tisdag 17 juni 2008

Inflation target missed

Inflation was once defined as "undue increase in the quantity of money". Such increases usually occurred when governments resorted to the printing presses. The effect, after a delay of a couple of years, was a generalised increase in all prices.

Nowadays, inflation just means an increase in prices of a basket of goods and services included in some index or other, such as the retail price index or the consumer price index. Governments have a vested interest in choosing an index which shows a low figure, especially as pensions, savings and benefits are linked to the selected figure.

It is unfortunately the case that housing costs have been excluded from the UK indexes for several years. Had they not been, the higher inflation figures revealed now would have shown up long ago. Now those high housing costs were indeed caused by an undue increase in the quantity of money, but it was not money created by government but by the banks. Eventually, this money will be paid back but that will be far into the future. In the meantime, people have borrowed money on the equity of the higher land values pumped up by the banks' easy lending policies. This money is now circulating and will tend to drive up prices generally.

The present round of "inflation" is attributed to higher food and energy costs, but if there was no more money in the system, the prices of other things, including, and principally, land, would be driven down. Thus housing costs should fall, and if these were included in the index, there would be no inflation.

That is in theory. But in practice, land prices are "sticky downwards" - they do not fall in response to falling demand but instead, land (property) is simply held off the market. Under a regime of land value taxation, owners could not afford to do this and would exert themselves in getting land onto the market and into use. In that situation, land values would respond smoothly, upwards or downwards, in response to changing demand and economic conditions. But there is no such system in place.

And so there will be an increase in vacant properties the property market will become sluggish. Since housing-related industry such as refurbishment is important for the economy, all sorts of related businesses will be short of work. This is the way to recession.

A repeat of the "stagflation" of the nineteen-seventies is unavoidable. My hunch is that inflation will be 11% over the next 24 months. How bad the recession will be is still a matter of guesswork, but the the growing gap between energy supply and energy demand is going to have an impact, as is the increasing amount of meat-eating in developing countries, which puts a disproportionate pressure on food supplies and food prices. Expect trouble ahead.

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