Last Thursday, interest rates in yet another European country went sub-zero. Writing for Quartz, Matt Phillips is struck by the sheer weirdness of the situation:
“Sweden’s Riksbank joined the central banking bizarro world today, pushing its key benchmark interest rate into negative territory. In other words, instead of paying interest to institutions that park money with it, Sweden’s central bank—like the national banks of Switzerland and Denmark and the European Central Bank—is now charging a small fee to safeguard the cash.”
Why anyone would want to subject their money to a negative interest rate is something we’ve looked at before on the Deep End, but in a deflationary environment the pain of doing so is obviously lessened:
“…much of Europe is in outright deflation right now, including Sweden if you go by its headline national consumer price index. (Its core inflation index, which strips out seasonal noise as well as the impact of food and energy prices, isn’t in negative territory, but is quite low.)”
Not that deflation is something we should wish for:
“While falling prices might sound good to consumers, they’re actually very bad for an economy as a whole. If households become accustomed to falling prices, it prompts them to put off purchases. (Why buy now, if it will be cheaper tomorrow?) For any individual shopper this strategy might make sense. But when it happens en masse it acts as a tremendous headwind to growth.”
European central bankers – including the European Central Bank itself and copycat outfits like the Swedish Riksbank – got things badly wrong when, in the earlier part of this decade, they tightened monetary policy:
“…Swedish policy makers made a massive mistake by embarking on a series of interest rate hikes in 2010, despite the fact that unemployment was too high, and core inflation was too low.”
At the time, the Bank of England came under a lot of pressure to do likewise. Only, in our case, this didn’t come from Europhiles wanting us to ape the ECB. Rather, it came from sections of the Eurosceptic right, insisting that runaway inflation was an immanent threat.
As early as 2012 is was pretty clear that the inflation hawks were wrong. Today, we can be grateful that they weren’t listened to.
None of this means that low interest rates are a good thing – they’re what got us into this mess in the first place – it’s just that deflation is worse.
Unlike much of Europe, Britain has, thus far, dodged the deflationary bullet. But there’s no room for complacency, not when the latest figures show UK CPI inflation at its lowest ever level. Our government needs to be ready with an effective policy response should outright deflation jump the Channel.
Last Friday, the Deep End featured the case for abolishing corporation tax and making up for the lost revenues with a higher rate of VAT. Given the evidence that the cost of corporation tax is passed on to consumers anyway, the theory is that the VAT substitution wouldn’t necessarily put up prices.
That said, if the transition were phased in over several years, it’s likely that the year-by-year VAT ‘escalator’ would persuade people to spend their money sooner rather than later – thus countering the logic of deflation, in which consumers put off purchases in the anticipation of lower prices.
A big obstacle to this reform is that a country that pursued it unilaterally would end up with much higher VAT rate than its neighbours. If, however, it were to be implemented on a Europe-wide basis then this issue would be resolved.
Europe’s struggle with deflation might just provide the necessary impetus.