ECONOMICS:Ireland's exports and price competitiveness will only improve if we continue the painful process of deflation, writes ANTHONY LEDDIN
IN DESIGNING a strategy to end Ireland’s “great recession”, one possible solution is to do the mirror opposite of what happened during the 2001-08 period.
A key cog in the economic wheel during this period was the real effective exchange rate. This variable summarises the movement of Irish prices relative to prices in 56 of our main trading partners taking into account trade share, price (wage) levels and exchange rate fluctuations.
It is the most comprehensive indicator of the trend in Ireland’s price competitiveness and an important determinant of the trade balance (exports minus imports).
Between September 2000 and April 2008, the real effective exchange rate rose 40 per cent implying a significant loss of price competitiveness. On a bilateral basis against Britain and the United States, there was a 51 per cent and 94 per cent loss of price competitiveness respectively.
This put Irish exporters and import-competing firms in an impossible situation. Not surprisingly, net exports fell from a surplus of €226 million in 1999 to a deficit of €10.124 billion in 2007.
There were three main factors behind this appreciation of the real exchange rate. First, the appreciation of the nominal euro exchange rate. Second, the pro-cyclical fiscal policy pursued by successive Irish governments. Third, the increase in investment in building and construction fuelled by negative real interest rates.
The second and third factors led to a general overheating of the economy, which manifested itself in wage and price inflation far ahead of that recorded by our main trading partners.
Normally, a fall in net exports of this magnitude would be sufficient to slow the economy down if not create a recession. However, investment in building and construction offset the fall in net exports and, over the period 2000 to 2007, the average real growth rate was 5.6 per cent and average unemployment 4.4 per cent.
In effect, the property bubble disguised the deterioration in price competitiveness and net exports, and gave the impression that, overall, the economy was performing satisfactorily. When the unsustainable property bubble eventually burst in 2008, the result was an unprecedented economic collapse.
Since 2008, this set of events has largely repeated itself but in the opposite direction. The euro has weakened on foreign exchange markets (despite some recent signs of renewed strength), the Government has introduced a set of deflationary fiscal policies. Price deflation has ensured high real interest rates and, in conjunction with the property implosion, a significant decline in investment. Also, in response to the harsh discipline of soaring unemployment, wage restraint here has been greater than in other euro zone countries. As a result, the real effective exchange rate fell 13 per cent between April 2008 and May 2010. Net exports, in turn, rose from minus €10.124 billion in 2007 to minus €4.853 billion in 2009 and the latest quarterly data is showing continued improvement.
What this indicates is that the economy is undergoing an automatic, albeit slow and painful, self-correcting process via deflation. This has improved competitiveness and the net export figure is responding.
The process has, however, some way to go. The real effective exchange rate needs to fall another 15-20 per cent to achieve the degree of competitiveness prevalent in 2000.
Given the euro exchange rate and inflation in our main trading partners, recent developments are not encouraging. Annualised CPI (consumer price index) inflation fell from plus 4 per cent in November 2008 to minus 6.5 per cent in October 2009. Since then deflation has subsided and inflation of 0.7 per cent was recorded in the 12 months to October 2010. Annualised HICP (harmonised index of consumer prices) inflation has not been as volatile. It fell to minus 3 per cent in September 2009 before rising to minus 0.8 per cent last month.
Commentators who see this as an end to deflation and a sign of economic recovery are reading the situation incorrectly.
So far, the Government has failed to communicate to the public how deflationary fiscal policy is going to facilitate recovery. Successive deflationary budgets are seen as an attempt to curtail the budget deficit and appease the financial markets. The inevitable consequence is deeper recession and more unemployment. However, in so far as the cutbacks result in lower prices, the economic recovery channel is via improvements in price competitiveness and a rise in net exports. Any fiscal measures that increase prices, on the other hand, will be a retrograde and harmful development.
The deflationary fiscal stance can also contribute to recovery by rebuilding confidence among consumers and investors, who are still scared at the prospect of national bankruptcy and, as a result, keeping their wallets and purses tightly closed. The national saving ratio has risen steeply as households and businesses reduce debt – which is only prudent given their fears about the state of the nation, but does nothing to restart economic growth.
The Government intends taking about €6 billion out of the economy in the forthcoming budget. The measures introduced must satisfy at least two criteria: reduce the budget deficit and continue to help moderate Ireland’s still startlingly high cost structure.
As things stand, the Government has no inflation policy. What the Irish economy needs now is more deflation from the public sector as a means to facilitating stimulus from other sectors – exports and private consumption.
Dr Anthony Leddin is head of the department of economics, University of Limerick
