Deflationary spirals

It appears that the fear of a deflationary spiral is being used as a major argument against wage cuts. My impression is that the idea is gaining traction out there in the real world, and so it seems worthwhile restating the reasons why it is wrong.

‘The’ price level in the Irish context is the European price level, which is determined by policy in Frankfurt. Nothing that happens in Irish labour markets will move this price level by one iota in either direction, and so nothing that we do here will set off a deflationary spiral. What we can influence is a relative price, namely the relative cost of living and doing business here. This relative cost exploded during the bubble, and it will eventually come down. The only issue is whether this happens quickly, or whether relative Irish costs will be ground down by unemployment and stagnation over the course of many years.

David Begg is right to fear a deflationary spiral, but what will determine whether we get one or not is the relative supply of ideologues and pragmatists in the ECB, not anything that happens here. And the sort of intertemporal logic which explains why deflation is so damaging can be turned on its head in the Irish context: as Philip points out, it implies that wage cuts need to happen all at once, now.

The Government should announce that all public sector wages, which it controls, be cut by x%, where x is determined by real exchange rate considerations. It should strongly suggest that all private sector wages be cut by the same amount. Ideally we would all jump together, and so the wage cuts would come into effect simultaneously on a given date. St Brigid’s Day would seem appropriate.

25 thoughts on “Deflationary spirals”

  1. An explicit recognisable and real cut in public sector pay is important for three reasons. First it demonstrates a clear commitment by Government to address the public finances. Second it will encourage a cut in private sector wages. Third, it will improve competitiveness. What d o we get some? Some vague mutterings about a pension levy for public sector workers. I’m not hopeful…!

  2. Kevin,

    The thing with an x% cut across all public sector wages is that targets those who did well from the pay increases but forgets about those who did very very well. I am thinking of the examples where senior servants got twice the rate of increase as lower grade servants. Should there not a straight row back on the rate of increaser. If I were a civil servant who gained a 8% increase while my cadre of senior management gained 16% in the same round of increases I would have concerns.

    As Philip Lane pointed out a few days Social harmony and fiscal reforms cant be separated.

  3. You first.

    My god you guys really should go back to school and learn about scams. I know there are individual economists of immense integrity, but as a profession, you really have some explaining to do.

    For the first act, you gear up society with monstrous debts. Load em up, load em high. And then when the s$%t hits the fan, tell them it’s all their own fault, they expect too much. And so not only do they have to pay their debts, but they have to do so with a cut in wages.

    So I say, your wages first.

    Some observations from my non-economist perspective:

    1. the problem with the public finances is structural. There are insufficient taxes on non productive wealth and high aggregate income.

    Pay cuts will produce minimal return to the exchequer, as it will reduce income tax, increase social welfare, and reduce consumption.

    The solution is obvious: Raise taxes on wealth.

    2. Private sector wages are not the problem. It’s disingenuous to suggest they are.

    I’ll defer to Prionsias Breathnach who wrote in the Irish Times:

    ‘According to Forfás data, payroll costs accounted for just 11 per cent of the total costs of foreign manufacturing firms (which produce over 90 per cent of industrial exports) in 2007. The reduction of five per cent in nominal wage costs (as some have suggested) would in fact only reduce their total costs by about half of one per cent.’

    So it must be the case that our cost base is too high due to: protected professions – I can think of an economist or two who should be sacked for giving rotten advice; underinvestment in critical infrastructure – public transport, broadband; lack of investment in social and public goods – e.g. childcare; property – uh oh, there’s a can of worms; productive innovation – ah we don’t need that, they’ll take a wage cut.

    Proposed solution 1. restructure the tax base to facilitate:

    a. investment in infrastructure, both public and private,
    b. the direction of resource consumption, and ultimately minimize it.

    Proposed solution 2. tackle the professions, stop listening to the ideologues (you know who you are)

    Also, would you care to respond to Prionsias Breathnachs assertion that ‘a policy of pursuing competitiveness through wage reductions inevitably means low living standards. Those who advocate such a policy never explain why the most competitive economies in the world are the ones with the highest pay levels and living standards.’

    Is it a case that we’re not a competitive economy. That the economic profession blinded by it’s delusions has directed us to a tax base insufficient to pay for appropriate education and critical infrastructure, .

