Taken from: What lies ahead: Ten predictions for 2015, first published by the IPPR on 6 January 2015
Europeans have no experience or memory of deflation. This is a worry. Britain and the EU will likely experience deflation in 2015. Disinflation – a slowing in the rise of price inflation – is already a feature of our economies. To understand disinflation and deflation, it helps to view both through the lens of debt.
Lending to the finance, insurance and real estate (FIRE) sectors far outweighs lending to the real, productive economy. Some estimates have put lending to the FIRE sector at 80 per cent of the total. Borrowing to finance the purchase of pre-existing assets rather than new, productive activity invariably inflates the prices of assets. Before the crisis, central bankers ignored inflated asset prices, but applied downward pressure on wages and prices.
Rises in asset prices oblige new commercial and household borrowers to borrow higher sums. But the larger the share of total income aimed at debt payments (even with low rates), the smaller the share of income that is aimed at investment and the purchase of goods and services. This places further downward pressure on both consumer prices and wages.
This disturbing phenomenon was a feature of the UK economy before the crisis. All three are linked, and conspire to contract activity in the real, productive sectors of the economy. UK bank lending to the real estate sector has started to decline, and house price rises have slowed. Falling asset prices will likely only exacerbate both the debt overhang and falls in consumer prices and wages.
It is doubtful whether central banks and finance ministries have sufficient policy tools to arrest a generalised, downward spiral of prices, which will lead to declines in profits, further falls in real wages, rising unemployment and ever-sharper falls in prices. Which is why deflation is such a terrifying prospect.