Sunday, December 21, 2008

Is there any good news?

The New York Times has a piece on finding good news in falling prices. A lot of it may also be true for Ireland. Here are some excerpts.

The cost of fruits, vegetables, clothing and vehicles are all dropping. Housing prices have been falling for more than two years, and a barrel of oil costs about $45, down from $145 in July.

The inflation report released by the government on Tuesday showed that the Consumer Price index was 3 percent lower last month than it had been three months earlier. It was the steepest such drop since 1933.

These declines have raised fears of a deflationary spiral — fears that help explain the Federal Reserve's’s surprisingly large interest rate reduction on Tuesday. And there is good reason to fear deflation.

Once prices start to fall, many consumers may decide to reduce their spending even more than they already have. Why buy a minivan today, after all, if it’s going to be cheaper in a few months? Multiplied by millions, such decisions weaken the economy further, forcing companies to reduce prices even more.

But a truly destructive cycle of deflation is still not the most likely outcome. For one thing, the price of oil cannot fall by another $100 in the next few months. For another, the federal government will soon, finally, be fully engaged in trying to stimulate the economy.

So amid all the legitimate worries about deflation, it’s worth considering what may be the one silver lining in the incredibly bad run of recent economic news: The cost of living is falling.

Jobs are disappearing, bonuses are shrinking and raises will be hard to come by. But the drop in prices, which isn’t over yet, will make life easier on millions of people. It’s possible, in fact, that the current recession will do less harm to the typical family’s income than it does to many other parts of the economy.

The reason is something called the sticky-wage theory. Economists have long been puzzled by the fact that most businesses simply will not cut their workers’ pay, even in a downturn. Businesses routinely lay off 10 percent of their workers to cut costs. They almost never cut pay by 10 percent across the board.

Traditional economic theory doesn’t do a good job of explaining this. During a recession, the price of hamburgers, shirts, cars and airline tickets falls. But the price of labor does not. It’s sticky.

In the 1990s, a Yale economist named Truman Bewley set out to solve this riddle by interviewing hundreds of executives, union officials and consultants. He emerged believing there was only one good explanation.

“Reducing the pay of existing employees was nearly unthinkable because of the impact of worker attitudes,” he wrote in his book “Why Wages Don’t Fall During a Recession,” summarizing the view of a typical executive he interviewed. “The advantage of layoffs over pay reduction was that they ‘get the misery out the door.’ ”

Companies resort to cutting jobs and giving only meager pay increases, increases that are even smaller than the low rate of inflation that’s typical during a recession. This recession may well be the worst in a generation — but thanks to the stickiness of wages, the pay drop for most families may not be much worse than that of a typical

I don’t mean to make things sound better than they are. The economy is bad and getting worse. A deflationary spiral remains a real threat, even if it’s not the most likely result. No matter what, unemployment is headed much higher.

But the drop in prices will still soften the blow. And at this point, American families can use any bit of economic help that they can get.

In Ireland the Central Statistics Office reports that prices as measured by the Consumer Price Index fell by 0.9% in November compared with October. While prices are still 2.5% higher when compared to November last year we can expect our annual inflation rate to drop close to and below zero over the next few months.

Prices are already cheaper in some categories than at this time last year; clothing and footwear (-7.2%), petrol (-6.6%), rent (-5.9%), furnishing and household equipment(-1.9%) and transport (-0.7%).

Also over the next few months households will begin to see the effect of the dramatic cut in ECB interest rates from 4.25% to 2.50%. For a 25 year €250,000 tracker rate mortgage of ECB +1% this will cause the monthly payment to drop from about €1,500 to €1,250 - a savings of €250 a month or €3,000 a year! Similar savings will be seen across other tracker and variable rate mortgages.

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