Deflation and Competitiveness

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.)

15 thoughts on “Deflation and Competitiveness”

  1. I would agree with most of this other than the ‘efforts to cut markups through more aggressive competition policies’.

    if wages and demand reduce will the market not set itself right on prices as there is less money chasing a product/service and thus the price will drop to meet that demand?

    I think that unemployment will go far beyond initial expectations of a maximum of 10% and that will cause quite a slump in demand across the board so no policy intervention is required.

  2. Karl, above, suggests that no policy intervention is required, but even with the public pay cuts, my understanding is that firms in partnership are not cutting wages, and one (the ESB) is raising them at a time of falling prices!

    The policy intervention required is for partnership to be scrapped and for firms to start properly managing (i.e. cutting) their pay bill.

    Also, the public pay levy announced yesterday will be tax deductible for pension relief! Surely this pension relief, for earners paying higher rate of tax (and especially those older) is a shocking waste of taxpayers money.

    The lack of talk in the press about eliminating distorting tax subsidies is alarming.

  3. Its quite clear at this point that entering the Eurozone has been disastrous for the Irish economy. Not only has it contributed to the current malaise (real rates were considerably lower the past few years than predicted by Taylor rule), but its also crippling us in that we cant do anything about it.

  4. I would have thought that a far more politically comprehensible and transparent approach would have been to egage in reverse benchmarking; that is, roll back recent pay deals. There would have been much greater clarity about the moneys saved; there would have been the impact on our broader competitiveness; public sector workers would at least get some political credit for having seen their wages being cut, which would enable us to move beyond the scapegoating; and, as Jer said many comments ago, there would have been a built-in measure of fairness in such an approach, given the way that wage differentials in the public sector have exploded in recent years.

    I would also, for political reasons, impose a cap on all wages in organisations paid for in whole or in part by the tax payer, which at this stage obviously includes the banks and other high profile bodies. 200K seems like a very generous cap to me, one could obviously make the case for a much lower one.

  5. @Kevin O’Rourke – benchmarking should indeed work both ways! the thing that kills me the most is that benchmarking is extended out to those who have already retired! so if a guy retired as LevelX Supervisor, then, 4 years later a benchmark comes in (he is on pension at this stage) he – as a pensioner- gets the benchmark too! WHAT A JOKE! the forward commitments of NPRF are insane, and its vital to remember – this is there solely for public servants not for regular OAP’s etc.

    @Ciaran ‘generated by wage cuts and efforts to cut markups through more aggressive competition policies’ wage cuts are mentioned seperately, efforts to cut markups would imply that it is general market rather than employment specific cuts that are being talked about. I would hold that public sector pay etc. is one thing but the general market must be allowed to function without state distortion.

    @Jeremy – if we were not part of the EU the IMF probably be here right now.

  6. “…no such self-correcting mechanism operates for a country with an independent currency.” Is that because in such a country deflation leads to exchange rate appreciation?

  7. @karl–The fate of countries not able to devalue or use monetary policy to avert a situation like this is pretty dismal. Everyone knows this. In contrast, the rapid recovery of the Asian economies after 1997, for example, was largely due to the subsequent devaluations. No one ever regretted leaving the ERM. It is also a fact that those countries who left the gold standard during the Great Depression recovered relatively quickly. What Im saying is monetary constraint is a recipe for disaster. It is not at all obvious that things would be much worse outside the Eurozone. Deflation is no panacea either: what’ll that do the real value of debt? A devaluation would have sidetracked all of this, and some inflation would be nice too. And lets not forget that the one size fits all monetary policy contributed to the excesses in peripheral Euro countries. I dont think its a coincidence that those countries for whom real rates were “too low” are in the worst situations at the moment.

  8. Nice exposition Philip. I have one query about the logic of your second paragraph. Having wage-led deflation be “self correcting” requires that the competitiveness effect outweigh the real interest rate/increased real debt effects. I think that this condition is likely to hold for a small open economy like Ireland’s. But the high level of nominal debt gives me pause. (You are right that the relative wage effect is a level effect while the real interest rate effect depends on continued deflation. And the deflation will eventually stop. But the real debt effect is also a level effect.)

