Central banks are reluctant to entertain the idea but allowing for more inflation might be the best way to start to rebuild the economy, writes MICHAEL CASEY

WHEN A recession is accompanied by price deflation, then recovery is even more difficult. If prices are falling, consumers will postpone purchases until prices fall further the next year or the year after that. Real investment in plant and equipment will also be postponed until the shelves are cleared of unwanted stock that accumulated during the downturn.

The consumer price index in Ireland fell by about 6 per cent over the two years 2009 and 2010 and, although it is increasing by some 2 per cent this year, it is driven mainly by commodity prices, whereas the prices of “everyday” goods and services are still flat or falling and subject to major discounts from time to time. Consumers will be slow to spend in much the same way as potential house purchasers will hesitate to buy properties in case the prices fall further.

One result of this, and of high unemployment, is that households are saving as much as they can. The Government, through the National Treasury Management Agency (NTMA), could easily mop up an extra €1-2 billion if it offered reasonable borrowing terms to the Irish public – better than those currently on offer. There would be substantial benefits to this course of action.

The other problem with low inflation is that we cannot erode the real value of our debt-service payments. In the 1980s we had a national debt of about 120 per cent of GNP (higher than at present) but it was manageable, partly because the relatively high rate of inflation during that period reduced the real burden of interest payments. Inflation is good for debtors and bad for creditors.

Low inflation also prevents governments from raising tax revenues by stealth. It is only when inflation is running at a relatively high rate that “fiscal drag” occurs. This pushes income-tax payers into higher tax bands by inflation and not by explicit government policy. While inflation would hit government spending too, it is likely that on balance the effect on the fiscal deficit would be positive.

The proof of the pudding, that some rate of inflation is good for economic growth, is surely the fact that the European Central Bank (ECB) deliberately set its 2 per cent target inflation rate in such a way that it should not fall much below that figure.

This was because of the fear of a Japanese-style deflation, which was extremely damaging to growth for many years in that country.

Many economists have demonstrated that a annual rate of inflation of 2 per cent is good for economic growth, although they recognise the danger of that rate being driven higher by the extrapolative expectations of wage earners and other economic agents.

Recently Kenneth Rogoff, former chief economist at the International Monetary Fund (IMF), has advocated an inflation rate of about 6 per cent a year for two years, as a partial solution to the present crisis in the United States.

There is little evidence to suggest that such an inflation rate would significantly damage an economy – unless this was way above the rate in other countries, thus eroding competitiveness. Although Rogoff was concentrating mainly on the US, it seems clear that the ECB should also heed this advice and not hesitate to engage in further quantitative easing, even if this requires a temporary amendment to their legal mandate of keeping inflation low at virtually any cost.

Deliberately increasing the money supply in the US in the 1930s and in Japan in the 1990s was quite successful. The gold standard was abandoned in the 1930s because it prevented increases in the money supply. Central bankers who are right in their fundamental belief in long-term price stability, have to compromise in extreme circumstances of prolonged recession. There can be little doubt that present circumstances fully justify a temporary departure from the old-time religion of central banks.

Ireland on its own cannot generate inflation because the money supply is controlled by the ECB. Cost-push inflation – forcing prices – is also ruled out because of the IMF/EU structural adjustment programme and the need to restore competitiveness in the public sector and especially in the indigenous exporting sector. But the ECB could generate inflation by quantitative easing or by reducing interest rates. (The fact that the ECB was increasing interest rates until recently shows how hidebound and traditional that institution is.)

We know Germany is haunted by memories of hyper-inflation in the inter-war period. Prices were rising so quickly that workers had to run to the shops with their wages in case the price of staple foods had doubled or quadrupled earlier the same day. Hyper-inflation makes it impossible to specify price clauses in contracts with the result that it becomes impossible to do business, and economies grind to a halt.

In Germany’s case the situation was made much worse by the emergence of National Socialism. Sociologists have suggested that hyper-inflation can also have the effect of destroying the significance of numbers and values, so that a figure like six million does not have any special meaning, even when applied to human lives. Whether this is true or not, the extreme caution of Germany with regard to inflation and monetary easing is well known and indeed understandable.

For practical policy purposes, the question is whether it is possible to have inflation of perhaps 5-6 per cent per year (as suggested by Rogoff) until the EU emerges from recession, and to prevent the situation from escalating into serious inflation of 10 per cent, say.

This, of course, would still be far from hyper-inflation but it would make most policy-makers very uncomfortable, especially as it could escalate further, driven by expectations.

If the EU were to consider a policy of significant monetary easing and the generation of inflation above the target rate, the following safeguards would have to be built in at the start of the process:

- Appropriate measures would have to be taken to ensure that the increase in the money supply would be transmitted to the real economy and not lie idle in zombie banks.

- When output and prices begin to rise in the euro zone, the ECB should be ready to reverse engines by raising interest rates.

- At that point the inflation target of 2 per cent should be explicitly reinstated and the ECB’s original legal mandate fully restored.

- Every opportunity should be used by EU institutions and by national governments to dampen inflationary expectations.

- Wages should not be indexed to the temporarily higher inflation of 5-6 per cent, but remain linked to the 2 per cent long-term target. The agreement of the social partners should be obtained in advance.

The issuance of Eurobonds to the international markets would, of course, have much the same effect as quantitative easing since the former would represent fresh injections of money into the different sovereign states. The main safeguard required in this context would be to ensure that the necessary fiscal adjustments are carried out to the letter in those badly managed countries that are out of favour with the international markets. The problem for now is that Germany has quashed the Eurobond idea.

The result of any form of monetary injection by the ECB would probably be the centralisation of fiscal policy in the future. Individual governments would not like ceding control to the centre, but it would be a price sovereign states would have to pay.

Ireland is already paying it. Let us hope the EU’s influence does not reach into the area of taxes on corporate profits.

Finally, if this policy of monetary easing/inflation were to be pursued it should be co-ordinated between the EU and the US. If, for example the EU were to generate inflation unilaterally then it is likely that the Euro would decline against the dollar.

The OECD has a mandate for international co-ordination but it would be helpful if Christine Lagarde could orient the IMF in that direction too.

Michael Casey is an economist and author.

His book, Ireland's Malaise, is published by the Liffey Press