Inflation target during deflation

Readers Question: How does inflation targeting operate when there is a deflation? and what are the problems associated with this?

It’s a good question to ask at the moment, especially with regard to the ECB and Eurozone.

Firstly, the EU inflation target is – below but close to 2%. If inflation falls below 2%, the Central Bank should pursue a loosening of monetary policy – lower interest rates (if possible), quantitative easing and allowing the exchange rate to fall.

The ECB state

By referring to “an increase in the HICP of below 2%” the definition makes clear that not only inflation above 2% but also deflation (i.e. price level declines) is inconsistent with price stability.

Basically, the ECB target is 2%

The UK has an inflation target of CPI 2% +/-1 (i.e an inflation rate of 1-3%)

If inflation falls below the target then this is a problem and Central Banks should be committed to solving it.

How to increase the inflation rate?

If inflation is falling below 1% – or even forecast to be falling below 1% a Central Bank should intervene. There are several things it can try and do.

1. Reduce interest rates. Lower interest rates make borrowing cheaper and should help to stimulate demand. However, for the UK and the EU, interest rates are already at zero. Therefore, interest rates are not an effective tool for fighting deflation.

The ECB themselves mention a problem of deflation

“Having such a safety margin against deflation is important because nominal interest rates cannot fall below zero. In a deflationary environment monetary policy may thus not be able to sufficiently stimulate aggregate demand by using its interest rate instrument. This makes it more difficult for monetary policy to fight deflation than to fight inflation.” (ECB Price stability)

2. Quantitative easing. – Money creation. In the UK and US, the Central Banks have electronically created money to purchase bonds and gilts. This has increased the monetary base and in theory increased the money supply in the economy. The effect of Q.E. is hard to quantify but it does seem that the economic recovery in UK and US has been stronger – with a higher inflation rate than Europe – Europe is reluctant to pursue Quantitative easing and as a result is seeing its inflation rate fall close to 0%.

The problem Europe has is that many (especially in Germany) have an almost irrational fear of creating money. Any policy of Q.E. could see itself challenged in European courts. It is also more difficult when you have a common currency area of many countries, whose bonds do you buy?

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Problems of Deflation

  • Deflation is defined as a fall in the general price level. It is a negative rate of inflation.
  • It means the value of money increases rather than decreases.
  • Deflation is not necessarily bad, but often periods of deflation / low inflation can lead to economic stagnation and periods of high unemployment. This is because deflation can discourage spending because things will be cheaper in the future. Deflation can also increase real debt burdens – reducing the spending power of firms and consumers.


In the twentieth century, periods of deflation have been relatively rare. Generally, western economies have experienced inflation. The most significant period of deflation for the UK was in the 1920s and 1930s. These decades (especially, the 1930s) were characterised by economic depression. Prolonged deflation is often considered to be very damaging as it can exacerbate an economic downturn leading to higher unemployment.

Problems of Deflation

  1. Discourages consumer spending. When there are falling prices, this often encourages people to delay purchases because they will be cheaper in the future. In particular, it can discourage consumers from buying luxury goods / non-essential items, e.g. flatscreen TV) because you could save money by waiting for it to be cheaper. Therefore, periods of deflation often lead to lower consumer spending and lower economic growth; (this in turn creates more deflationary pressure in the economy. Certainly this fall in consumer spending was a feature of the Japanese experience of deflation (Japanese financial crisis).
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Impact of falling oil prices

In recent months the price of crude oil has fallen 30%. This fall in the price of oil has a significant impact in reducing transport and other business costs. Falling oil prices is good news for oil importers, such as Western Europe, China, India and Japan; however, it is bad news for oil exporters, such as Venezuela, Kuwait, Iraq and Nigeria.


Impact on oil consumers

Lower oil prices help to reduce the cost of living. Oil related transport costs will directly fall, leading to lower cost of living and a lower inflation rate. Falling oil prices is one reason behind the recent fall in UK inflation to 1.2%

With stagnant real wages, this fall in the cost of living is important for giving Western consumers more discretionary income (more income to spend). A fall in oil prices is effectively like a free tax cut. In theory, the fall in oil prices could lead to higher spending on other goods and services and add to real GDP.

