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An economist: Debunking the myths of Ireland’s cost of living crisis

Economist Victor Duggan says much of the conversation around inflation and the cost of living crisis is outdated and inaccurate.

Victor Duggan Economist

IN MID-FEBRUARY, I wrote here that inflation was widely expected to peak in the early months of the year “before falling back over the following 18 months or so towards the levels around 2% that we had become accustomed to.”

Highlighting geopolitical threats, I did note that “risks appear to be skewed towards inflation staying higher for longer than is currently anticipated.”

The game changed when Vladimir Putin invaded Ukraine on 24 February. Oil prices initially surged by about 50% while gas prices nearly tripled. Although both have come off their March highs, they remain much higher than pre-war prices.

External factors

Ominously, there is a growing consensus the war in Ukraine will be prolonged, and further speculation that Putin could shut off European gas this winter. Meanwhile, international food prices have hit historic highs, even before the impact of Russia’s Black Sea blockade fully feeds through to grain markets. High prices and scarce supply of food and energy will likely get worse before they get better.

Irish consumer prices kept accelerating through May, annual inflation reaching 7.8%. We’ve yet to see what figure the Central Statistics Office gives us for June by the end of the month, but on Friday, the EU statistical agency Eurostat put Ireland’s annual inflation rate at 9.6%, a percentage point higher than the Euro area average of 8.6%. A combination of momentum in prices and the subdued monthly inflation seen in June and July 2021 suggest the annual rate hasn’t peaked yet.

Surging inflation is a global phenomenon, and it has everywhere come to dominate political debate around domestic issues. Whether inadvertently or more cynically, this debate has been characterised by much pedalling of myths. So, let’s knock some of those on the head:

Myth 1: We’re going back to the 1970s

Some lazy parallels have been drawn with the last period of sustained and synchronised inflation. Prices accelerated in Western countries in the late 1960s, spiked higher after the twin oil crises of 1973 and 1979, coming back down only during the recessions of the early 1980s.

But, our economies are very different today compared to 50 years ago. For better or worse: we are far less dependent on oil, we have more flexible labour and product markets, we have credible and independent central banks, and – most importantly – long-term expectations of higher inflation have not become entrenched.

Myth 2: Wages are driving inflation

Again harking back to the spectre of the 1970s, there has been much weeping and gnashing of teeth over the so-called ‘wage-price spiral’, where wages chase prices higher, feeding through to ever-higher prices in a vicious circle.

But, there is absolutely no evidence that wages are a source of recent inflation. Up to March of this year, hourly earnings increased at an annual rate of only 1.9%, and only 0.4% in the public sector, far below the inflation rate.

Wages actually fell in the construction and hospitality sectors. This means most workers are suffering real-term pay cuts this year. Far from wages driving price increases, it is inflation that is rightly leading workers and their trade unions to demand pay hikes.

Myth 3: Governments can’t control prices

While this may be true in aggregate in a market economy, the government does have direct pricing power when it comes to fixed fees and charges on public services, such as passport renewal or bus and train fares at semi states.

And, to be fair, the government should be commended for reducing the cost of public transport earlier this year. The introduction of rent pressure zones, where rent can’t exceed inflation, and minimum pricing on alcohol shows the government is also willing and able to use its regulatory powers to control prices in supposedly competitive markets to achieve public policy objectives. Unfortunately, the latter intervention will have added to our inflation woes, with beer and spirits both registering double-digit price increases in the year to May.

Government also controls indirect tax rates, such as VAT and excise, which account for an important share of the price of most goods and services. If the government presses ahead with a further €7.50 carbon tax increase in the budget, as previously committed, this will further add to inflation.

There is a strong argument for a ‘price trigger’ – such as $100 per barrel of oil (Brent) and €100 per MW/h of gas (Dutch TTF) – above which the carbon tax increase would be postponed. If the point of the carbon tax is to discourage the use of hydrocarbons by raising the price, then there is no need to add fuel to the flames at a time when families are already struggling.

Myth 4: Mitigating measures make things worse

There is an argument that tax cuts or spending increases aimed at easing the burden of inflation will only add to the problem. It is true that increasing the budget deficit or reducing the surplus, can have an inflationary impact at the margin. But, firstly, current inflation is largely caused by external factors rather than by domestic demand, so this is less of a concern.

Secondly, if it were a concern, there is no reason why compensatory measures couldn’t be introduced to ensure neutral effects on the budget and on inflation. Thirdly, the ESRI recently estimated that the government would run a surplus in 2022, so even fiscal measures that aren’t ‘paid for’ need not necessarily lead to higher borrowing.

The timing of the 2023 budget is a political decision, an exercise in expectations management. In itself, bringing it forward a few weeks is unlikely to make a massive difference to people’s back pockets. But, given the extent to which inflation is being imported to Ireland, while control of monetary policy has been exported to Frankfurt, fiscal and regulatory policies are the government’s main levers to ease the burden.

Certainly, special attention needs to be paid to those at highest risk of energy and food poverty, those unable to heat their homes or put enough food on the table. But, Ireland needs a pay rise: wages and welfare rates need to increase significantly if we are to avoid the steepest fall in living standards since the dark days of 2009.

Victor Duggan is an economist.

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About the author:

Victor Duggan  / Economist

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