David Begg criticises the ‘deflationary’ strategy in an article in today’s Irish Times (you can read it here). In reading this article, it is helpful to remember that the term deflation requires subtle interpretation for a member of a monetary union. In particular, the main substantive issue is whether real devaluation is a necessary part of a recovery strategy, where real devaluation means a decline in relative wages and prices in Ireland relative to our trading partners. For a low-inflation monetary union, an individual member country may require a temporary period of deflation in order to attain a significant real devaluation.
David Begg argues that there is little evidence that deflation facilitates recovery. However, there is a strong body of evidence that real devaluation is helpful. Just taking Irish economic history, the devaluations of 1986 and 1993 were contributory factors to economic growth.
It is certainly true that the global recession means that the level of external demand is low. It is also true that the re-orientation of spending in the world economy towards Asia and away from the United States does not help Ireland, given the nature of trading patterns. However, these external factors simply underline the scale of the negative shock that Ireland is enduring.
It is also true that high levels of household debt means that deflation carries an extra cost in terms of raising the real burden of debt repayments. However, the single biggest risk factor in debt repayment is unemployment and a strategy that minimises the growth in unemployment through the restoration of competitiveness dominates.
The real question is whether there is a credible alternative. If Ireland had run a counter-cyclical fiscal policy during the good years, there may have been room to do more in terms of counter-cyclical fiscal expansion now. However, the scale of the fiscal deficits and the fragile state of international bond markets mean that significant fiscal expansion cannot be entertained.
Rather, the focus has to be on restoring international competitiveness through real devaluation (plus other measures to fight monopoly power in the economy and improve productivity). This will stimulate not only the export sector but also the domestic nontraded sector, since the level of domestic consumption will be boosted if Ireland can establish a sustainable growth path. In relation to the export sector, the gain will not only be in terms of the performance of existing sectors and firms but also in relation to the ‘extensive margin’ (new firms exporting for the first time, sectors emerging as internationally competitive). In turn, suppliers of domestic services to these firms will gain, such that the employment impact will be wider than just the export sector itself.