News coverage often is pretty simple when it comes to inflation: Russia’s invasion of Ukraine is to blame. Without that, inflation would not be a problem. This is understandable from a political perspective, where the most important task is to find someone or something to blame if things go wrong. But it is wrong!
We had very high inflation already before Russia decided to attack Ukraine. The consumer price inflation at that time was already at 6 percent for the euro area. Also, at that time at the ECB the argument was (still) being made that inflation was „transitory.“ Looking back, that argument was not just wrong but delusional as well as there was no clear sign of a trend reversal.
Quite the contrary: The producer and wholesale prices kept rising – even though they were already at levels most of us would have thought of as a bad joke only a few years ago. In February 2022 producer price inflation was already close to 24(!) percent with no trend reversal in sight. At that point, what could lead anyone to assume that consumer prices will fall soon? Dogma? Naiveté? The argument made at the ECB was either utter delusion – based and reinforced by wrong models – or a vicious lie.
But enough on the „transitory“ fiasco. What led to the situation we are in now? Since it could not have been the Russian invasion, the causes of this inflation wave go back a long time. The ultimate cause is a misguided economic policy, which, in the (mistaken) belief that it could improve market outcomes through political intervention, has repeatedly created false signals and declining productivity as well as deficiencies in the satisfaction of consumer needs. To mask these problems (partly successfully), irresponsible debt and monetary policies were used, which provided short-term relief that led to even bigger problems in the medium and long term. Now, the long term is here, and it is here with a vengeance.
The public debt at the EU level lies at about 100 percent of GDP. On top of that, the financial risk loaded onto the shoulders of the euro area population in recent years is equivalent to about 30,000 euros per euro area worker. However, these are only the potential risks at the ECB level as a result of the bond-buying programs – there are many other potentially costly risks at the EU and national levels. Essentially, this means that numerous institutions in the EU and the nation states have taken on so many risks that they cannot allow an economic crisis, let alone a market correction because the entire EU system would falter within a very short time.
In addition, low and negative interest rates in recent years have made market participants dependent on these low-interest rates. The economy has reacted to the new environment and made corresponding investments, which are largely financed by debt. Prices in the real estate sector have risen sharply so that real estate can now only be financed through loans for the majority of people. As a result, the economy is dependent on low-interest rates as never before, and even small increases in the interest rate can lead to an economic crisis that would make the economic crisis of 2008 seem like a trifle. Therefore, the ECB cannot raise interest rates significantly to fight inflation.
Thus, the question arises: Given average rates of six percent increase in the M2 money supply, which is most relevant for price increases, why have prices only risen sharply only now and not much earlier? A fair question one might add
For starters, in some sectors such as real estate, price increases have been above consumer price inflation for quite some time. The reason for this is that in the real estate sector, globalization has had less of an impact on prices than in other sectors of the economy. This is also the answer to why price increases in other sectors have been lower in the past: Globalization has led to a sharp fall in prices, which in turn has been overcompensated by expansionary monetary policy. In other words, if the money supply had not been expanded, prices would probably have fallen.
But the positive effects of globalization can no longer be relied upon (at least temporarily). The reason is primarily SARS-CoV-2 and the political response to it. Almost all economically prosperous countries reacted to the pandemic with lockdowns that shut down parts of the economy completely and other sectors partially. This had an impact on supply chains within a very short time: even those companies that could have produced despite the lockdown often had to stop production due to a lack of intermediate products. Even the end of the lockdowns only helped to a limited extent because of the asynchronous nature of the lockdowns. If a lockdown was still in force in the countries where the intermediate products were manufactured, it was not possible to produce in the countries where the lockdown had ended. This led to lacking supply resulting in price increases.
Some see the pandemic and the subsequent lockdowns as the trigger for the price increases, however, those are not the underlying causes. In principle, the ECB would have the tools it needs to curb inflation. Just as it expanded the money supply to keep inflation at close to two percent despite price cuts as a result of globalization, it can also ensure that the current high price increases fall back to lower levels by shrinking the money supply. The fact that it is not doing this to a sufficient extent (and is highly unlikely to do so in the future) is because they know it would trigger an economic crisis. However, the ECB will not be able to avoid an economic crisis, even though it will fight it with all its might. This leaves the ECB with the choice between different crises.
The situation we find ourselves in is frightening. On the one hand, the ECB is hell-bent on preventing an economic crisis – and, from its point of view, it has to, because an economic crisis would jeopardize the existence of the euro. On the other hand, inflation cannot be meaningfully fought under these conditions. This is all the more true if those factors that have so far ensured only moderately large price increases despite large monetary expansions – such as globalization – now cease to apply. This does not mean that prices will now continue to rise steadily. We may experience a phase of disinflation, even without intervention by the ECB. However, one should not make the mistake of seeing an end to the inflation problem in this phase.
What the ECB is likely to attempt in this seemingly hopeless situation is a “bifurcation” of monetary policy. On the one hand, it will try to raise interest rates slightly, but on the other hand, it will provide increased financial support to states via the increased purchase of government bonds. Those market participants that are state-owned or close to state institutions are supported on favorable terms – regardless of risk. Market-based risk considerations will become largely meaningless, but only temporarily. Sooner or later, the risk will materialize, and the question will then be how much damage has already been done at that point.
This tragic scenario could be partially escaped by not prolonging the mistakes of the past. Economic policy intervention must be reduced to an absolute minimum, optimally to zero. The irresponsible debt policy must be ended. Monetary policy must be normalized as quickly as possible. And most importantly, the ensuing market correction must be allowed to happen, painful as it will be. None of this will happen, however, because it would mean the end of the euro and contradict today’s economic policy self-conception.
The question of alternatives must therefore be raised. One possible alternative is to abolish the barriers to the issuance and use of alternative money. This would have several positive effects. First, market participants could decide for themselves which money they prefer. Second, in the event of a currency collapse, structures would then already be in place to fall back on. Third, because the ECB would then have to compete with other money, it would be forced to pursue a more sensible monetary policy. A return to reason would be urgently needed – given the dilemmas into which economic and monetary policy have maneuvered themselves.