Inflation, disinflation and deflation

This article was published in the Malta Independent on Sunday - 04 05 2014

The divide of the euro area countries, between the strong core and the weak periphery (with Malta being an exception: a speck of core on the periphery), is now showing up in the debate about the risk of the euro area falling into secular low inflation (or into outright deflation), or whether this is a temporary phenomenon that will unwind and restore healthy equilibrium across the whole euro area.

All euro area countries are experiencing an extended period of low inflation showing a marked departure from the “close to but below two per cent” official target of the European Central Bank (ECB). Strong core countries, Malta included, are experiencing inflation of around one per cent whereas the weak periphery countries are close to zero and some, like Spain, are recording negative inflation, i.e. falling consumer prices.

Some readers may question this concern about low inflation when we spent the last quarter of the last century fighting high inflation. Should we therefore not be celebrating the achievement, rather than worrying about it? The answer to that is, as almost always, it depends.

Low inflation or indeed falling prices could be both a blessing and a curse.

If low inflation or falling prices result from positive supply shocks then it is a blessing. Following the industrial revolution of the late 19th century, great leaps of productivity led to increased supply of consumer goods at cheaper prices giving consumers better choices and value for their money. That certainly is a blessing which stimulates consumer demand and leads to economic growth and job creation as a welcome bedfellow to falling prices. 

Take the drop in our utility rates. Surely these will eventually work their way to lower readings in our domestic inflation, but equally surely no one should be complaining about it. That is a positive supply shock, leaving purchasing power in consumer’s pockets which will be spent on other consumables, giving a stimulus to demand and leading to economic growth and job creation.

On the other hand, if low inflation or outright deflation is a result of demand shocks, then that is the curse and if prolonged could be difficult to reverse. The lost decades in Japan following the bursting of the eighties’ speculative boom, clearly demonstrate as much.

Countries in the euro area periphery, Greece, Ireland, Portugal, Italy, Spain, Cyprus and Slovenia have been forced to address their fiscal stress by crushing internal demand. Higher taxes and harsh expenditure cuts drained purchasing power from consumers’ hands. As a consequence, their economies shrank, unemployment exploded, especially among young people seeking their first job, and prices stagnated or indeed started to fall.

The core countries argue that the situation is worth watching but it calls for no intervention. They maintain that their low inflation is mostly virtuous and was the result of lower energy and food costs and the periphery countries should persist with their painful restructuring as this would eventually restore their competitiveness and lay the foundation of export-led economic growth and job creation.

The periphery countries do not dispute the need to persist in their restructuring process. But they argue, with good reason, that low inflation and falling prices make their task much harder, giving the impression that they are running on the spot with little to show to maintain democratic support for the pain of restructuring. With so much pain and so little gain, the risk is that the electorate could lose their staying power with painful restructuring and could be lured by false prophets from the extreme right and left, who promise easy, populist but unreal solutions.

The upcoming MEP elections could be the democratic signal that the divide between the core and the periphery, if allowed to fester, could prejudice the democratic foundations of the EU and the euro area. If, as expected, extreme parties gain significant representation in the formation of the next European Parliament, it could send a strong signal to core countries that allowing periphery countries to stew in their pain with little real support was a grave miscalculation. It threatens the sustainability of so much of the good that has been achieved. This is not in anybody’s interest, and most of all not in the interest of core European countries.

Caught in this debate is the ECB as the only pan-European institution that is empowered to act swiftly without the heavy baggage of the slow institutional decision making of EU structures. The German-led core is putting pressure on the ECB to sit this out without adopting non-conventional monetary measures that helped the US and the UK manoeuvre their way out of the recession better than the EU. The periphery countries are demanding that the ECB takes preventive measures to address the risk of deflation which could kill demand just when their economies are showing some signs of stabilisation, even if it is stabilisation at low levels. If falling prices become a mindset for consumers, they postpone consumption expecting to buy cheaper tomorrow than today, leading to a dangerous deflationary spiral.

If the April reading of inflation shows no progress in the dismal euro area average inflation 0.5% p.a. of March 2014, the argument of the periphery should gain weight and force the ECB into action.

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Second time right for public transport

The first attempt to provide this country with an efficient public transport system was a dismal failure.  But it was a failure of execution not of principle. It is the same experience we had with privatisation of postal service. The first attempt with Posta Limited was a miserable failure. The second attempt with MaltaPost proved a success. So many good ideas are destroyed because of bad execution.

It is imperative for success of the second attempt to ensure that it meets three criteria:

1. The route network must be well thought out with sustainability in mind but ensuring timeliness and efficiency.Better to sacrifice some route frequency and coverage for punctuality and reliability.
2. The commercial underpinning must rely on cheap bus fares to generate revenue growth from volume rather than price increases.
3. To achieve these objectives the service has to be subsidised, possibly on a decreasing scale as confidence in reliability augments its usage.

An interesting experiment is going on in the state of Oregon in the US. Taxes on fuel are being reduced but drivers of private vehicles are being charged per mile driven on state roads through electronic billing. Technology now permits such devices especially in a small place like Malta.

We should not remove taxes on fuel as that would lead to waste and unintended subsidies for energy uses outside public transport. But we can switch our annual licence fees to a usage scale rather than a flat charge irrespective of usage. This would also permit the flexibility of charging differential tariff for different time segments, high in the rush hours and low or zero in the easy traffic hours. It would also permit different tariffs for different locations to distinguish between traffic hotspots and other areas without congestion.

In the end, once a reliable and efficient public transport service is in place, the burden of the necessary subsidies could be shifted from the general taxpayers to those who continue to prefer private transport