The idea of nothing has an interesting history in mathematics, and there’s even a theory that the Catholic Church tried to outlaw the concept of zero because the idea of nothingness could mean there was a circumstance in which there could be no God.

I tend not to believe that tale, of course, partly because it was promulgated by Christopher Hitchens, who was a great storyteller but a sloppy historian; and partly because if there is one thing I know about the Catholics is that they are good at counting things – land, treasure, number of churches, the cost of lawsuits. You get the idea.

If you want to know more about zero, read Zero: The Biography of a Dangerous Idea, by Charles Seife. It’s very good. Or give me a bell and I will lend you my copy. I quite like sharing books – I think it’s important.

But here’s why zero is a frightening concept today. In the first quarter of this year – that is from January 1 to March 30 – Australia’s inflation rate was zero. Not even zero-point-something. It was zero. Zip. Nada. Zilch. Sweet f#%k-all.

Inflation rates are tricky to calculate, and the Reserve Bank of Australia (RBA) does it by building a basket of goods and services which they refer to as the Consumer Price Index (CPI). Everything from the cost of housing to the cost of your telephone is in the CPI. The elements aren’t treated equally, of course; they are weighted to signal their importance. Housing contributes 23 per cent of the index and is the most important while communications contributes 3 per cent of the index and is the least important. You did this in Year 10 economics. I won’t bore you further.

All this is to say that the CPI and the inflation rate aren’t perfect numbers, they are best guesses. Economists long to live in an algorithmic universe, because if they did then economics would be a science, but they don’t, and it isn’t. A lot of economics relies on doing the best with the numbers you have and the inflation rate falls into that category.

Low, falling – and going lower?

But here’s the thing. Our inflation rate has been low and falling for a while. Have a look at the chart below. Technically, inflation has been in decline since 2018, when it peaked at a high of 2.1 per cent, which is hardly a shockingly high number.

Click on image to enlarge

But here’s the deal. Low inflation in the long term is bad; zero inflation in the short term is pretty bad; and the evil twin of inflation (deflation) is worse, and here’s why.

Since the end of the Second World War, Australia, like most western economies, has mostly been run by governments which subscribe to monetarism as their primary economic guiding principle. If you don’t know about monetarism you have to look up the work of Milton Freidman (frankly something of a genius) and his alternative, John Maynard Keynes (also something of a genius), and work out which of their theses you think is most correct.

Friedman said the growth in an economy is determined by the amount of supply of money in the economy, which is regulated by the cost of money (interest rates), so government’s primary job is to control the supply of money through the cost of money to achieve a balanced rate of growth. Remember that in Friedman’s time they had seen hyperinflation, stagflation and deflation. These weren’t vague economic ideas to these guys, they were real and they had seen it all: wheelbarrows full of money used to buy bread in the Weimar Republic, and a middle class that was asset rich yet still unable to feed their families. 

The problem in Australia  is that for the past few years our economy has been largely driven by two export groups – mining and agriculture – and to a smaller degree, services like education.

Mining and agriculture prices are driven by demand (who needs coal, iron ore and gas) and the cost of supply. Are we a relatively expensive place to get that from? Or are we cheap? That’s determined by all sorts of things, like quality of the product, how expensive it is to dig up or grow, the cost of labour, the value of our currency, whether or not it has rained, and so on.

And we have been lucky. We have ridden a few booms and a few clever government programs to have the longest run of economic growth ever (not joking: at 27 years, we have the Guinness World Record for economic growth). But that’s over. Its finished. I’m going to be brave and call it done. I may be wrong, but as I said before, economics is not algorithmic.

That sinking feeling

Now the growth phase is over we are facing what the Europeans have been facing since 2007, and the Japanese have been facing since 1992: deflation. When incomes fall (our real wages haven’t risen since 2007) and asset prices fall (in Australia that’s best measured by home prices, and they are trending down) you get deflation.

So, here’s the thing. It seems we are moving from weak inflation to deflation, and it’s the government’s task now to weigh one evil against another.

This is a particularly unfortunate outcome for what I expect will be an incoming Labor government. It’s going to have to balance the wishes of the owners of capital against the wishes of wage-earners to try and get the economy moving again. I make no predictions of success, except to say it’s going to be hard.

To understand why it’s going to be hard, it’s worthwhile listening to Keynes despite the fact he wasn’t the father of monetarism. But he understood it, and in 1923 he started to wrestle with what is now our biggest economic question.

“Inflation is unjust and deflation is inexpedient,” Keynes said, and added that of the two deflation is worse because it provokes unemployment, while inflation disappoints investors.

