It is expected that one talks positively about one’s own country of origin. So it is no surprise that this Brit is all agog with the UK economy’s short- and medium-term prospects. While the U.S., Euro zone and even Japan are worried about potential deflation, the UK is set to enjoy an advantage. To understand why, one has to understand why deflation is bad, and why for the UK the situation is different.
The theory is that once you, me, and CEO’s come to expect lower prices in the future we are likely to put off investment today, as we believe we can make the same investment later but at a lower cost. As we defer investment, demand in the economy falls further, thus depressing prices again. This creates a spiral that tends to reinforce itself and this tends to end up pretty badly for everyone involved. For example there are no real economic growth case studies that have emerged from extended deflationary periods. However, that last statement only holds true when you look at a single economic situation. If you look at a more complex model, perhaps a global model with multiple discrete economies inter-operating, the story can be different.
The UK’s version of the story is different. It so happens that the UK is currently seeing a drop in the public savings rate and at the same time a sustained bout of increasing consumer demand – perhaps as a result of diverted savings. If this continues, and the signs are that it will, the deflationary period will not have the same negative impact for the UK as for other economies, at least in the short term. In fact it will act as a boon in that it the low inflation will act as if a positive supply-side shock. As input prices fall (factors of production; raw materials, labor etc.), so margins will widen thus increasing profits and possibly increasing investment as a result. The very insulation surrounding the UK economy means it won’t experience the same negative cycle that the rest of the advanced economies will. The only caveat is that exports from the UK will beholden to those other economies and regions for which demand will be flat or falling. Thus there remains a natural break in the UK’s positive cycle baked in. And given the UK is an open trading nation, that break may not be too far off in the future. Question is: how far can the UK grow, while others tank, before the global slow down drags the UK backwards?
For the trigger for this blog see the U.S. print edition of the Financial Times, Thursday December 4, 2014, Comment titled, “This bout of low inflation is good news for British finances“.
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