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.)

Some Progress in Understanding Fiscal Impact of Pension Levy

As reported by today’s Irish Times, the tax offset means that, while the pension levy saves €1.4 billion in gross terms, the tax offset means that the net saving will be €900 million in a full year: the explanatory articles are here and here. However, according to the Irish Times report, the loss in tax revenue as a result of the levy was already factored into the previously-published tax projections of the government. Accordingly, it is the gross €1.4 billion that is relevant in getting to the target of  €2 billion in savings.

Historical source material

As an economic historian, I want to make life easier for my future colleagues of some decades hence. In that spirit, here are links to some primary sources that make interesting reading even today.

Back to the banks

The policy pendulum looks set to swing back to dealing with credit flow in the banking system.  With so many policy proposals floating around internationally, I would be very interested to hear current views on the best policy course for the government. 

 Taking it as given that there has been a severe contraction of new credit, how much is due to: (i) a collapse in the demand for credit as firms and households repair balance sheets; or (ii) a collapse in the supply of credit?  

 Under (ii), is the main reason for the decline in supply: (a) the declining creditworthiness of potential borrowers; or (b) the risk aversion of bankers as they teeter on the edge of insolvency?

 It seems to me that if the contraction is mainly driven by some combination of (i) and (ii a), the government would be wise to limit the additional fiscal commitment.   A large package would further tighten the fiscal solvency constraint and force a more rapid fiscal correction. 

 The case for a large package seems more compelling if the credit contraction is being driven by the caution of the bankers.   Whatever the size of the package, what is the proper balance between re-capitalisation, insurance for new credit flows, troubled asset purchases, etc? 

French balloon shot down over Berlin

Predictably, if sadly, Sarkozy’s idea of a Berlin summit to discuss what should be done if a Eurozone member were to get into trouble has been dismissed by Berlin. Discussing such things ex ante, on a purely theoretical basis of course, will turn out to be preferable to discussing them ex post, if ex post ever arrives. The German reasoning is that some things just shouldn’t be talked about in public:

A Berlin, un porte-parole du gouvernement, Thomas Steg, a estimé qu’une telle rencontre n’est “pas nécessaire dans l’immédiat. L’expérience nous a appris qu’il y a certains sujets relevant de l’Eurogroupe dont il vaut mieux ne pas discuter en public”.

Whether saying publicly that there are certain things that you shouldn’t talk about publicly is in fact reassuring, is probably something that one could debate.