Falling prices

We are all familiar with the rigidity in prices that comes from import barriers, monopolies and other restraints on trade. The opposite is price flexibility - the readiness of individual prices to rise or fall in response to conditions in their particular markets. Price flexibility provides the lubrication that a healthy economy thrives on.

However, the merits of flexibility in individual prices have little to do with the broader and destabilizing price changes that sweep across the economy. The fight against inflation - a condition of generally rising prices - is one that was hard fought for many decades. The persistence of inflation over several decades - sometimes severe, sometimes moderate - conditioned many into thinking that inflation is a permanent fixture of the modern landscape, and that we will not live long enough to ever see falling prices.

As it turns out, deflation or the problem of generally declining prices, now has become one of the hottest topics around. Lately, the American central bank, the Federal Reserve, declared: "the probability of an unwelcome, substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level". Such words represent quite a shift in policy orientation, coming from central bankers whose careers were built around a stiff vigilance against inflation.

Central bankers know they have to watch lest the world's economies slip from low inflation into dropping prices and collapsing demand. Deflation makes it harder for central bankers to implement expansionary policies. Even if your business borrows at an interest rate of zero, servicing your debt is a struggle if the price of what you sell is dropping.

Falling prices are not always bad. For example, widespread downward pressure on prices from improved technology is always welcome. There are occasions where technology makes production cheaper, as well as occasions where the price of a product is unchanged but its quality has improved. Statistically, this is equivalent to a price drop.

Similarly, there is downward pressure on prices from intensified competition. No seller welcomes new competition, but in fact greater competition that may come from lowered trade barriers and the other manifestations of globalisation improves efficiency, spurs quality-improving and cost-cutting technology. It makes for leaner and healthier enterprises that are better placed to exploit demand growth when it returns.

A serious problem is the deflation that comes from dropping or collapsed demand. Recently, there has been a mixture of dropping prices for goods for which there is intense international competition, while prices continue to rise for many services that face little competition from abroad. Haircuts or plumbing services abroad do not compete with those at home with the same intensity as imported toys, plastic products, computers, television sets, etc.

The divide is between products that are easily traded internationally and the rest. The prices of the first have been dropping - the result of ever more intense competition scrambling for a world demand that is lethargic. On the other hand, many services are not traded internationally, and in many countries prices of services have continued to rise.

In a number of countries, car prices fall (or at least they do not rise in line with quality improvements), while the cost of insuring the car and keeping it in good running order keeps rising. Internationally, prices of consumer durables, including furniture items and white goods, have been falling.

An interesting observation was made by an American commentator in the latest issue of Business Week, who noticed the demographic split in the consequences of deflation.

The over-40s are more likely than younger households to have their expensive big durable acquisitions of expensive durable goods behind them. They are less likely to benefit from dropping prices other than when it is time for replacement, whereas inflation-prone maintenance and upkeep costs are a larger proportion of expenditures for these older households. Similarly, childless couples are less hit by the rising costs of such services as education, medical care and child care than loom large for households with children.

In Malta's particular case, ours is a wide-open economy, and it is especially hard for us to escape a worldwide slowdown in demand growth. The other side of the coin is that as a large importer, we can gain from lower prices of imported consumer products. In fact, the ongoing dismantling of import restrictions coincides with low price growth or outright price drops internationally, producing substantial combined benefits for the Maltese consumer.

Take a look at the latest retail price index. The official inflation rate in March, the latest available, was 1.46 per cent, measured with a 12-month moving-average method. Actually, March prices were 0.5 per cent higher than a year earlier, in March 2002. The Opposition has to give up on getting any mileage out of an "inflation problem".

A look at the specifics reveals some interesting detail. Take prices of clothing and footwear, a category that accounts for 8.2 per cent of overall prices. Despite a spike during March 2003, clothing and footwear prices in that month were 10.5 per cent below a year earlier. The category "household equipment and house maintenance costs", which accounts for 7.7 per cent of the overall consumer budget, saw a 2.1 per cent drop from March 2002. This last one is especially interesting because it combines imported products, which are traded in more intensely competitive world markets, with local maintenance services, the market which is almost immune from foreign competition.

Another aspect of our economy is that our services sector is less isolated from foreign competition than in most other countries. That's because demand for our services by foreign tourists is such a big part of our economy. The divide between internationally untraded services and internationally traded goods is less rigid here than abroad.

Our exports have a large component of imported intermediate inputs. So falling world prices hit both sides of the industrial equation. Cheaper inputs bought abroad are passed through into cheaper exports. What we have to make sure is that the net component of exports that is made of domestic inputs, mainly labour, remains competitive.

An interesting exercise is to use GDP statistics to extract the implicit price indexes of the major components of the national accounts, including imports and exports. What is revealed is the roller coaster in the prices of what we import and export, as well as the prices of the machinery that we invest in, which is largely imported.

Export prices shot up in 2000, fell considerably in 2001 and went back up in 2002. So did import prices. Another of our characteristics is that the small overall size of the economy limits possible diversification. The range of products that we export is relatively limited, and we are dependent on a small number of large export products.

On top of our exposure to falling international prices, we also have to deal with the added volatility brought about by the limits to our diversification. Despite this limitation, the Maltese economy has shown significant resilience and an ability to weather international upheavals quite well with a very limited effect on employment growth and unemployment.

This result is also due to appropriate economic management. Contrast recent years with the stagnation and uncertainty created during Dr Sant's two years in government. And yet, during the last election campaign, Labour tried to portray the Sant years as some kind of golden period. The Labour media seems to enjoy building fairytales, and then blame others for its inability to convince the middle ground!