    Don’t you think a little bit of navel gazing would be appropriate at this particular juncture.

  4. I have never really understood how the term “spiral” applies to an economy. Commentators used to say that Japan was caught in a deflationary spiral. Certainly Japan had problems because of deflation and the zero lower bound on nominal interest rate, but in what sense did that economy spiral downward? In the limit, does real GDP go to zero? For sure there are propagation mechanisms and reinforcing factors that increase the effects of a given shock, but spirials?!

    Kevin, you asked some time ago in relation to pay cuts whether we could do better than pulling numbers from the air to put a value on x. My sense is that there seems to be a consensus that x should be around 10 percent. Too big, too small, or just right?

  5. Kevin, I agree with your position on wage cuts. And Alan’s 10 percent suggest sounds about right. But I’m not so sure about your delflation argument. What matters for Ireland’s real interest rate is Ireland’s expected inflation rate. While for the very long term this might be anchored at the ECB’s 2 percent target, the Irish rate could deviate for an extended period of time. To the extent that wage policy affects the inflation differential–which seems plausible enough if the demonstration effect to the private sector works as hoped–won’t that affect the real interest rate? We also have to worry about the effect of negative inflation on the real value of debt. Bottom line: wage cuts look like good policy on balance, but we can’t completely dismiss the deflatioary expectations channel. Maybe others know of more direct evidence of the tradeoff between the competitiveness and deflationary effects.

  6. Folks proposing a private sector wage cut should get out more. It has been under way in construction for over a year and is now propagating through the financial sector, accounting and law firms (the recession comes to Dublin!) into retail and hospitality industries. Many have seen their pay cut to zero (it’s called unemployment). Has anybody got data on what is happening to private sector pay?

  7. Jer, I guess the point about an across the board cut is that it is easy to agree on one number. But yes, an alternative would be to row back on a couple of agreements, including Buckley and so on, and I don’t think as an economics professor I am in a position to object to that.

    Colm: delighted to hear we are so flexible! Yes, it would be nice to get data.

    John: is the answer to your question that we need to get the price cut out of the way as soon as possible?

  8. Liam queries the importance of wage levels for international competitiveness.

    The key here is to distinguish between shifts in the labour demand schedule (the relation between wages and the level of employment) and movements along the schedule. Of course, a given level of employment can be associated with a high level of wages if labour productivity is sufficiently high. Accordingly, we can all agree that better education, innovation, management and all other factors that increase labour productivity is highly desirable.

    However, for a given level of labour productivity, it is still the case that the labour demand schedule has a negative slope: a cut in wages for a given level of productivity should boost employment.

    Accordingly, it is perfectly consistent to advocate a wage cut (a movement along the labour demand schedule), while also supporting policies (education, infrastructure, etc) to boost labour productivity (an outward shift in the labour demand schedule).

  9. Alan, I still haven’t heard a compelling reason why 10% is the right number. Maybe it has been arrived at by looking, not at the unemployment crisis but at the government financial crisis, and by deciding that €2 bn is what we want to save this year. (Although as Brendan pointed out, if that were the logic we would need more than a 10% cut.) Maybe it is just a political sense that it is easy to coordinate around nice round numbers. But Jer’s suggestion is also one that the punters should be able to easily understand. None of this has much to do with competitiveness or unemployment though, and I haven’t seen any hard analysis of what is required on that score.

  10. Rowing back, as mentioned above, has seemed to me to be quite a good way of framing this. It suggests (rightly) that, in many macro respects, “we were OK” until a few years ago and then lost the run of ourselves. Of course not everything can be undone, but some things can.

    As I passed the Mansion House this morning, I was actually shocked to see a Mercedes with reg no. 09 D 1. The need for rowing back has not sunk in yet in some quarters.

  11. Kevin, to answer your question above, I agree that bringing Irish prices and costs down quickly is the best approach. But I think that even under the best circumstances it will take a few years of below
    European average inflation (and indeed negative inflation) to restore competitiveness. There is no getitng way from the fact that the deflationary expectations channel will be a work during this time.

