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.

Did the Euro contribute to the Irish bubble?

Jim O’Leary discusses Ireland’s EMU membership in his Irish Times column today.  An interesting question is whether Ireland would have avoided a bubble had it opted not to join EMU.  The issue here is the relevant counterfactual.  Since quite a number of non-member European peripheral countries that were growing quickly for convergence reasons also enjoyed credit booms due to the global decline in risk aversion and compression of spreads, it is not so obvious that staying outside EMU would have delivered stability (think of Iceland and various CEE countries).

If expectations of price appreciation grip the housing market, small differences in the level of interest rates do not make too much difference.  To the extent that high levels of immigration helped to fuel perceptions of strong fundamentals in the housing market, that dimension is orthogonal to EMU:  the two other countries that were early liberalisers were also not members of EMU (Sweden and the UK).

Accordingly, if the relevant comparison set is composed of other non-advanced European countries (in terms of income levels relative to potential in the late 1990s), then it is not clear that EMU was a fundamental factor.   Rather, key differentiating factors may include the quality of banking regulation and the probity of fiscal policy.

Clearly, this is a very open debate that calls for more research!

New Thinking on Fiscal Policy

From the frontiers of knowledge (yes, it’s grading time again): “Fiscal contraction was first noticed in the 1960s by a man by the name of Fiscal and it was him who derived the short, medium and long run effects of it and how they would occur and the reasons for it…” 

What a great opportunity for public transport

This will be a nice case study for future students of business administration. Consider a company that holds a near monopoly in a segment of a market that has been growing by 7.7% per year for a decade. What does such a company need to do to turn a loss?

Bus Eireann and Dublin Bus managed this feat (after subsidies). I will not speculate how and why. But with respect for the workers that are being laid off, I think this situation provides a great opportunity for public transport in Ireland.

Bus Eireann and Dublin Bus need to cut costs. They want to do this by reducing the number of busses on the road and the number of drivers on the payroll. That is their choice. The plan is to trim the schedule. That is wrong. Instead of reducing frequency at selected routes, they should give up some routes altogether. The regulator should then sell the concession on these routes to the highest bidder. (This would not save public finance.) Service levels would be maintained where commercially viable. Competition would lead to lower transport costs. (This would not restore competiveness.) Unemployment would fall (but the incoming operators may prefer to hire other drivers than the ones just let go).

Overall demand for transport is down in any recession, but the share of cheap (i.e., bus) transport is up, so I think there is a business case for bus routes in Dublin.

Over time, the state-owned, subsidised incumbents may get their act together, or they may be replaced by commercial operators altogether.

This post was written in Switzerland, where there is a train waiting at the airport to take you to the university’s doorstep. I landed at 2:30 pm in Zurich and was well in time for my 4 pm lecture in Bern. Zurich and Bern are as far apart as Dublin and Athlone.

Social Harmony and Fiscal Reform

Social solidarity is clearly highly desirable during a period of severe economic and fiscal distress. Accordingly, it is important that the government works out a fiscal adjustment programme that is rigorous but still perceived by the general electorate as distributing the burden as fairly as possible.  Of course, fairness is in the eye of the beholder to some extent but a primary political objective should be to successfully achieve fiscal stabilisation while avoiding social disruption that is now evident in some other European countries. See this article in The Times (London) on the upheaval in Iceland and Greece.