What is deflation and what does it mean for the working class?

by James Meadway

20 May 2015

Yesterday news broke that the UK economy has gone into deflation for the first time since records began in 1996. George Osborne, the Chancellor of the Exchequer, was warned against complacency after declaring it “good news”. In this article, James Meadway from the New Economics Foundation explains what deflation is, how it happened, and what it means for the UK economy, wages and the working class.

Prices in the UK are, on the official measure, falling for the first time since 1960. For decades in this country, prices, on average, have risen steadily over time. This is inflation – a steady increase in the general level of prices. Since the end of 2011, the rate of inflation has been falling. This means that although prices in general are still rising, the rate of that increase has itself been slowing down.

In the summer and autumn of last year the price of oil began to fall sharply. Between July and April 2015, it more than halved, dropping to around $43 per barrel sold. The reason the price fell quite so low is due to the decision, made by OPEC but led by Saudi Arabia, to keep the production of oil high. It has meant those dependent on oil production, including whole countries like Venezuela, have been hammered. But so too have new producers of more expensive oil, like US shale.

For those not dependent on an income from oil, it has felt like a bonus. With oil prices declining, transport costs less. That means the cost of anything requiring transport has come down – food, most notably.

Falling prices mean that every pound anyone earns goes a little bit further. For six years, pay increases did not keep up with price increases. This was the longest period of sustained decline in living standards since the Industrial Revolution. Over the last few months, as inflation fell to record lows, and then turned negative, pay rises finally outpaced price rises.

However, this situation can only be temporary. As prices fall, those selling goods and services will look to cut costs. Those costs can include the costs of labour: wages and salaries.

In other words, it’s not possible to sustain an improvement in living standards through falling prices alone. And if falling prices turn into falling wages, the economy can get stuck in a spiral downwards: falling prices pull down incomes, which leads to lower demand and bring prices down still further.

This can happen when, as in the UK, those at work are in a weak bargaining position. As we’ve seen over the last few years, most workers have not been able to hold their pay up even against low levels of inflation. The rise of zero-hour contracts and some dubious ‘self-employment’ (with close to 80% of the self-employed now earning poverty pay) very strongly imply that workers in the UK are in a seriously weak position.

The temptation for bosses will be to pass on falling prices. Already, employers’ surveys suggest that pay settlements this year will be lower than last – itself hardly a bumper year.

There is another, final, sting from deflation. Prices and incomes may fall over time. This implies everyone has less money. But debts still have to be paid in money. Deflation means debts become a heavier real burden, dragging the economy down further. An economy with huge debts, particularly in the private sector, is at significant risk.

The surest way to avoid these dangers is to rapidly increase wages and salaries. With productivity stagnant, however, employers will not be inclined to generosity. And it may not be possible to compel them to raise wages with workers, in general, unable to bargain effectively. Government intervention would be needed. Scrapping the 1% pay limit in the public sector, or boosting the national minimum wage to a living-wage level would both shore up workers’ positions in the labour market and raise their earnings.

Oil prices have picked up again. The Bank of England remains optimistic that pay will increase over this year, on the back of improvements to productivity. Both would help avoid the deflationary spiral. But the dangers for the UK are more significant than is being assumed.

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