Why did the Irish price level decline so much and so fast? A deconstruction.
from Merijn Knibbe
In a previous blogpost I drew attention to the fact that the Irish price level went down from the highest level in the entire Eurozone to a little above the average. Does this show that austerity can work, even if, according to one of its ‘loudest’ proponents, Hans-Werner Sinn, ten years of ‘internal devaluation pain’ are needed before a country can return to prosperity (if ever…!)? Does this decline of the Irish price level mean that planned wage cuts can be used to engineer a lower price level and that, in the end, there will be light at the end of the tunnel (for the German creditors)? Hmmm. I was puzzled by the Irish data, especially because the consumer price index did not show the dramatic declines needed to get the price level down so much. So I looked at the other price indices: investment prices and prices paid by the government. Comparing these data (source: Eurostat) yielded that, though wage cutting may have played a role in getting the price level down, prices of housing and (new) construction were probably more important.
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A final verdict should be based upon an even more detailed deconstruction of the price levels as well as upon a thorough investigation of the way in which the aggregates are calculated – I do not exclude that, as construction imploded, any kind of weighting scheme based upon historical weights used to calculate the price level which might overstate the influence of construction on the aggregate, for instance. But that’s the kind of work the specialists at the Irish Central Bank and the CSO should do. My point is that, before 2008, there must have been considerable house and land price inflation while there is considerable housing and house and land price deflation at the moment – which sends the entire Irish economy into a situation of grinding (debt) deflation not sown by the consumer price index and not caused by lower wages. Without further investigation of the situation, Ireland can not be used as a succesful example of using planeed wage cuts to decrease the price-level.
Also, the banks, which used overpriced real estate as collateral to emit money which in its turn enabled house price inflation to continue, are still reaping the seigniorage profits of the interest paid on these mortgages (yes, that statement is fully consistent with economic theory). And, weirdly, they still do not have to adapt the debts they own to the new price level. They are taking the same amount of money out of a deflated economy.
This is interesting. I think more critical analysis of the construction of price indexes and aggregates is really needed and potentially an area where heterodox economists could contribute.
Is there some reason you don’t report nominal Irish wages here? That seems like the most direct way of getting at the question. I had the idea — I could easily be wrong — that Irish wages had fallen quite a bit.
Well, Krugman blogged about it and there is a bit more on http://irisheconthoughts.wordpress.com/2011/12/15/more-nominal-wage-rigidity/.
There seems to be actually quite a degree of nominal wage rigidity. Yet again, there are differences at the secoral level. The blogpost above shows a decline in construction – consistent with Merijn’s data.