoliberalism proved resilient, but has nevertheless been in disarray.  The obstacles to a sustained recovery and a new period of substantial growth in the international economy look formidable.  Peter Jay called the Keynesian political economy of the 1970s an amalgam of unstable forces and forecast that something would have to give, either free collective bargaining, or full employment, or democracy, if inflation was to be brought under control. In different countries one or more of those things, sometimes all of them, were indeed sacrificed, and in the course of the struggles around them the neoliberal order was born.

Now, in its turn, neoliberalism is struggling for survival, with the western economies facing a deflation trap if they cannot find ways to increase demand – which means increasing wages. Some, like the UK, are concealing their problems by encouraging a return to the old pattern of financial growth, with all the attendant risks of asset bubbles and financial excess down the line.  Others, like the eurozone economies, remain wedded to strict ‘ordo-liberal’ financial discipline and are marching solemnly into the deflation trap.

There are no easy solutions to all of this.  As in the 1970s, the international economy needs a profound restructuring to gradually remove the new obstacles to growth which have accumulated in the last thirty years.  But this requires the political will and the political capacity to tackle some big questions – reforming the governance of the international economy, finding a new growth model in the face of increasing environmental constraints and striking a new democratic bargain to counter the drift to ever increasing inequality and declining political legitimacy.

The scale of the challenge is clear. The scale of the response lags far behind.