GOODBYE TO THE MONEY ILLUSION

Is inflation good or bad? Martin Weyer finds that the experts are not so sure

IN THAT sunlit pre-war era when Hobbs was forever batting at the Oval and affable prime ministers took month-long holidays at Aix-les-Bains, the level of retail prices in this country had scarcely changed, apart from wartime blips, since the late-17th cen- tury. John Major — with his liking for old counties, regional railways and fried break- fasts — often gives the impression of want- ing to carry us back to an ideal version of Baldwin's England. Now he and Norman Lamont have even gone so far as to offer the possibility of a new golden age of stable prices: a commitment to zero inflation, or

We's been publicly shamed. The KGB took no interest in him.' as near to zero as makes no difference.

All to the good, you may think. Curious, then, to find a survey in Corporate Finance magazine (April 1992) in which 72 per cent of the respondents (treasurers and finance directors of leading European companies) answered 'no' to the question, 'Do you think zero inflation is a worthwhile policy goal?' They claim that a modest and steady rate of inflation, a point or two either side of 5 per cent per annum, lubricates the economic machinery in a helpful way with- out doing anyone very much harm, whilst the effort of actually getting to zero will create new and uncomfortable frictions such as mass unemployment and a collapse in the house market.

Prices have risen, here and in most other developed countries, in every year since Mr Major's third birthday in 1946. In Britain they also rose sharply between 1933 and 1940; over the whole period since 1933 they have gone up by no less than 4,000 per cent. Inflation is the norm for the house- wife, the shopkeeper and the corporate chief. It's like The Archers: you would have to be really quite old to remember what life was like without it. Now a debate is devel- oping as to whether, in fact, we might pre- fer to keep it. I have been gathering opinions on both sides.

Zero inflation has several important the- oretical benefits. The first is that it allows investors, whether large companies or small individuals, a clearer view of long- term investments. The real cost of borrow- ing money to invest becomes self-evident; the future return becomes more pre- dictable. This should have the desirable effect of drawing capital into serious man- ufacturing industry and productive research, away from frivolous shopping malls and speculative office blocks. As inflation ripped in 1974, William (now Lord) Rees-Mogg wrote (in The Reigning Error) that it 'makes men take short views: when money is good they plant oaks, when it is bad they can at best plant cabbages'. Our landscape is now littered with giant, mutant cabbages.

The second benefit is that the value of savings and fixed pensions will no longer suffer constant erosion. There will be an end to the insidious redistribution of wealth from thrifty old folks to the heavily borrowing, wage-earning, lager-lout young. As longevity and low birth-rates push up the age profile of the population, so this becomes all the more important.

Third, zero inflation improves efficiency by allowing prices to behave more accu- rately as signals of scarcity, without the confusion of a perpetual rising tide. This does not, of course, mean that all prices stay the same; individual prices will always fluctuate with supply and demand, but the aggregate cost of a full supermarket trolley will remain roughly stable. The price of, say, Iranian caviar may continue to go up, but goods which become more abundant by progress in technology, like satellite dishes and mobile telephones, will get noticeably cheaper.

Most of the Euro-businessmen quoted by Corporate Finance would rather see inflation at anything up to 4 per cent, about where Britain, France and Germany are now. The difference is trifling, you may think; but not over a long period. Four per cent inflation means a Spectator cover price of £4.25 in a generation's time, £11.40 when your grandchild buys it in 2042. At 5 per cent it would be over £18.

Industrial chiefs, however, know that it is easier to get away with price increases if the consumer thinks not only that prices generally go up anyway, but also that his income will continue to grow — what economists call 'money illusion'. Thus the treasurer of the French group LVMH, owners of Modt et Chandon, is quoted as bemoaning the difficulty, now that infla- tion is so low, of passing on increases in grape prices to champagne drinkers. With- out the help of 'money illusion', compa- nies will have to face more often the painful process of squeezing costs to main- tain or improve their profit margins.

And without inflation, wages would only go up if there was real productivity improvements to pay for them or if the skills involved became more scarce. We would lose the feel-good factor of the annual cost-of-living pay rise. Many jobs would simply attract the same pay year in, year out, just as the elderly gentleman who helps me with my garden remembers his father, a forester, bringing home the unchanging weekly sum of 34 shillings and thruppence throughout the 1920s and 30s.

The 'help the aged' argument for elimi- nating inflation is not as weighty as it seems. Indexation has become widespread in pension schemes in the past 20 years the company pension I will eventually col- lect is protected against inflation of up to 5 per cent — and there are index-linked savings instruments in which to keep your money if you want to.

And what of house prices? Gary Marsh, research head at the Halifax Building Society, says that so long as there are no more booms and busts a steady 3 or 4 per cent inflation rate will help the housing market along nicely. But even with no inflation in consumer prices, house prices would still appreciate for two reasons: they would reflect earnings growth in the econo- my as a whole and they would reflect the scarcity of land.

If you already own a house, your equity in it would continue gently to grow. But, for those whose wages remained fixed, buy- ing a first home would be correspondingly more difficult even if interest rates were low. Witness Japan, the country with the most obvious combination of low inflation, high growth, scarce land and real estate millionaires; as a result, the Japanese have had to invent the two-generation mortgage.

So a mixed chorus of pragmatic opinion says that life might be easier if we just let prices carry on rising at their present rate. But we should not lose sight of the contrary argument from first principles. Thirty years ago, when inflation had become endemic at rates similar to today, the Conservative philosopher Michael Oakeshott described it as 'the mother of servitude'.

The pro-inflation arguments are, as Tim Congdon, author of For a Stable Pound, says, 'absolute rubbish'. The inability to forecast real interest rates and interpret price signals creates chronic waste of resources. After the deflationary agony of recent years, getting from 4 per cent to zero should prove to be perfectly bearable.

And zero is the only good inflation rate; the long-term benefits of transparent inter- est rates, efficient prices and safer savings will be immeasurable. It is merely the cor- rupted thinking of economists trained in the 1970s, the fraudulent thinking of specu- lators, the lack of actual experience of liv- ing with stable prices, which make people argue otherwise. Commonsense suggests we should give good money a try.

No doubt the debate will continue to heat up as the reality of stable prices approaches, here and elsewhere. New Zealand is expected to be first to break the crucial 2 per cent barrier next year. (It is no coincidence that the salaries of the execu- tives of the New Zealand central bank are linked to the rate of inflation: the lower it is, the more they get paid.) Inflation rates in the major European economies are tied together by the Exchange Rate Mecha- nism, so that the zero target can only be reached, in effect, if all are committed and Germany takes the lead. But once the strains of reunification have been digested, the Bundesbank will light the path as it did in the 1980s and Britain, with much huffing and puffing, will be able to follow.

Then, for the first time in our lives, we will have the chance to find out whether Rees-Mogg was right, that 'good money permits every citizen to fulfil his own plans. It gives a real target not only to great ambi- tions but also to humble ones. It would restore the sanity of economic life.'