MARKET COMMENT
Deflation Is A Red Herring

By James Carlisle
December 5, 2002

Arguably the biggest concern for stock market investors at the moment is deflation -- the prospect of prices and corporate profits getting caught in a downwards spiral because everyone has too much debt and not enough money to buy anything. It's understandable that people are worried about it. Inflation and interest rates have fallen steadily over the last ten years and this has pushed up asset prices to reflect lower yields. In the case of property, it's meant bigger and bigger mortgages. Even though these mortgages cost the same as ever to finance, with monthly payments standing broadly still in relation to earnings and rents, it raises the prospect of a massive credit crunch in people's minds.

To see just how nasty deflation can be, in stock market terms, you only have to look at Japan, where a determination to maintain the integrity of the Yen has seen the economy stagnate throughout the nineties. The Nikkei 300 now stands at just 170, 67% down from its 1989 peak of 520. But that just isn't going to happen over here. Our culture is not like the Japanese. Without meaning to characterise entire countries by their TV game shows, I'll do just that: they have people being buried alive, while we have people getting drunk and lying on sofas for ten weeks.

The Japanese will tolerate economic pain for year after year to maintain the value of their currency. We simply won't. That's why we have fireman asking for a 40% pay rise. More remarkable, though, is the fact that most people (in my narrow experience and myself included) seem to think they should get perhaps half of that. Then there are the doctors and the nurses, who also need to be paid more. And the teachers. And everyone else that I've forgotten.

Whatever the Government says about its mandate, what the electorate wants is (a) not to pay much tax and (b) to put more money into public services. There's only one way these things can happen together and that's by putting more money in, but by quietly allowing some inflation to negate the real value of those extra pounds. The Chancellor had the same dilemma with last week's budget: lower tax receipts combined with increasing spending. The solution is to make some bullish projections for the economy and borrow more. The end result is that the pound will bear the brunt if things go wrong.

To be fair, Gordon Brown has deliberately hamstrung himself by giving the Bank of England control of interest rates. So if he starts getting carried away, then the Bank will raise rates to protect the pound. That would reduce growth forecasts and restrict the Chancellor's scope for borrowing and spending. The fact is, though,  that our political culture puts the bias in this country always in the direction of inflation. If a Chancellor started to get clever on us and refuse the extra spending, then we'd just elect a new, fluffier one that will give the nurses their five per cent. There's nothing much wrong with that, but it does mean that inflation, rather than deflation, will always be our main concern. At least while we still have control over our own currency.