Drastic change is needed to dampen inflation and reinvigorate the eurozone

Gunther Schnabl

July 12, 2022

Inflation rates in the euro area, the United States and the United Kingdom have risen far beyond the self-imposed targets of the central banks. US president Joe Biden, the German chancellor Scholz, and ECB president Christine Lagarde have pointed to the coronavirus and the Russian president Putin as the main culprits. But what about central banks as the guardians of price stability?

The roots of the current inflation go back to the late 1980s, when the US Fed president Alan Greenspan cut interest rates sharply in response to financial crises and hesitated to increase interest rates in the recoveries. As this asymmetric monetary policy pattern became common in the other industrialised countries, interest rates globally declined towards zero. Central banks started purchasing large amounts of assets, particularly government bonds, which has inflated their balance sheets.

Although Milton Friedman has argued that inflation is always and everywhere a monetary phenomenon, officially measured consumer price inflation remained low for a long time despite the strong monetary expansion for three reasons. First, while stock and real estate prices hiked, inflation measurement was limited to consumer prices. In the euro area, even owner-occupied housing is excluded from inflation measurement.

Second, quality adjustment in inflation measurement was intensified. Particularly as industrial goods prices measured in stores are adjusted downward in the statistics, when the quality has improved. This is for example the case when a computer has more computing power or a refrigerator consumes less energy. By contrast, for other groups of goods where a gradual decline in quality can be suspected – e.g., services (more self-service) or food (less sustainable production) – there is no upward price adjustment. Moreover, in the basket of goods underlying inflation measurement the weights of goods with low prices and thereby low price increases tended to be increased.

Third, since the turn of the millennium the increasingly loose monetary policies of all major central banks boosted investment in China, which is endowed with a large amount of cheap labor. The tremendous expansion of the production capacities in China contributed to stable price levels in the industrialized countries, because the prices of many imported industrial goods declined. The threat of further production relocations to China helped keeping the wage demands of trade unions in check.

Nevertheless, consumer price inflation picked up since mid 2021, because during the corona crisis central banks and governments have put even more money into circulation. This stimulated demand when shops, restaurants and hotels were opened again. In addition, central banks facilitated a significant expansion of regulations in the form of lockdowns, supply chain laws, new environmental standards, and trade sanctions, because the negative effects on employment could be offset with public aid thanks to the extensive government bond purchases of central banks.

As wage settlements in the industrialised countries have been weak for a long time due to low productivity gains and wage competition from China, now many employees are hit hard by the sudden price increases. Yet suddenly, the bargaining power of trade unions is strengthened again, as the huge corona rescue programs have drained the labor markets. The price-wage-spirals, which have kept inflation high in the 1970s, have set in again.

Many governments aim to solve the inflation problem with price caps, tax cuts as well as subsidies for corporations and consumers. This will fail, because the resulting additional budget deficits will further increase the pressure on the central banks to buy government bonds. The core problem is, however, that over a long time increasingly expansionary monetary, fiscal and regulatory policies have undermined the free-market principles that once kept production cost and prices low. Zombified corporations, highly indebted governments, and the green allocation of credit are pushing prices up, while declining productivity prevents wages from catching up.

Thus, the only way to tame the dramatic loss of purchasing power is to lift interest rates. This would force governments to curtail expenditure and to leave more room for private economic activity again. Corporations would be forced to become more efficient again, rather than striving for government aid and central bank support. As this would create pressure to deregulate, the productivity would rise again, helping to reduce costs and prices.

The US Fed and the Bank of England have already increased interest rates decisively. As economic turbulences are likely to emerge in face of rising financing costs, they will need fighting spirit to continue this path. In contrast, the ECB seems to be trapped by the high government debt of several southern euro area countries, trying to hide high inflation behind a green monetary policy.

Therefore, for the less indebted and more market-oriented countries in northern part of the euro area, the only exit strategy may be the introduction of a parallel currency in Germany. This could revive the pre-euro currency competition, which has once promoted welfare all over Europe.


Written by Gunther Schnabl

Gunther Schnabl is a Professor for Economic Policy and International Economics at Leipzig University.

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