    In any case, whatever your views on Keynes, it is interesting to re-read Chapter 19 of the General Theory with these issues in mind. He discusses a number channels through which the economy could self-correct via wage deflation.

    He notes the competitiveness effect as follows:

    “If we are dealing wih an unclosed system, and the reduction in money-wages is a a reduction relative to money-wages abroad . . . it will intend to increase the balance of trade. This assumes, of course, that the advantage is not offset by a change in tariff, quotas, etc. The strength of the traditional belief in the efficacy of a reduction in money-wages as a means of increasing employment in Great Britain, as compared with the United States, is probably attributable to the later being, comparatively with ourselves, a closed system.”

    On the increased real value of debt, he says:

    “On the other hand, the depressing influence on entrepreneurs of their greater burden of debt may partly offset any cheerful reactions form the reduction of wages. Indeed if the fall of wages and prices goes far, the embarrassment of those who are heavily indebted may soon reach the point of insolvency, — with adverse effects on investment. Moreover the effect of a loe price-level on the real burden of the National Debt and hence on taxation is likely to prove very adverse to business confidence.”

    As it occurs just above this quote, I can’t resist quoting one more passage. I think the following nicely dovetails with your call for a flexible system of national wage bargaining to secure needed reductions in the wage level:

    “Since a special reduction of money-wages is always advantageous to an individual entrepreneur or industry, a general reduction (though its actual effects are different) may also produce an optimistic tone in the minds of entrepreneurs, which may break through the vicious circle of unduly pessimtic estimates . . . and set things moving again. On the other hand, if the workers make the same mistake as their employers about the effects of a general reduction, labour troubles may offset this favourable factor; apart from which, since there is, as a rule, no means of securing a simultaneous and equal reduction of money-wages in all industries, it is in the interest of workers to resist a reduction in their own particular case. In fact, a movement by employers to revise money-wage bargains downward will be more strongly resisted than a gradual and automatic lowering of real wages as a result of rising prices.”

  9. @Jeremy: excellent points, although I think that the resulting inflation that a ‘new currency’ would bring are disasterous, especially when it is from an economy in trouble – hence all calls to leave the euro are basically bunk.

    we would have to offer huge interest rates to attract bond investment (and be beside luminary economies like argentina/venezuala/iceland etc.) paying for the high rates by printing money and thus huge inflation. for every country which recovered with increased money supply there are three who didn’t get it right and exploded with inflation (yugoslavia, turkey, germany, zimbabwe etc.) which leaves only one other option – deflation

  10. There has been some feedback that my posting suggests that I believe that the wage factor is responsible for high ESB prices. Just to clarify: my posting also recommended tackling monopoly power in the economy and also that the government should address excessively-high administrative prices. Accordingly, I am in favour of structural change in the electricity sector that will lead to a decline in prices, not only via the elimination of the ‘surplus’ component in wages but also via other factors that contribute to the high total price. (I am open as to whether this requires more entry in the electricity market or tougher regulation of ESB or some combination, depending on whether is the production or distribution of electricity.)

  11. The elephant in the room is the debts owed by Irish individuals and businesses. Whether the debt is to other Irish people or, via our deranged banks, to foreign speculators it is clear that deflation will only make their position worse. And even the creditors won’t be too happy, because they’d probably prefer a stimulated economy capable of some repayments, to a dead economy that cannot make repayments.

    This is where I, belatedly, see the benefits of nationalising the banks instead of letting them go bust. The final step in replicating the beneficial effects of a devaluation is to use state banks to give soft loans and forgive portions of debts. I’m surprised at myself for suggesting this, but I don’t see any alternative.

    This obviously requires massive government borrowing, but if we can’t have inflation we need the government to borrow money to forgive debts and to fund stimulus.

    We shouldn’t borrow to subsidize overly large pay packets, as it will further harm competitiveness. So that means that debt forgiveness looks more realistic if we want Keynesian style stimulus and if we want to, in effect, devalue.

    Aaron – amateur armchair economist – don’t take me too seriously 🙂

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