Macro economic impact of falling oil prices

  1. Lower inflation
  2. Higher output


This diagram shows that a fall in oil prices (and a fall in firms costs) will shift Short Run Aggregate Supply (SRAS) to the right, causing lower inflation and higher real GDP. (Some economists say a 10% fall in oil prices leads to a 0.1% increase in GDP (BBC article on falling oil prices)

3. Balance of payments

Oil importers will benefit from a falling oil price because the value of their oil imports will drop. This will reduce the current account deficit of oil importers; this is important for a country like India who imports 75% of oil consumption and currently has a large current account deficit. However, for oil exporters, a falling oil price will do the opposite reducing the value of their exports and causing lower trade surplus. The UK is currently a small net importer of oil, so will have limited impact on UK current account.

Oil Exporters

For oil exporters a falling oil price is bad news. Many oil exporting countries rely on tax revenue from oil production to fund government spending. For example, Russia gains 70% of all tax revenues from oil and gas. Falling oil prices will lead to a government budget deficit, and will require either higher taxes or government spending cuts. Other oil exporters like Venezuela are relying on oil revenues to fund generous social spending. A fall in oil prices could lead to a significant budget deficit and social problems.

Other oil exporters, such as Saudi Arabia and UAE have built up substantial foreign currency reserves; they can afford temporary falls in oil prices because they have substantial reserves. This is why Saudi Arabia has so far not responded by cutting output.

Why falling oil prices is not enough for Europe

Usually falling oil prices would be welcomed by oil importing countries. However, many are deeply fearful about prospects for the European and global economy.

Firstly, the fall in oil prices is largely a reflection of weak global demand. Continued low growth around the world, is holding back demand. Thus the falling price of oil is a reflection of weak global growth – rather than the harbinger of economic recovery.


Deflation nightmare. The biggest fear in Europe at the moment is the slide towards deflation and the fear of a ‘Japan style’ lost decade. EU inflation has fallen to a five year low (0.4% in August 2014) 31% of Eurozone goods are now falling in price. This is a concern because deflation tends to cause serious macro-economic problems: Continue Reading →


What happens when the government runs out of money?

Readers Question: Since the debt is mainly in the form of government bonds or gilts then it can only be paid back when the term of the bond terminates. What happens if there is not enough money to pay this back?


Government bonds are a method for the government to borrow money. They sell bonds (e.g. for £1,000) and promise to pay back the bond holder in say 30 years. In the meantime, they will pay an interest rate of e.g. 5% a year as compensation.

Default on debt. If the government has no money to pay bond holders, then it will be defaulting on its debt. Bond holders lose their investment.

The government will be reluctant to do this because once it has started to default on its debt – no-one will want to buy or hold government bonds – so you will see the price of government bonds fall, and the market interest rate rise. The government will have to pay much higher interest rates to compensate for the risk of default and it will be difficult to attract buyers of bonds in the future.

Haircut / partial default. If the government is in great financial difficulty it may offer a deal to bond holders that it will pay back a certain percentage, e.g. 50%. In response for writing off 50% of the bond, bondholders may feel it is better to get 50% than nothing. Alternatively, the government may extend the maturity of the bond, e.g. change a 30 year bond into a 45 year bond, to give itself more time to pay it back.
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The price of petrol and tax levels in UK

The UK has one of the highest tax rates on petrol / diesel in Europe – roughly 60% of the final price of petrol goes to the government in excise duty or VAT.

  • UK fuel duty is currently 58p per litre for petrol and diesel
  • VAT accounts for 20-25p per litre
  • The product cost is around 50p per litre
  • firms profit margins is often as low as 5p per litre – even lower for supermarkets, who use petrol as a type of ‘loss leader’ to entice shoppers into the supermarket to spend on groceries.

Between 1993 and 1999, fuel duty rose at 3% above inflation, causing an increase in the price of petrol. However, in 2011, the chancellor introduced a fuel duty stabiliser with a pledge to pledge to keep rates down.


Source: Fuel duty UK

However, there are economic arguments to suggest that breaking the fuel duty escalator is a mistake. With falling inflation, falling oil prices and rising congestion levels – higher petrol tax could help improve struggling government tax revenues and also contribute to a better environment and lower congestion levels.

