THUS Magazine

The view that inflation is an evil ‘debasement of the currency’ with terrible social, political and economic consequences is still orthodoxy among central bankers and the vast majority of economists. Over the next few years we are likely to see it return and become embedded in Western economies. This may not be such a bad thing, argues Chris Gilchrist.

Economists, governments and central banks have grown increasingly worried about the level of consumer indebtedness, which is especially high in the US and the UK. In the UK, mortgage lending on residential properties is now over £1,200 billion. Unsecured debt adds another £230 billion, with credit card debt running at more than £57 billion per month. Mortgage affordability has deteriorated steadily since 2000, with 2007′s first-time home buyers using a third of net household income to make mortgage repayments. Repossessions are rising fast, as are defaults on consumer debt.

Everyone understands the linkage between spending and debt, and few dispute that a healthy economy depends on consumer spending. But the increasing cost of servicing and repaying household debt is now the biggest drag on the economy. The ‘credit crunch’ has forced politicians and monetary authorities to turn on the taps, using methodologies such as quantitative easing, to prevent a catastrophic spending freeze, which will result in deflation, as evidenced in Japan in the 1990s, or an increase in the rate of inflation. The worst case scenario would be stagflation, the toxic combination of monetary inflation and economic stagnation which occurred in the UK after the 1973 oil price shocks and which laid the foundations for the ongoing fixation with curbing inflation at all costs. In an ideal world, prices remain relatively stable while economic growth proceeds apace. Today’s crisis has largely arisen because the supply of credit has dried up. To avoid stagflation, we may be obliged to embrace inflation. And this may have the effect of reducing the real value of the debt mountain and freeing up consumer spending power.

This argument in favour of the beneficial effects of inflation is supported by the case for inflation as a mechanism for reducing the state’s own burden of debt. By 2012, total UK government debt is likely to be about £800 billion or 60% of GDP. Repayment of this debt will require a larger slice of government revenue, which will mean less schools/hospitals/services or higher taxes. Inflation will soften the blow. An inflation rate of 5% for five years would cut £200 billion from the real value of UK debt and make it much easier for politicians to pursue their social and political aims.

Policymakers obsess about inflation in the form of rising prices, but generally ignore the way a reasonable rate of inflation erodes debt. For example, the effect of one year’s inflation at 5% on the UK’s £1,400 billion of consumer debt is a real write-off of £70 billion, more than the tax cuts in all of Gordon Brown’s Budgets combined. Over five years, 5% inflation would cut the real value of debt of all the UK’s indebted households by an average of about £20,000.

Baby boomers made money from home ownership in the 1970s not so much from the rise in prices – the average rise in house prices from 2000-05 was greater than that of any five-year period in the 1970s in real terms – but from the inflationary devaluation of their debts. For example, the real value of my mortgage halved over five years from 1973-8. Like most people’s, my earnings rose roughly in line with prices, so mortgage repayments accounted for a shrinking proportion of my earnings, and I carried on spending.

We know from the experience of the 1970s that people are much happier with house prices rising at 4% a year and inflation at 8% than they are with inflation at zero and house prices falling by 4%. After a long period of relatively stable prices, it will take several years of rising inflation before consumer behaviour adjusts to the ‘money illusion’ (we tend to treat tomorrow’s pound as equal in value to today’s even though it will buy less). Five years of inflation at about 5% could make housing affordable again for first-time buyers as well as releasing substantial spending power for homeowners as mortgage repayments absorb a declining fraction of income.

Higher inflation rates will have another major benefit: it will partially reverse the huge transfer of wealth that has taken place over the past decade from the young and poor to the old and rich, partly through the rise in house prices and partly through rising income inequality. Inflation transfers wealth in the opposite direction, from the old and the rich to the young and the poor. However desirable it may be, such a transfer is politically impossible if it has to be accomplished through taxes in a no-inflation environment. The young, who must save more towards their retirement, need to raid the piggy banks of the old. Inflation enables them to do this quietly and without confrontation. Meanwhile, the one big category of potential inflation losers – the old poor – are the easiest to protect through inflation-linked state benefits.

These arguments are even more applicable to the US, which I expect to be the first to endorse inflation as the ‘least bad alternative’. The UK, then mainland Europe, will – at first reluctantly – follow the US lead. When it is embedded, economists will tear up their anti-inflation tirades and start to write treatises about why it is a Good Thing.

About the author:

Chris Gilchrist has 30 years’ experience as a financial journalist, editor, author, lecturer, TV and radio broadcaster and commentator. He launched a series of monthly financial magazines and has been involved in programme series for Channel 4, BBC1 and BBC Radio 4. He is currently a director of investment advisers Churchill Investments PLC.