The fallacy of competitive deflation

Michael Burke: One of the key planks of government economic policy is the notion of 'competitive deflation'. It has another airing here, where it is argued that, given Ireland's membership of the Euro Area, it is the least worse option available.

The idea of competitive devaluation (or internal devaluation in a single currency area) is a simple one; the local economy is in the mire, there is nothing we can do about monetary policy - interest rates or the exchange rate, and the only way to boost the economy is to increase exports. Of course, this completely ignores the role of fiscal policy. Other countries in the Euro Area have adopted fiscal stimulus and it has brought a far greater degree of stability than Ireland on three key fronts; the economy, the deficit and long-term interest rates. Of course, all these three are linked.

Underlying the notion of competitive devaluation is the idea that the private sector can save its way to prosperity. Saving is currently occurring: the private sector's savings in Ireland will exceed 10% of GDP in 2010, according to the OECD. But there is no sign of prosperity.

This is because there is a faulty assumption at the heart of 'competitive deflation'. It relies on the idea that, if the private sector saves in this way but continues to consume and invest in the same proportions, all that will then happen is that prices will fall, and goods and services will be cheaper at the new, lower level of spending. However, this ignores two trends that tend to occur in crises and are happening currently, most especially in Ireland.

The first is that, in a recession, investment falls much faster than consumption. In Ireland, personal consumption has fallen from its peak by 15.1%, whereas gross fixed capital formation has fallen by 52.5%. Deflation has occurred. But the ratio between consumption and investment has changed markedly for the worse. Accepting the new status quo would be to embed a new, adverse consumption/investment ratio, which actually undermines competitiveness.

The second reason why this new orthodox criticism is invalid is the level of debt. If prices fall, as orthodoxy expects and is currently happening, debt-sevicing becomes more, not less difficult. The real level of the debt only increases - as has happened in Japan since the beginning of the 1990s deflation in that country. Ireland is already currently experiencing deflation, and policy is aimed at actively promoting it. Ireland's policymakers are the only ones in the world who believe that the Japanese experience is worth emulating.