Arguments for higher tax on petrol

Environmental costs of petrol. Using petrol causes carbon dioxide (CO2 emissions which contribute to global warming. But, also burning petrol / diesel creates other compounds  toxic to life. For example carbon monoxide and methanol. Also, fine particulates of soot cause from car exhausts cause lung problems and are carcinogenic. Air quality standards in cities would be improved by reducing petrol and diesel consumption. Higher tax would act as an incentive to reduce the pollution caused by driving petrol/ diesel cars (See: tax on negative externality for more on the economics of taxing these negative externalities)

Costs of congestion. Cheaper petrol will cause increased congestion levels. Time wasted in traffic jams is a major individual cost and also cost for business. Without increasing the price of petrol, there will be a rise in the social cost of traffic congestion. The CBI estimate that congestion costs the UK economy £8bn a year. Given the limited scope for increasing the road network in many areas, pricing will have to pay a role – otherwise, we will pay for cheap petrol in other ways.

Improved fuel efficiency and falling tax revenue. One of the benefits of increasing petrol duty in the past has been to increase the incentive for manufacturers and consumers to choose more fuel efficient cars. The consequence is that although petrol tax has risen, the total amount of fuel duty we actually pay is falling – because we are using less fuel. This means government tax revenue from petrol tax is falling. In 2012, the government could expect £38bn from fuel duty and VED. (Link) But, by 2029, this tax revenue could be £13bn lower.

A study by the Institute for Fiscal Studies (IFS) has stated the government face a significant fall in tax revenue from fuel duty and vehicle excise duty (VED). They state that revenue will fall from the current levels of 1.7pc and 0.4pc of GDP respectively, to 1.1pc and 0.1pc by 2029 – in its report Fuel for Thought, commissioned by the RAC Foundation.

Given the poor performance of UK tax revenues in recent years, increasing petrol tax would help meet this deficit. Also, higher petrol tax would further increase the incentive for greater fuel efficiency.

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Attempting to reduce debt after First World War

In the recent blog – Post-war economic boom and reduction in debt, we saw how the UK successfully reduced national debt as a % of GDP from 230% of GDP to 30% of GDP, over a period of 40 years.

However, the story after the First World War was very different. The UK finished the First World War with similar levels of debt. However, attempts to reduce the debt burden were largely unsuccessful.

UK debt 1920s

After the war, debt continued to rise to 180% of GDP in 1923. However, debt as a percentage of GDP barely fell to 160% in the late 1920s, before a slight rise at the start of the great depression.

However, this continued high level of national debt occurred despite years of austerity and attempting to balance the budget.

1913-38-UK budget-deficit

The primary budget deficit excludes interest payments on the debt. Even including interest payments (Public sector net lending) the UK ran a balanced budget  until the late 1930s.

Yet, this balanced budget did nothing to reduce the overall debt burden.

In the early 1920s, we see a sharp change in the budget. The government pursued a tightening of fiscal policy – spending cuts and tax rises to try and balance the budget.

A failed economy

real gdp 1920s

The UK economic performance of the 1920s was very poor. The post-war recession was very deep, and it took several years of slow growth to recapture the lost output.

The poor economic performance of the UK was due to several factors

1. Fiscal austerity and the highly contractionary budgets of the early 1990s

2. Relatively high real interest rates

real interest rates

With a period of deflation in early 1920s, the real interest rate become very high – good for savers but highly damaging for those with debt.

3. Return to gold standard and an overvalued exchange rate which led to expensive exports and a decline in competitiveness.

Conclusion and parallel with Europe

The 1920s were a lost decade for the UK economy. Despite the ‘Treasury view‘ dominating about the need to balance the budget, we never saw a reduction in the debt to GDP ratio from the very high level. The problem was that fiscal austerity was combined with:

  • Tight monetary policy – high interest rates
  • Deflation – falling prices causing lower aggregate demand
  • Overvalued exchange rate, leading to a fall in exports.

If you want to reduce the ratio of debt to GDP, the UK economy in the 1920s is a perfect model of how NOT to do it.

The problem is that the UK economy in the 1920s has many parallels to the current European economy.

