VAT cut in the UK & the mysterious spectre of deflation

As the world economy continues to produce absorbing news on a daily basis, here’s a look at a couple of particularly interesting developments from this still young week: the British government’s forthcoming VAT rate cut announced in the pre-Budget report yesterday; and the newly-emerged public debate surrounding the potential troubles coming from deflation. – Deflation? – Not a hugely likely scenario, as I admit, but with everyone talking about it now the issue certainly deserves a handful of enlightening paragraphs!

 

VAT first.

 

So what exactly happened? Yesterday, the British government said that it will cut the national VAT rate by 2.5 percentage points to 15%, down from the current 17.5%, for more than a year – to be more specific, for the 13 month period from next week Monday, 1 December until the end of 2009. This temporary decrease comes as part of a wider £20 billion package designed to stimulate the ailing British economy as it is moves into recession.

 

Interestingly, the announcement is nicely in line with the final declaration of the G20 summit that took place in Washington 10 days ago, where heads of government representing around 85% of the world economy promised that they would use “fiscal measures to stimulate domestic demand to rapid effect, as appropriate, while maintaining a policy framework conducive to fiscal sustainability.” For details, see my post from 17 November!

 

So which products will get cheaper following the VAT cut, and which will not?

 

• The price of an average supermarket basket will roughly remain stable, simply because foods are exempt from VAT in the UK (I want that in Germany, too!)

 

• The price of booze will remain the same. You wouldn’t believe it but right in the run-up to Christmas, the government announced a duty rise on alcoholic drinks to cancel out the effects of the VAT reduction. Outrageous, isn’t it!

 

• Tobacco and petrol prices will also remain the same, and again it’s the duty rise thing

 

• And finally, standard non-food ranges will get cheaper, as long as retailers pass on the VAT cut to shoppers. So it’s potentially good news for people interested in consumer electronics, clothing, DIY goods etc

 

But is the cut big enough to boost retail sales? Here are some examples, so you can form your own opinion. If your trusted retailer or restaurant passes on the full VAT cut to you, then you will save

 

• £0.11 on a £5 woolly hat

 

• £0.17 on a £8 DVD

 

• £0.85 on a £40 restaurant meal

 

• £10.64 on a £500 TV

 

• £2.3 million on a £110 million Boeing 747

 

I think we can easily see from this that even if retailers and restaurants pass on the full reduction, it’s not going to massively boost the spending power of middle Britain. So what’s the point?

Apparently, the British government wants to be seen as doing something, and this is really a good thing. The mere fact that political leaders prove they’re able to react quickly to the economic downturn is a substantial contribution to building consumer confidence. Meanwhile, we can expect retailers who pass on the VAT cut to their customers to use this as a promotional vehicle, and again the mere fact that British high streets will be full of “VAT reduction” signs will be pour balm on the wounds of Britain’s plagued shoppers. Not all of them will notice that they actually save just a tiny 17 pence on their DVD, and I’m not even sure if saving 10 quid on a £500 TV will move many people to tears. But it’s the psychological signal that helps.

 

True, given the comparatively small amounts in question, many retailers will no doubt be tempted to cash in on the VAT cut by silently boosting their margins. But that’d be a risky strategy, as these retailers would be the ideal target for nasty page one story in most tabloids. Greedy fatcats! Rip-off Britain! Shameless profiteers! You don’t want to see your picture under such headlines.

 

Interestingly, British retailers have broadly welcomed yesterday’s government announcement but warned that the reduction was difficult to implement with extensive price tag and IT updates required within just a few days. That’s quite a logistical challenge indeed. Some retailers also voiced criticism that the administrative effort came at a time when stores were particularly busy and price cuts were in danger of going unnoticed, with numerous bargain offers available already and a period of clearance sales due to follow during the next few weeks.

 

And finally, here’s the downside of any tax cut. While the £20 billion stimulus package is a valuable element in restoring consumer confidence and helping businesses, in one way or another, it is clear that the forthcoming VAT reduction will need to be reversed when the economy is doing better, simply to contain public borrowing, which will hit record levels in 2009/10. To be more specific: While the VAT rate will go back to 17.5% in 2010, the government has already announced that national insurance contributions will rise from 2011, and so will the income tax for those earning more than £100,000. I can already see the media attacking an increasingly unpopular government for stifling a freshly-blooming economic upturn – though times ahead for whoever wins the next general elections!

 

Deflation

 

To round it all off, here’s a few paragraphs on the mysterious spectre of inflation which has appeared in the public debate recently. Several people have asked me what it means and how dangerous it is, so here’s a short summary!

 

Deflation is the opposite of inflation – it’s there when prices for a wide range of goods and services are falling, rather than going up (moderate increases are the normal thing). In the Western economies, we’ve long been witnessing this phenomenon in individual product groups, such as consumer electronics: with the share of cheap imported goods from China rising and rising, the average price of a DVD player or TV has been falling for years. The same goes for most clothing ranges.

 

Now, if prices fall for an individual product group that’s not a dramatic development. Things do get more difficult if consumer prices start falling for a very broad range of goods, but even under this scenario we need to differentiate: There can be short-lived price decreases that naturally follow excessive price hikes, such as the enormous rise in energy and food commodity prices this summer. If these prices fall back to a more healthy level, this might result in a short deflationary period, but that’s still a welcome development.

The real problem starts when a sustained period of falling prices triggers a vicious circle, the so-called deflationary spiral. Such a downward spiral can start during a recession, with retailers reducing prices to encourage higher levels of consumer spending. However in a worst-case scenario, people will not go and spend money, but continue to wait for prices to fall even further. The resulting lower retail sales will lead to redundancies in both retail and manufacturing, and as corporate investment plans are postponed, unemployment will grow even further. This in turn will lead to a further reduction in demand, which will lead to further price cuts… and as interest rates approach zero and investing money at no significant yield becomes increasingly pointless (the wish to simply keep one’s money, rather than spending or investing it, is called the liquidity preference), there’s a danger of financial markets running dry. And with the purchasing power of money increasing as a result of falling prices, deflations favour millionaires with lots of cash while hurting small indebted house buyers who watch their homes lose value, which can lead to social unrest, etc etc – so much for the theory.

 

In practice, there are only a few examples of prolonged deflationary periods that we could learn from. Japan was caught in a decade of deflation beginning in the early 1990s, but when governments tried to stimulate the economy with the most obvious move – drastically reducing interest rates in the hope of boosting consumer demand, which would in turn persuade businesses to set higher prices - this had no visible effect. Reducing interest rates for a long period of time can even be detrimental, as the world has just found out in the wake of the US credit and mortgage bubble, which was facilitated by years of cheap credit availability. Meanwhile, government spending is not a guaranteed route to economic recovery either.

 

So, to sum it up, there are no obvious rules and recipes for reversing deflation. At least, governments around the world have understood the importance of a functioning credit market for economic recovery, which is an improvement when compared with the Great Depression in the 1930s and Japan in the 1990s.

There’s a lot of speculation around about how likely the scenario of a prolonged deflationary period is for the Western markets. Germany’s leading tabloid, Bild, yesterday quoted an economist as saying: “I’m scared”. That’s the good old tabloids! But currently, most people agree that a period of sustained deflation is pretty unlikely. True, looking at the speed at which the world economy keeps changing these days, we shouldn’t be too sure of anything. But even if deflation strikes, we simply don’t know how badly this will affect our job markets. In Japan, unemployment rose continuously during the 1990s but always remained moderate when compared with, say, Germany and France.

 

Once again, I close this post saying that we’ll see clearer soon.

 

Have a good week.

 

Boris