Well, surprise surprise ... here comes deflation
What is likely to be the big economic surprise over the months ahead? This might seem like a fatuous question given that surprises are, well, surprises.
They're the events we typically don't expect. Nevertheless, it's not such a daft approach, if only because the economics profession has been consistently tripped up over the last couple of years by a collective failure of imagination.
It's easy enough to argue that we're on the verge of a sustained recovery in economic activity. After all, interest rates are very low, plenty of money has been printed over the last couple of years, and governments have borrowed heavily in a bid to inject some vitality into the economic process. Yet much the same could have been said about Japan over the last 20 years. In Japan's case, however, these “loose” policies just didn't work. Knowing, then, that policies seem to be supportive doesn't really get us very far. Are UK interest rates at their lowest level in 300 years because policy is very supportive, or because the underlying economy is very fragile?
These are difficult enough questions but the questions don't end there. Paul Tucker, the Deputy Governor of the Bank of England, summed up many of the problems faced by your typical central banker in remarks to the Institute of Economic Affairs last month. Mr Tucker expressed concern about the dangers of supply disruptions. He noted that companies in the UK had chosen to mothball some of their productive capacity in response to the crisis. In Mr Tucker's view, the quicker this capacity was brought back into economic life the better. His argument leads to a perverse conclusion: the quicker demand recovers, the lower the risk of a rise in inflation.
Mr Tucker is right to emphasise the importance of an economy's supply potential. I am not convinced, however, that a loss of supply potential necessarily leads to an increase in inflation risk.
As an economy stagnates, a mechanism has to be found to reduce the value of assets in real terms. One mechanism is, of course, higher inflation.
Inflation, at least of the unanticipated variety, redistributes wealth from creditors to debtors. Anyone holding an asset will quickly discover that it wasn't all it was cracked up to be. This was the experience of investors in the 1970s.
There is also another mechanism. Asset values — the prices of housing, stock markets, commercial real estate — can simply drop in nominal terms. As this process takes hold, so the incentive to repay debt increases, leading to persistently weak nominal demand and the threat not of inflation but, instead, of deflation. You only have to look at Japan over the last two decades to see how this mechanism works.
And you only have to look at very low inflation rates and weak money supply growth in the US and the eurozone to recognise that Japan-type symptoms are being recorded in many parts of the industrialised world today.
True, equity prices have risen strongly over the last year or so, but temporary equity rallies were very much part of Japan's experience: sadly, they merely punctuated a longer-term bear market.
The UK is unusual today because inflation is a little too high, particularly given the huge loss in demand over the last couple of years. However, given sterling's substantial drop in 2008, this is not that surprising.
I do not think that the biggest influence on prices will be supply-side bottlenecks.
We live in a world of deleveraging and debt repayment: it might be a world that damages supply potential but it's a world which ultimately is deflationary. That, I think, will be the big surprise in the years ahead.