  • Europe is pursing fiscal austerity but is seeing a fall in real GDP
  • Inflation is dangerously low and close to deflation
  • Many Eurozone countries are still facing an overvalued exchange rate
  • Monetary policy is relatively tight, with the ECB still reluctant to offer a significant loosening of monetary policy. (see: deflationary bias of the Eurozone)



National debt – mortgage comparison

Readers Question. You make the point that the debt to GDP fell in the post war period since the GDP rose faster than the debt but that still left the debt to be repaid and as such there was still the interest to be paid. I was expecting you to explain how the current debt could be eliminated. It is so large that I can’t see how it can be done. Talks of reducing the deficit pale into insignificance in the light of reducing the total debt.

The point is the debt burden was steadily reduced over a period of 40 years. It was becoming a smaller share of national income. That’s how we will pay off the current debt – steadily over the next 30 or 40 years. There is no necessity to completely pay off the debt.

National debt – mortgage comparison

People who struggle with the idea of government debt probably think nothing of taking out a mortgage of up to 400% of their annual income. With a mortgage you pay back your debt over a period of 40 years – and you could continue to roll the mortgage over for a longer period if you wanted.

Suppose you take out a mortgage for £100,000 and have a monthly repayment of £500.

If your income is £2,000 a month – 25% of your monthly pay goes on ‘servicing’ your mortgage debt.

If your income increases to £4,000 a month, then cost of servicing your debt falls to just 12.5% of your monthly income. Therefore rising income is making it relatively easier to pay for your mortgage.

You don’t have to worry about paying off your mortgage all at once. The crucial thing is can you afford the mortgage payments? If your income fell to £1,000, then your debt becomes a real problem because 50% of your income has to go on paying your debt.

There is nothing ‘immoral’ about taking out a mortgage. Similarly there is nothing ‘immoral’ about government borrowing. Government borrowing can be beneficial, e.g. borrowing at 1% to finance public sector investment which gives a rate of return of 10% a year. – In that case society is benefiting from government borrowing.

Cost of servicing debt

A key issue is what % of GDP / % of tax revenues goes on servicing debt



UK post-war economic boom and reduction in debt

Readers Question: What caused the massive decrease in the debt to GDP ratio for the UK following World War II?



UK national debt peaked in the late 1940s at over 230% of GDP. From the early 1950s to early 1990s, we see a consistent decrease in the debt to GDP. Using the above measure of national debt, UK debt as a % of GDP reached a low of 25% in 1993. (1)  Since then UK public sector debt has increased to the present level of 77% of GDP.

The main reason UK debt to GDP fell in the post-war period was the sustained period of economic growth and near full employment until the late 1970s. This growth saw rising real incomes which in turn led to higher tax revenues and falling debt to GDP ratios.

Higher government spending

Firstly, debt to GDP was definitely not reduced through cutting government expenditure.

government spending real terms

UK government spending

Note – Debt to GDP fell, despite higher real government spending on the newly formed welfare state and national health service. In fact government spending as a % of GDP rose from around 35% of GDP in the early 1950s to the high 40%s in the 1970s. See: UK government spending

Why did UK debt to GDP fall?

Firstly, it is a very good question to ask. In the past few years, many European policy makers have felt that rising debt levels needed panic levels of austerity / spending cuts. But, that didn’t happen in the UK in the post war period.

The second thing is that total real debt increased in this period. But, GDP increased at a faster rate. Therefore, the debt to GDP ratio fell.

The third thing is a disclaimer – to fully answer the question, I would need to do more research on the period. Bear in mind, my answer may not be comprehensive. But, I will do the best I can.

Post war economic boom


This graph shows UK real GDP.  In 1955 it was less than £100,000 m (quarterly). By  the early 1970s, real GDP had doubled in a relatively short period of time.

economic growth

What caused economic growth?

The UK economy benefited from the period of rapid global economic growth, especially in Western Europe. In fact, in this period, UK growth lagged behind many of our Western European neighbours. But, overall the UK enjoyed a period of rapid growth in trade and economic growth. UK growth was so rapid, we experienced labour shortages – leading to the mass immigration of the 1950s and 60s to help feel labour market shortages.

Demand management and the absence of recessions

One of the cornerstones of William Beveridge’s Welfare proposals was the assumption that a comprehensive welfare state required considerable efforts to achieve near full employment. The UK experienced boom and bust cycles, but the downturns were relatively minor and there were no real recessions of any significance until 1973. It would be interesting to know why there why there were so few recessions in the post war economic period. Demand management may have played a role.