Those were not his exact words. His language wasn’t the same as ours, even though he was a very fine writer. He tended to refer to investors as “rentiers” – people seeking economic rent. In any case, as I always say: Onward.

Keynes’ logic was that both inflation and deflation are bad because contracts – things like prices set by businesses and Government – are “sticky”, by which he meant that they changed slower than the market changed. He wrote that in 1923 and I’m pretty sure things haven’t got a lot better. We ought to be ashamed of that.

Think about it this way. Rising prices reduce the value of savings and pensions, which makes people worse off; while falling prices push profit expectations and asset prices (like houses) down, increase the burden of debt and encourage the hoarding of capital.

The horse-cart sequencing issue

So that’s why governments favour a slight bias towards inflation, and why most governments can be accused of being “Keynesian” – a term of abuse from your socialist colleagues who decry it as horse-and-cart economics. Look that up; this article is already too long.

Since 2008 in western Europe and America and, let’s be honest, in the most meaningful economies in the world (remembering that the whole Australian Economy isn’t even as big as the Californian economy), wage growth has been zero or negative, and asset prices have been pretty weak.

For reasons known to history, most of the central banks that matter decided just before the turn of the century that a 2 per cent inflation rate was the Goldilocks number (one that is neither too high nor too low) to give consumers confidence, and the right number to stimulate the “animal spirits” of entrepreneurs, it provides what’s called “a stability anchor” for the economies.

Every year since the GFC the US Federal Reserve and the European Central Bank have missed that target, and the dreary old Bank of England has hit the number precisely once.

So now in Australia we face the same issue – the great repricing of assets that America and western Europe experienced after the GFC may have finally arrived. House prices, the costs of businesses and probably real wages are falling, and it looks like we are entering deflation.

So, what does that mean for the idea of a recovery?  Well quite a lot actually and since you’ve stuck with me this long, let’s plunge in.

Real inflation in Australia is different to the rest of the world. Ours tends to be driven by housing, theirs by the cost of oil, but we are a long way from facing that.

What the Godfather of Gloom knew

For a start I want to squash the idea that there is any such thing as “benign deflation”. It is a complete bugger because, to quote Leonard Cohen from the great song Everybody Knows: “Everybody’s talking to their pockets”. It is circumstantial evidence, of course, but some of us think that the great Canadian songwriter was very much influenced by monetarist theory, and he must have been thinking, when he wrote this song, about the suppression of private sector spending in a deflationary situation.

During a period of deflation people stop spending, because why buy something today if it will be cheaper in the future. Economies large and small – unless they are able to reprice input costs (like labour, capital or consumables) – will grind to a halt. And as Keynes pointed out, these contracts are “sticky” they won’t be repriced so money will get stuck in the system.

These aren’t the only things that will happen. For more information read Roger Bootle’s 1996 book The Death of Inflation: Surviving and Thriving in the Zero Era (once again I will lend you my copy). He predicted all of this. In truth, he stole the idea from a 1995 copy of The Economist magazine – but let he who is without sin chuck the first rock, and all that.

Look let me be clear. It’s not like governments all over the world haven’t tried to get their economies moving again, by cutting interest rates (in lots of western Europe the cost of money is already less than 1 per cent) or by running the printing press (the Bank of England has pumped about a trillion Aussie dollars into its system since 2008, and the Fed about $3 trillion) and it has kind of worked.

Source: European Central Bank. Click on image to enlarge

Will history repeat itself?

We don’t know with any great accuracy what this will mean to us. Governments might start spending hard, because that seems to have worked before. They might start artificially inflating wages, which unless there is some compensatory mechanism will affect business quite badly.

One of the areas in which it will have a real and interesting effect is superannuation. Deflation will favour industry funds because they have a very good line to employment growth and a better mix of capital, tending to favour hard assets which are revalued less frequently than the assets held by retail funds. This effect after the effect of the Royal Commission is going to be interesting to say the least.

Interesting because industry funds will be able to turn their attention to SMSF’s which being tilted to cash and property will be hurt by deflation, and to corporate funds – which frankly need some attention anyway.

I want to make it clear that I quite like having a robust retail and industry fund superannuation market. Tension between the two schemes creates a better outcome for investors and consumers are perfectly capable of choosing between a paternalistic management system (industry funds) and an individualistic system (everything else).

But folks, no one working in government or industry really knows, because they have never seen it before, and if they are capable of taking lessons from the economies that have handled it well (like the West Germans) then that evidence is hard to see. And so, as the aging Bette Davis says in the classic 1950 movie All About Eve: “Fasten your seat belts; it’s going to be a bumpy night”.