Prices Go Splat.

Lord. The large print giveth, and the small print taketh away. The Central Statistics Office released its latest update for Ireland’s price level this week, showing inflation has returned to Ireland, after a brief absence. Prices in general are 3.2% higher in April compared with April 2010. This price level is calculated by adding up the price changes in various sectors of the economy to come up with an average measure of price changes, negative, or positive, that we usually call inflation.

Inflation is a steady increase in the price level. A little bit of inflation, say 2% per year, is a sign of a healthy, growing economy. Too much inflation is a bad thing because it erodes purchasing power. If there are only apples for sale in the world, and they cost a euro each, and you have a tenner, your purchasing power is ten. If the price of the apple goes up to two euros, your purchasing power drops to five. Inflation hurts people on fixed incomes—the old, the poor, and those with savings, much more than other classes in society. A deflation is the opposite—the general price level falls over time. So apples drop from 1 euro to 50 cents, meaning you can now buy 20 apples with your tenner. Deflation is a good thing for the individual, but a bad thing for heavily indebted economies.  The real cost of paying back the debt goes up as your purchasing power goes up, because the price level is going down. So you could buy all these apples now, but instead you have to use this increased purchasing power paying down debt. It’s more costly for you. No one needs to be reminded that Ireland is a heavily indebted nation.

Recently Ireland has experienced a deflation. Cumulatively the price level fell 3.5% from 2008 to 2010. The headline figure of 3.2% inflation released this week indicates that this period of prices dropping is over. Lots of coverage extolled the virtues of a return to inflation as a sign of economic health. But the economy doesn’t look that healthy to me. Skeptically digging into the components of this average is instructive, because the positive message disappears when you look closely at the numbers.

Dig a little into the stats, and you find that most of the increase in the inflation index comes from energy price increases, which went up nearly 12%.  These energy increases have nothing to do with the health of the Irish economy. They are price changes coming from abroad that we have to deal with because of our reliance on imported fuels. The rest of the price increase came from mortgages and insurance price rises. Again, neither of these are signs of a particularly buoyant economy. The domestic components of the index, particularly in the private sector, were actually negative. So we saw price drops in furnishings, in education, in recreation, in restaurants and hotels. We saw very modest increases in clothing and footwear of about 0.1%. So parts of the domestic economy we’d like to see experiencing growth and increased demand for their products and services are still cutting their prices to maintain some sales to keep themselves alive.

Now, some of these sectors might have been overvalued due to the bubble, and with disposable incomes dropping, price drops were inevitable. But sectors experiencing deflation don’t hire. They don’t invest in more productive capital, and they don’t pay more taxes to the government. Worse still, people on the street think prices will fall further, and so don’t buy now, expecting the goods and services to be cheaper in a few months. Which they are, because retailers continue to cut prices to eke out a living, waiting for an upturn that may not arrive before they become insolvent.

The lesson is this: we as economists need to highlight the changes in prices coming from abroad, and those coming from the domestic economy, as well as price changes coming from public sector-dominated industries like health (up 2.5%), and the private sector (Alcoholic beverages, down 0.9%). This partition of the statistics into a four-quadrant info graphic would curb the over reliance in the media on a headline measure, and give the public more relevant information about the relative health of the parts of the economy they care about, while maintaining comparability with European-wide statistics like the Harmonized Index of Consumer Prices.  

Deflation is a warning sign for policy makers that might be ignored if it is not displayed correctly for them. We have had too many instances in Irish public life where people weren’t made aware of a potential problem until it is far too late. Let’s change that now, starting with simple measures like inflation and deflation. We shouldn’t let the large print bury the key message of the statistics, which is that the domestic economy is still deflating.

Published in yesterday’s Sunday Independent.