Economics is essentially about making choices to address the problem of scarcity of resources and infinite wants. In a market economy, the price mechanism is the guide for the daily choices made by governments, households, and business operators. Therefore, changes in relative prices provide a signal to reassess choices and adjust accordingly to maximise welfare.

In frictionless markets, changes in relative prices reflect shifting preferences of consumers and productive efficiencies of producers, which provide signals for saving and investment behaviour, and incentives for economies to renew themselves over time to improve sustainably the welfare of citizens. This is the ultimate benefit of the price stability objective of central banks.

Threats to price stability are simmering with the recovery from the pandemic shock and exacerbated with the Russian invasion of Ukraine. Disruptions in production and distribution channels across the globe from these two events have triggered a bout of inflation, especially in commodity prices.  

Such large swings in relative prices inevitably generate welfare effects on consumers and businesses alike. Non-commodity producers, like Malta and most euro area countries, are experiencing a historically huge terms of trade shock.

This means that in the absence of adjustments in economic behaviour, non-commodity producing countries would need to deplete their stock of foreign assets or increase their debt towards countries selling such higher- priced commodities.

These circumstances often prompt calls for policy action to limit the transmission of price increases on consumers, especially those of energy products. Such policy action represents a distortion to the price mechanism, and consequently in the saving and investment behaviour of households and businesses.

Distortions to the price mechanism are, however, not necessarily undesirable, though not cost free. For example, policies affecting relative prices in response to a temporary economic shock could help support consumer and business confidence and avoid sharp swings in welfare. In the absence of such policies, sharp short-term welfare losses could require economies an excessively long time to recover.

The global policy response to the pandemic was a success in this regard, but has also meant higher debt levels, requiring future periods of fiscal consolidation.

However, there is no easy way to judge when a shock is permanent or temporary, or how long is temporary. Policy decisions that unnecessarily prolong the distortion in prices could impact future welfare of citizens.

Policy choices very often involve trade-offs that require a fine balancing act to optimise welfare. For example, economic diversification is usually considered virtuous because ‘putting all eggs in one basket’ could expose countries to higher volatility in citizen’s welfare.

However, carrying a basket for every egg is highly inefficient and would ultimately imply a lower level of welfare. Indeed, international trade theory shows that producing only those goods and services in which a country has a comparative advantage optimises welfare, which is the underlying basis for globalisation and free trade.

There is no easy way to judge when a shock is permanent or temporary, or how long is temporary- Alexander Demarco

In reality, every country needs to strike a balance between diversification and specialisation. This is no easy task, and it is not usually the case that governments have superior knowledge of what the right balance should be.

However, if unfettered by distortions, the price mechanism is usually efficient at weeding out weak and unprofitable businesses. Similarly, the price mechanism for labour services (wages) provides incentives to the skills that people seek.

Reality is, however, more complex. The price mechanism is not free from distortions as prices (and wages) are impacted by various kinds of regulations that are grounded on a myriad of considerations, including social, environmental, security, health, and market failure, among others.

While many prescribe policies, such as that of upskilling and reskilling, to direct human resources towards certain skills, which in theory are highly desirable, in practice implementation may entail difficulties.

Reality is that not all human beings can become engineers, information technology specialists or possess the talent or skill that is considered to generate high value-added. Similarly, asking persons late in their adult life to change their skills because their existing ones have become obsolete due to technological developments or changing societal preferences, is not always feasible.            

Likewise, preserving certain business models may make little sense from a national welfare perspective, but, nonetheless, operators often seek to lobby for their protection and survival, usually using the spectre of job losses to convince policymakers that they are worth defending. To increase welfare, economies need to be dynamic, with societies accepting death of firms in the same way they embrace start-ups and new sectors.

A major challenge today is that the pace of change is becoming more rapid and fraught with a higher frequency of large shocks, reflecting the growing interconnectedness of economies from globalisation. This piles greater pressure on human beings to adapt quickly to such transformations. While most are likely to succeed, however, some inevitably fall behind.

Society needs to find the right balance of policies that are conducive towards making economies more dynamic, taking into account environmental considerations to ensure welfare sustainability but, at the same time, build social safety nets for those who fall behind. This is by no means a simple task as economic agents often resist change and lobby to defend the status quo and preserve their respective self-interests.

The present elevated uncertainty, arising from the conflict in Ukraine and the lingering pandemic, is providing stiff challenges to policymakers in the choices they need to make to preserve current welfare without compromising that of future generations.

Focus should remain on preserving the signalling properties of the price mechanism and channelling investment towards digitalisation and greening the economy to address existential threats to the planet, while rebuilding fiscal buffers for the next economic shocks.

Alexander Demarco is Deputy Governor of the Central Bank of Malta.