Belfast Telegraph

Thursday 10 July 2014

Everything turns full circle with inflation

It is a sobering thought that almost everything I was told in college about economics is now regarded as downright, even dangerous, nonsense. Fortunately, I was not paying too much attention.

As I was saying the other week, it would not surprise me if some of these ideas came back into fashion after the havoc wrought by uncontrolled financial markets.

Government borrowing is already quite popular in some unexpected quarters as a way of easing the pain. But if there is one area one would choose as ripe for an intellectual makeover, it would be inflation.

This is because ideas about inflation have always seemed to be more fluid and uncertain than ideas on just about anything else.

We still seem unsure about what exactly counts as inflation, how it is caused, or what to do about it. The one thing we can be sure of is that it's back, with consumer prices currently rising at 5%, and last year's overall average of 4.9% the highest since 2001.

Some old college nonsense is back too, as pay talks loom. The Henry Ford argument ("I pay my workers well so that they can buy my cars") is enjoying a new vogue.

With the economy slowing, we must not curb consumption further by having wage increases below inflation, goes the line. It's a long time since I heard that one. The Government could indeed do a bit to stimulate the economy by borrowing more, to give its workers a generous pay rise.

Whether that is quite the fairest place to spend its borrowed money is another question. For one thing, employers will be more concerned about saving their businesses than stimulating the economy, and are highly unlikely to match any government generosity when it comes to their workers.

Let's hope not anyway. Whatever the short-term benefits of large pay rises on consumption, they seem certain to be outweighed by the longer losses on taxation, growth and employment.

Contrary to popular belief, though, the level of pay rise may not make that much difference to inflation in Ireland.

Milton Friedman may have exaggerated when he said inflation is always and everywhere a monetary phenomenon, but there are strict limits as to how much control a small economy in a currency union can have on its rate of inflation, even one with a government which takes its responsibilities seriously.

Recent Fianna Fáil-led governments took their responsibilities seriously. Their excuse for ignoring — even inflaming the boom —was the Greenspan defence: inflation was low so there was no need to do anything about the booming economies, despite clear signs of stress and excess in both.

It is already apparent that Fianna Fáil and the Fed were wrong. The many factors which delivered the low inflation — falling prices for Chinese manufactures, cheap oil and, particularly in Ireland's case, low interest rates — were all temporary phenomena which have now vanished.

A couple of old ideas may make a justified comeback as a result. Veteran Financial Times commentator Sir Samuel Brittan has revived his idea that central banks should pay more attention to the "nominal" growth of the economy, measured in cash terms.

Looked at in this way, Ireland's average nominal growth of almost 9% in the four years to 2007 might have been taken as a warning sign. In the Republic we no longer have an interest rate-setting central bank, which leaves the onus on the Government and its budgetary stance to do something about it.

Fiscal management of this kind is also an old, deeply unfashionable, idea. It has limitations, especially in a small open economy, but running pro-cyclical budgets, as the last two governments did, is even more dangerous in a currency union where there may be no correlation between the state of our economy and the European Central Bank interest rate.

Governments are less inclined to be found wanting when economies are slowing, being much quicker to increase borrowing when growth is below trend than to raise taxes when economic expansion is above trend.

We will certainly see bigger borrowing in Ireland as growth falls, but the precise amount of the Budget deficit is likely to be a subject of heated debate. That debate, as well as about pay, might usefully take up Sir Samuel's point, and concentrate on expected nominal growth rather than inflation.

Actual inflation is largely out of our control and hugely volatile, ranging from a low of 2.2% to a high of 4.9% in the past five years.

Nor is Ireland having a particularly bad inflation experience right now. Everyone is. On the EU measure, Irish inflation averaged 2.8% over those five years, versus just over 2.1% in the euro area as a whole. The gap has narrowed since, with Ireland's 3.5% rate in February only just ahead of the euro area's 3.2%.

Compare that with 2000-03, when the EU measure for Ireland averaged 4.5% — more than double the euro area rate. The main cause was the weak euro.

A well-proven old idea is that currency movements are the biggest single determinant of Irish inflation. I would wager that the euro's current strength will be reflected in lower Irish inflation in due course, and it may well be back to around 2.5% next year.

There is not much sign of it as yet. As with governments and their budgets, firms are slower to pass on currency savings to customers than they are to offload rising costs with higher prices.

The best way to do something about that is to foster maximum competition, especially in the domestic market. As the OECD again complained last week, there is a great reluctance to do so.

This is hardly surprising. When it comes to more competition, the social partners — government, employers and unions — are of one mind. They are agin' it — proving once again Adam Smith's assertion that such people rarely meet without indulging in a conspiracy against the paying public.

Brendan Keenan writes for the Irish Independent

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