David McWilliams has expressed concern about the risk of deflation in Ireland and recommends that we “engineer inflation by pumping money into society”: you can read his article here.
For a member of a currency union, there is a natural limit to national-level deflation. Ireland may well face a sustained period of inflation below the euro area average (such that it may be negative in absolute terms for a while), this is self-correcting since it implies an improvement in competitiveness, which will in turn generate a boost in economic activity and a return to an inflation rate at around the euro area average. In contrast, no such self-correcting mechanism operates for a country with an independent currency. So long as the ECB avoids deflation at the euro area level, a true deflationary spiral for Ireland is not possible.
Of course, even if deflation (or low positive inflation) is just a temporary phase for Ireland, it can last for several years. It certainly amplifies the extent of the downturn, since it implies the real interest rate (the nominal rate minus the expected rate of inflation) will be high. This is the mirror image of amplification of the boom period that was generated by the low real interest rate during our prolonged period of relatively high inflation.
One lesson is that it is much better to have a sharp fall in the price level now (generated by wage cuts and efforts to cut markups through more aggressive competition policies), rather than a gradual decline in the price level over several years.
It is worth remarking that the structure of the national pay deal does not provide the appropriate kind of ”incomes policy” that can help this process. In particular, deviation from the national pay deal is only permitted if a firm is in very serious financial distress. Rather, we need cost reductions even in sectors that are still profitable, since prices of all goods and services matter for the level of competitiveness.
A good example is the ESB. It would be very useful to see wage correction in this sector, which will help to reduce input costs for many businesses.
Another way to express this point is that the national pay deal can accomodate firm-specific shocks but not macro-level shocks. To respond to macro-level shocks, the national pay deal should be re-negotiated to allow a generalised reduction in costs across the economy. (As a complement, competition policies could be reinforced and ‘administered’ prices could be forced down.)