Restoring competitiveness through greater productivity is the only sustainable remedy to our high rate of inflation, writes Danny McCoy
The Central Statistics Office (CSO) yesterday published its updated methodology for calculating inflation. The adjustment to the basket of goods and services on which inflation is based occurs every five years and reflects changing consumption patterns. The make-up of the new basket of goods and services confirms some of the recent trends in Irish society.
People now spend a much greater proportion of their disposable income on services rather than on goods. In particular, services such as dining out, entertainment and leisure, and personal care are all now consumed in much greater volumes.
The new basket also demonstrates a number of trends which might surprise some people.
We now spend proportionately much less of our income on alcohol and cigarettes than we did five years ago. Housing costs have grown as an expenditure item but not by as much as most people would have expected.
Long commuting distances mean that transport now accounts for a much greater proportion of total expenditure. Health and education are also larger expenditure items than they were five years ago.
There is a very clear Government fingerprint on many of the items which are increasing their share of expenditure. Areas where broader government policy can have significant impact such as housing, transport, health and education are all eating up more of our disposable income.
The re-weighting of the items used to calculate inflation also provides a timely opportunity to review how inflation is measured in Ireland and the impact which this has on our international competitiveness through influencing wage expectations. The CSO's headline inflation measure tells us that on average consumer prices increased by 4 per cent last year.
When we measure inflation using the approach applied elsewhere in the EU, inflation was 2.7 per cent. Other EU countries use the harmonised index of consumer prices which exclude mortgage interest and insurance services for instance.
While the Irish measure of the harmonised index of consumer prices remained somewhat above the euro area average of 2.2 per cent, it provides a much more accurate reflection of price trends in Ireland relative to those in other EU countries.
Movements in the EU harmonised index influence interest rate decisions by the European Central Bank and wage movements across many of the countries which we compete with to sell our goods and services. By continuing to emphasise an inflation measure which is different to that used elsewhere in the EU, Ireland can potentially put itself at a significant competitive disadvantage by engendering higher price expectations.
Irrespective of the inflation measure used, it is clear that excessive cost increases in Ireland remain a threat to economic stability. Over the past five years wage growth here has been more than double the EU average. From a business perspective this has led to a rising relative cost base and a loss of market share in international trade.
High wage growth underpinned by high productivity growth would improve the standard of living for workers. However, high wage growth, without commensurate productivity improvement, ultimately leads to higher inflation and the increase in pay is largely given up in the form of higher prices for goods and services. As firms struggle to compete on international markets due to their higher cost base, company closures and redundancies are likely to follow.
While a range of individual company circumstances led to some of the high profile redundancy announcements in recent weeks, a common theme in many of the company closures has been Ireland's rising cost base. For workers, not only does high wage growth in tandem with high price inflation fail to yield any real improvement in spending power but ultimately it could well cost them their jobs.
The recent economic history of Germany provides a lesson towards restoring Ireland's cost competitiveness. Germany's GDP growth in the final quarter of 2006 was the second highest since reunification.
Moderate wage growth and low inflation have been key to Germany's recovery. Average wages in Germany have increased by just over 9 per cent since 2000 - in Ireland wages have increased by 38 per cent over this period. Many German firms boosted productivity by negotiating longer working hours with workers without additional pay.
It therefore comes as no surprise to see that Germany's export performance is going from strength to strength, while Ireland continues to lose market share in international trade. The road to low inflation might not be without its bumps. With services now taking a greater proportion of the consumer's basket, this more labour-intensive sector's prices are significantly determined by wage growth.
Higher wages will beget higher prices unless justified by productivity growth. The current high inflation rate is a common enemy to all. Restoring competitiveness through greater productivity is the only sustainable remedy.
Danny McCoy is director of policy at employers' group Ibec