Spare us that sinking feeling of deflation

The story about a report written by the European Commission on the Maltese economy went largely unnoticed as most of the headline news was largely focused on appeals by candidates seeking our attention for the coveted vote in the coming MEP election.
The report was positive on the state of the economy, saying it is expected to grow “robustly” in the coming two years. I have written before that there seems to be a quiet Renaissance in domestic demand, which is fuelling economic expansion purely as a result of strong household consumption and a number of large-scale investment projects.
What is the cause of this benign news, when our exports are not increasing (except for tourism) and it is too early for the promised savings in reduced utility tariffs to feature on invoices charged by ARMS? Rummaging through domestic bills and most still tell you the bitterness felt when paying high utility rates is omnipresent.
So what can be the harbinger of this slow yet steady improvement in feel good factor? Is it because Brussels have congratulated us on a respectable growth registered last year in GDP, which is almost as high as that achieved by the healthy UK economy? I doubt it. The commission said real GDP growth is forecast to moderate slightly reaching 2.3 per cent this year and 2.1 per cent next year.
Proudly we can rejoice that under the stewardship of finance minister Edward Scicluna, real GDP growth reached was 2.4 per cent last year. He maintained his promise with the electorate to reduce the deficit to 2.8%, which had previously edged upwards of 3.3% by end of 2012 due to slippages caused by the 2013 election. The only fly in the ointment is the creeping level of unemployment, which at 6.8% is still much lower than the EU average but ought to be reduced to below 6% given that our workers' participation in proportion to the total labour force is comparatively low (e.g., only 42% for females).
Another annoying factor is education, which is fast becoming our Damocles sword as the high percentage (40%) of early school dropouts is worrying, notwithstanding the massive allocation by the State to provide for free education from Kindergarden up to tertiary levels (all supported by monthly stipends). One may be excused for questioning how this state of affairs can continue to exist when over the years, party propaganda reminds us of millions spent on building modern schools with a target of inaugurating a new college each year.
Still, the Commission congratulated the government on a number of additional investment projects in the pipeline (thanks to the hidden hand of Malta Enterprise) and of course in the medium-term such projects will help sweeten the pangs of creeping unemployment. It goes on to warn us of protracted delays in the planned construction by the consortium responsible to erect the gas-operated power plant. But these problems are manageable and with due attention can be solved without straining our limited resources.
What can be our coup de grace is the drop in prices and the entry, as if by stealth, of the phenomena of disinflation. Party apologists remind us of the blessing that prices are dropping and inflation is under wraps and is actually falling. Can this be a good trend in the medium term?
Not so fast. The European Central Bank informs us that with quantitative easing and other measures, the downward pressure on prices will continue in a race to the bottom. Nobody takes deflation seriously, forgetting for a moment that after the severe crisis in 2007/8 with its dosage of heavy austerity, political leaders are not expecting another depression to follow - on the contrary, countries in the Mediterranean pray for a revival of their economies, linked to a steady improvement in job creation.
But can this be wishful thinking? Will it get worse before it gets better? Official reports tell us that risks in the wider Eurozone are growing because inflation in bigger economies, such as Germany and France, is weak at 1.3% and 0.7% respectively. Some may ask - surely low inflation is a bonus that one expects when economies climb up from their low standing, as a result of the global crisis triggered in the USA by the sub- prime bubble? The answer is that low inflation is the other side of a bad coin, starting with Greece which is already mired in deflation, seeing its prices falling 1.8% in the year and moving on to Portugal, Spain and Ireland which are all on the brink.
The danger exists that once consumers expect prices to keep falling, they put off buying things, weakening the economy even further. A euro sceptic commentator writing in the Sunday Times of London suggested to the ECB to impose negative interest rates. I cannot ever imagine this being put into effect in Malta with the two main banks effectively being taxed for excess liquidity. This begs the question - what is the Central Bank's role and what tools does it possess to keep a lid on inflation? The biggest problem facing central banks today is that inflation is too low.
Last year witnessed a perilous drop in the euro area, when annual consumer-price inflation was only 0.7% in third quarter, down from 2.5% the previous year. Is this the effect of shrinking economies, with the belated effect of stiff austerity measures? Or is it simply the start of a menacing economic cycle when commodity prices are falling and consumers delay purchases on the hope of even better bargains tomorrow? Very low inflation in the euro zone makes it much more difficult for countries like Malta, which only reached the 47th position in the global list of competitive countries.
At this juncture, readers may question my logic as I started this article by waxing lyrical on the bright future of the economy and the acclamations showered on us in the latest report by the Commission yet we have to combat the surreptitious growth of a deflationary menace. Unless restrained, such deflation may lead workers to resist nominal cuts in pay more fiercely than they do the subtler erosion of their income through inflation. Typically exporters will be tempted to catch up with competitors by lowering wages or at least try to freeze them and although their unions may resist this, the short-term alternative may be lay-offs and tighter productivity measures.
Already last September, when euro-wide inflation was 1.1%, prices were falling by 1% in Greece. They were flat in Ireland and rising by just 0.3% in Portugal and in our case, with public debt exceeding the 60% threshold during times when prices are falling, debt, which is fixed in nominal terms, becomes more onerous to service in real terms. During past profligate years, when "money was no problem", we lived through higher inflation and paradoxically this made our debt servicing appear to be less burdensome but now it is like an albatross around our necks.
The classic example is Japan. There deflation is both deeply damaging and is hard to sustain especially as Japan is burdened with high debts. Since loans are fixed in nominal terms, falling wages and prices increase the burden of paying them. And now that the spectre of unemployment is raising its head in Malta, is it wise to ignore the effects of deflation? Even though unemployment at 6.8% is not yet at a critical level, unbridled ultra-low inflation can in the future bring in unpleasant side effects. As a general rule, it tends to lead to a higher-than-necessary joblessness: America's unemployment rate is 7.2%, France's 11.1% and Spain's 26.6% and UK 6.9%.
But it is not all doom and gloom since the Commission predicts our GDP growth next year will be exemplary (reaching 2.1% when we need 5%) so we may be better armed to fight the deflationary spiral that, if uncontrolled, will lead to lowering of wages and leaves the doors wide open for job losses.
To conclude, I hope all readers, having enjoyed the festivities marking our tenth anniversary of joining EU club, will forward to the next decade with better monitoring of inflation by the ECB. The European Central Bank did cut its main policy rate from 0.5% to 0.25% late last year but still has more work to do to loosen financial conditions, including making cheap credit available for start-ups.
Ideally ECB must also stress that although its mainstream inflation target rate is 2%, it continues to make sure that all countries in the euro zone avoid falling through the safety net - even if that means that some members have to bite the bullet and adjust their wage levels downwards to remain competitive and save jobs.