On inflation

THE barber paused in mid-snip when the radio interrupted its nonstop pop to announce that interest rates had gone to 15%. That's a pound on the price of the haircut, he said. By the following lunchtime the proprietor of a local restaurant was expressing great relief at the news that the 10% rate had been restored. We're all working for the banks now; and many people are running to stand still.

That evening I was sitting at dinner with a leading member of the financial and business community, a pillar of the London Stock Exchange. He startled me by saying that what this country needed was a little inflation.

His immediate justification for this rejection of the Government’s official aim of a zero rate was that a higher rate of inflation would restore the value of property assets and reduce the real value of debt.

The collapse of the late-eighties property boom, in both the commercial and private sectors, was a significant factor in causing the recession in the south. Their failure to recover, and the caution of consumers once caught in killing debt and now twice shy, were forces tending to prolong it.

The great hole torn in bank liquidity by bad debts had forced them to put intolerable pressure on viable and promising businesses. To reduce inflation to zero, the argument went, would carry virtue to a self-defeating point. It would in fact be deflationary and send us into prolonged recession.

One of our other companions at dinner was the financial director of an important Scottish company. He pointed out that modest inflation was a social and economic lubricant. It allowed companies to adjust costs over a period of time and, he said, it gave the workforce the illusion of rising wages which was easier to get away with than giving them next to nothing in a non-inflationary environment.

The two points of view illustrate the best and the worst of applied Keynesian economics: on the one hand they were a largely successful mechanism for avoiding recession and mass unemployment; on the other they fostered illusions and allowed the deferment of painful decisions.

Remember John Maynard (later Lord) Keynes (1883-1946)? He was of course the economist whose theories formed the basis of economic policy in most of the countries of the industrialised world after the war but which became discredited in the sixties.

He worked at the Treasury during the First World War and was its principal representative at the negotiations for the Treaty of Versailles, resigning in protest at the excessive burden of reparations imposed on Germany.

In 1925 he denounced Britain’s return to the gold standard, predicting that a self-regulating economy would descend into recession and mass unemployment. By 1936, in The General Theory of Employment, Interest and Money, he had fully set out the idea that governments could avoid mass unemployment by adjusting demand in the economy. They could vary interest rates, the levels of credit, and the amount of public spending. The theory permitted a modest amount of inflation but assumed that wages would follow prices in the upward curve of the economic cycle.

Keynesian orthodoxy was rejected by the New Right and was supplanted in America by Reaganism and in Britain by Thatcherism. It had become associated with stop-go economic policies and stagflation. The rise of collectivism and trade unionism, and excessive wage demands, constantly undermined its assumptions. That explained why incomes policy so preoccupied governments of both complexions during the sixties.

Growing demands on the public purse were accompanied by increased political resistance to paying more taxes. Governments in the industrialised world began to stem the growth in public spending. Many economies had begun to eat themselves to death.

Reagan avoided the issue and turned America from being the world’s biggest creditor nation into the biggest debtor in the space of 10 years, leaving his country with the destabilising legacy which Bush and Clinton are carting around with them in the presidential election. They have no coherent programme for dealing with it.

Mrs Thatcher made the attack on inflation one of the central facets of her policy. She also tightly controlled public spending and pursued efficiences on the supply side. Then came the credit orgy of the late eighties followed by the slump in property values. Now her successors struggle to find a coherent way forward.

I have for a long time suspected that John Major has more of Keynes in him than Thatcher though the struggle for his soul has not been decisively won by either tendency. When he gave an interview to The Herald before the election he spent a lot of time justifying the need to maintain public spending in a recession; that was pure John Maynard Keynes.

But it sits uneasily with his commitment to lower taxation. Reduced revenues limit the Government’s capacity to regulate the economic cycle. And his commitment to zero inflation, I suspect, results from an over-interpretation of Thatcherism.

When Mr Major was in Scotland last week, I bumped into one of his friends. He advised me that the speech he gave to CBI Scotland at the Forte Crest in Glasgow was worth careful reading because it contained a coded attack on the Thatcherite right.

That passage, which I think I have identified, reads a little ironically now. It speaks of ”betrayal”. He said: ”The soft option, the devaluer’s option, the inflationary option, would be betrayal.” And then he said: ”Maynard Keynes — whom I don’t often quote — was right when he said, ‘There is no surer means of overturning the existing basis of society than to debauch the currency’.”

Some of that was swept away this week by enormous flows of money across the foreign exchanges and I guess that Keynes himself would not have supported the decision to defend the pound against irresistible market pressures, although he was an architect of Bretton Woods and the fixed parities that prevailed for many years after the war.

The Prime Minister has not taken sterling out of the ERM. He has merely suspended its membership and intends to rejoin once the value of the currency has been adjusted by the markets. He is defying pressure from the business community by sticking to a 10% interest rate because he does not want its value to fall to the point where it destroys his anti-inflationary policy (a devalued pound puts up the price of imported goods).

The problem with this is that speculative flows and political instability will continue to cause turbulence in the currency markets from time to time. The international economy, where foreign exchange controls are now largely absent, is too big a beast to be saddled by any national government.

Yet the fight against inflation must be carried on. It is a genuine evil, attacking the roots of society if it gets out of hand. Each time it returns it seems to do so in more virulent form. I would speculate that Mr Major and Mr Lamont do not seriously aspire to a zero rate. They simply want to keep it at levels consistent with a virtuous Keynesian circle.

Somebody said that Britain was a country in love with inflation. Events are proving him right. The business community says let the pound go hang even if it increases inflation. It is a difficult choice. Mass unemployment, which is afflicting us, is a less pernicious evil than inflation only because its effects are not universal but confined to its unfortunate victims.

A combination of runaway inflation and mass unemployment hardly bears thinking about. It is the nightmare breeding ground of fascism and ugly nationalism. That spectre should haunt us all as Major and Lamont strive to prevent the debauching of sterling and enforce competitive realism in the economy. And as for those glib and nationalist critics who attack the Bundesbank as it struggles with the enormous internal stresses of unification — they should remember history.