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Saving rates in the UK

It is not a good time to be a saver in the UK. Interest rates are 0.5% and inflation has been above 2% for a high proportion of the previous five years. Because inflation is higher than nominal interest rates, we are seeing negative real interest rates. This means many savers are seeing a decline in the real value of their savings. Pensioners who are relying on interest payments as income, are seeing a decline in their income.

Inflation and interest rates


In most of the post-war period we have seen positive real interest rates – Base rates above the headline inflation. This means that savers are protected from the effects of inflation.

H0wever, 2008 marks a sharp contrast, with Bank of England base rates falling to 0.5% and inflation reaching above 5%.

In recent months, inflation has fallen to below 2%, but that is still higher than base rates of 0.5%

Effectively, you are getting 0.5% return on your saving, but prices are going up 2%, so the real value of your savings is falling by 1.5%.

Base rates and bank rates

The contrast between base rates and inflation looks very high. But, actually bank savings rates have not fallen as much as base rates. This is because banks were short of money in the credit crunch and were keener to attract deposits than lend money. Therefore, when the Bank of England cut interest rates to 0.5%, commercial banks were not so keen to reduce their own interest rates by as much. Usually commercial bank rates closely follow base rates, but after 2008 we see a break in this correlation.


Source: Bank of England. Series IUMB6VJ | IUMWTFA

In 2008/09, base rates are cut from 5% to 0.5%, but fixed interest rates  (series IUMWTFA) only fall to 2.5 / 3%. Interestingly since mid 2012, fixed interest rates have continued to fall closer to 1%. This suggests the banks are less desperate to attract saving deposits and so can reduce interest rates.

It is a similar story with instant access saving rates (series IUMB6VJ) Since mid 2012, rates have fallen from 1.6% to 0.6%. This suggest the financial sector is in better health, but it means a poorer return for savers.


However, if you look around, you can still see higher fixed rates for those willing to ‘lock their money away’

It also depends how much money you can save. For example, according to ‘Money Saving Expert‘ you could get 3.25% if you can put £25,000 away for 5 years. – hardly a great deal, but you would just about get a positive real interest rate.

Should the Bank of England do more for savers?

In the past few years, many groups representing savers have felt they have been ignored – and the government / Bank of England should have done more to give a better rate of return for savers.

However, the past five years have seen declining living standards for most groups of people – real wages have fallen. Unemployment has been very high. The cost of renting has been very high. Given the general economic decline, savers have not been alone in seeing falling living standards. It is complicated by the fact that people with high levels of saving are more likely to be household owners. Homeowners have seen record low mortgage interest payments and rising house prices, which, to some extent, have offset the fall in the return on savings.

Young people without savings, but paying rent, have seen a bigger squeeze on their living standards.

However, someone who is relying on their savings to pay rent, is definitely in a bind.

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Global currency

Readers Question:  Should The World Adopt A Unified Currency?


I haven’t given it much thought; given the great difficulties of the Euro single currency within parts of the European Union, the idea of extending this to include even more disparate countries seems a non-starter.

From a philosophic point of view, I think the world is heading towards greater integration, and perhaps in a thousands of years we will global governments, global fiscal transfers and we could move towards a global single currency. But, this would require a completely different mindset of selflessness, breaking down parochial self-interest and seeing the world as one world-family.

Alas, I can’t see this spiritual evolution happening quickly. Some issues to consider in a single currency.

What happens when countries have different inflation rates, but the same currency? In Europe, countries with higher inflation rates (e.g. Greece, Spain, Portugal) were left with large current account deficits, lower exports and lower growth. A global currency, would see even bigger disparities in relative costs and competitiveness.

Single monetary policy. For a single currency to be practical, the assumption would be that you need a single monetary policy. That would be highly impractical and could be devastating for some economies who have different rates of economic growth. For example, we might have very low interest rates, but countries with fast rates of growth could see inflation. It might be more practical to have a single currency, but have regional variations in interest rates. I’m not quite sure how this would work or what the consequences would be. But, with a single global currency you would see a lot of capital flows from less prosperous countries – especially with any variation in interest rate. Continue Reading →

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