    I think the current state of the housing market is an extreme if somewhat special example of deflationary expectations at work. Nobody is buying because everyone expects prices to fall further. This freezes up a significant chunk of the economy. A long-drawn out decline to (or below) fundamental values is extremely damaging. Although Frank Barry previously had some harsh words for some of the older fundamental value estimations, I think there would be a lot of value in credible–to the extent that is possilbe in such an uncertain environment–studies of current fundamental values. This might help cooordinate expectations, speed adjustment, and prevent a damagingly drawn-out deflationary process.

  12. Our exports have continued to grow despite the real appreciation of the euro. This suggests that we need to know more about the determinants of export prices in Ireland. To the extent that the import content of our exports is high the exchange rate depreciation might not necessarily foster exports. It is however clear that public sector pay cuts would help to restore sustainability of public finance which is key to restoring macroeconomic and financial stability.

  13. Excuse the heresy, but I would question whether our competitiveness is nearly as bad as you would assume reading this blog (though this doesn’t argue against nominal wage adjustment to get a lift from exports isn’t desirable).

    Ireland’s transformation from an electronics export base to a services/pharma base over the last decade has been genuinely impressive. Further, according to the NCC report and some work I have done, our ability to attract FDI remains strong – see the NCC graph 3.03 which shows that we are second only to Singapore in terms of attracting Greenfield FDI, and are 5x the OECD average. Finally, wages costs in Ireland do not appear to be out of line with the rest of the EU when social security costs are included (though public sector pay is way off). Even the IDA is saying that their pipeline remains strong. The strong argument for nominal wage reduction to boost competitiveness to me is on the indigenous exporting side.

    What is also out of line is non-pay costs, which results in business costs being ok-ish in Ireland (as pay is 2/3s of costs) though consumer prices are relatively high (consumers don’t have employees). Which poses the question – why if wages are ok-ish, are prices out of line? Either productivity or monpoly rents in locally provided services are badly out of kilter. Which suggests that more intellectual effort should be placed in reforming private local services, and that the public sector is far from the only sector that needs examination right now.

  14. Kevin:

    I think David Begg is being strictly Keynesian in his use of the phrase “deflationary”. He implies a sticky-price world in which the fall in aggregate demand resulting from a wage cut would lead pari passu to a fall in domestic output and employment. While the small open Irish economy obviously does not fit this model exactly, the fear of a demand-led downward spiral (sorry Alan!) cannot be entirely dismissed.

  15. I was thinking about Colm’s private sector wage cuts some more. There would be a great Masters thesis here if there were the data. My bet would be that the extent of wage cuts will turn out to depend on the sector (sheltered vs non-sheltered) and on the size of the establishment. But of course I could be completely wrong.

  16. John: another thing that I guess would help speed adjustment in the housing market is accurate data regarding prices. This surely ought to be a priority.

  17. As one of the few Liam’s in the Irish Economics academic world (only two others that I know of), I should probably point out that the current Liam commentating is not myself. Excellent blog!

  18. By the way, although no downward domestic price “spiral” of any great significance is possible, let’s not exaggerate the degree to which the single currency unifies the price level and inflation rates. You only have to look at the early years of the euro when our inflation was quite a bit higher than rest of Europe: presumably it could be quite a bit lower for a while.

  19. AFAIK the 09D1 Merc is a long standing gift for a year from a major garage to the mayor. As to whether garages should be so doing, I demur.

  20. we need more articles about what deflation is and isn’t, a change in asset prices (particularly when over-valued) is not deflation. The fact that i paid less for a digital camera is this year than in 07 equally is not deflation, are the same people screaming ‘deflationary spiral’ when oil prices dropped from $146 a barrel? no they are not.

    an element of deflation is actually what is required in order to return to a well balanced economy, a total collapse in demand would be catastrophic but if you accept that demand can exist at some level (which was a key element of the Great Depression – it basically didn’t) then the deflation call is nothing more than fear mongering at its worst.

    @kevinorourke – private sector wages cuts: from what i can see in financial services it’s a slaughterhouse at the moment, many would rather a ‘wage cut’ than what they are actually getting – which is the door.

  21. Deflation is a generalised (it affects all prices), persistent (a number of years) and expected decline in the level of prices. A temporary decline in the level of prices, even negative inflation necessary to bring the prices to a new (lower) equilibrium is not deflation, it is disinflation. I can provide evidence that not all prices are falling in Ireland. I have recently noticed that the price of the Air Coach bus ticket has increased by 14.3 %.

Comments are closed.