Inflation has reached new highs. In Germany, the Federal Statistical Office reported an inflation rate of 11.3% (HICP) for November and Eurostat reports 10.0% for the euro zone. In the USA, where inflation has recently cooled somewhat, the figure is still 7.7%. In both Europe and the USA, the sharp rise in prices is a political problem. In the USA, it has probably cost the Democrats their majority in Congress. In Germany, the population is worried. In France, rising prices are giving boost to the “National Rally” party and the yellow-vest protesters.
Since central banks for a long time failed to recognize inflationary pressures and then downplayed them as temporary, they are no longer able to curb inflation in a hurry. Even when interest rates are raised decisively, it takes several months for them to have an effect on the inflation rate.
It is therefore not surprising that around the world solutions to the problem are being hastily sought. In principle, it is the task of central banks to anticipate and combat inflationary risks. However, since central banks for a long time failed to recognize inflationary pressures and then downplayed them as temporary, they are no longer able to curb inflation in a hurry. Even when interest rates are raised decisively, it takes several months for them to have an effect on the inflation rate. If short-term remedies are to be found, then the ball is in the court of the governments
Expensive Short-Term Solutions: “Inflation Compensation,” Price Brakes, and Subsidies.
In Europe, they are trying one-time payments, in particular to compensate for rising energy prices. France’s President Macron, as the “Santa Claus of the nation,” already announced an “inflation compensation” for 38 million French people with low incomes at the beginning of the energy crisis. Austria has paid out a “climate bonus” and “anti-inflation bonus” totaling 500 euros in light of high inflation. The German government is currently planning an “inflation premium” of 800 to 1,500 euros for low- and middle-income earners. Recipients of social benefits, pensioners and students also stand to benefit.
On the other hand, price brakes have emerged. While the German government is still tinkering with the electricity and gas price brake, the French government already froze gas prices for private households in the fall of 2021. Electricity prices may rise by a maximum of four percent in France in 2022. Hungary’s President Orban has not only cut electricity and gas prices, but also capped prices for sugar, eggs, potatoes and milk. In Japan, not only are many foodstuffs subsidized (as in the EU), but also mass transit, cars, gasoline and higher education. Electricity, water, and gas prices are also regulated (Mayer and Schnabl 2022).
The problem with subsidies is that they are expensive. Many billions are due. In France, the government stepped in this year with 16 billion euros. Germany has mobilized a special fund of 200 billion euros for a defense shield against excessively high energy prices. In Hungary and many other countries, government budgets are deep in deficit. The already high national debt continues to grow. If, at the same time, central banks suspend their purchases of government bonds and raise interest rates, the probability of sovereign debt crises increases.
Medium-Term Painful Solutions: Interest Rate Hikes and Deficit Reduction.
This leads to the role of fiscal policy in fighting inflation. High inflation occurs when states do not finance rising spending commitments through taxes over the long term, but instead rely on the printing press. Accordingly, the European Union treaties not only made the European Central Bank independent, but also imposed debt limits on the member states of the monetary union. By implication, this means that states must reduce their spending commitments and cut debt to bring inflationary pressures under control in the medium term. Otherwise, the scope for central banks to raise interest rates is limited.
This realization seems to have prevailed in Japan, where with government debt at 260% of GDP, the government’s interest burden would quickly rise to unbearable levels if the Bank of Japan were to raise rates. So far, there has been no interest rate hike. For the U.S. and the Eurozone there is a manifest contradiction between the central banks’ announced interest rate hikes and the governments’ ever more ambitious spending plans. The European Central Bank already seems to want to prevent possible sovereign debt crises in highly indebted euro countries with its “transmission protection instrument.”
In the United Kingdom, Liz Truss stumbled into a financial crisis with the idea of a debt-financed tax cut when interest rates were expected to rise, and thus continued stumbling right into her removal. After the Bank of England announced further interest rate hikes, the new Chancellor of the Exchequer, Jeremy Hunt, now wants to balance the budget with tax increases and spending cuts. It remains to be seen whether Prime Minister Rishi Sunak will succeed in taking over the legacy of Margret Thatcher, who, as the Iron Lady, once restructured the state finances and stabilized the British pound.
Incisive Long-Term Solutions: Monetary Reform, Debt Relief, Return to Independent Monetary Policy and a Market Economy.
Another example of successful debt reduction is the case of post-World War I Italy, where Benito Mussolini cut wages, raised consumption taxes, and paid of wartime debts by cutting both corporate taxes and government spending (see Mayer and Schnabl 2021). Mussolini successfully defended against speculators an exchange rate of 90 lire against the British pound.
Under the Gerhard Schröder government in Germany, reforms also significantly reduced the German government’s spending burdens and achieved a decline in unemployment. However, these successes only became visible under his successor, Angela Merkel, as the productivity gains achieved initially flowed to (and were consumed by) the southern euro countries and the United States.
In another case, the U.S. and the U.K. reduced the national debt incurred during World War II by using capital controls to push interest rates on government bonds below the growth rate. Under normal circumstances, so-called financial repression has had negative growth effects by weakening the incentive to save and disrupting bank lending (McKinnon 1973). But the U.S. had created conditions for high growth worldwide at the time by stabilizing price levels and exchange rates under the Bretton Woods system. World trade was liberalized under the General Agreement on Tariffs and Trade. Market economy reforms in Germany and Japan turned the two countries into growth locomotives.
The German economic and monetary reform after World War II led to an economic miracle under Ludwig Erhard (1957), after the devaluation of savings eliminated the large money supply overhang and the high national debt. An independent central bank not only established a stable currency, but also limited the role of the state in the economy. Free-market principles such as private property, liability and freedom of contract were anchored in a liberal constitution, flanked by a consistent competition policy.
Outlook: A Reflection on Free-Market Principles, or the “Argentinization” of Europe?
Thus, there are enough examples of how the highly indebted Western welfare states could bring inflation under control. However, financial repression, which reached large dimensions in the wake of the global financial crisis (2007–2012), is not an option, because instead of reforms and free trade, deglobalization and more regulation are on governments’ wish lists. New visions and new spending wishes dominate, which amount to the dismantling of free-market principles and even more central-bank-financed government spending.
This is particularly true of the European Union, where little there seems to be little will to reform. The European Central Bank’s monetary policy still seems geared to keeping both cash-strapped euro states and their zombified companies and banks afloat. If this continues, then “Argentinization” looms: Argentina was once one of the most prosperous countries on earth. But constant central bank-financed government deficits, state-directed lending and inflation have disrupted the country economically and socially. Hopefully, Western industrialized nations will rethink things soon.
Erhard, Ludwig 1957: Wohlstand für alle. Econ Verlag, Düsseldorf, Wien (New edition with a Foreword by Lars Feld, Berlin 2020).
Mayer, Thomas / Schnabl, Gunther (2021): How to Escape from the Debt Trap: Lessons from the Past. CESifoWorking Paper 9078.
Mayer, Thomas / Schnabl, Gunther (2022): Japan’s Low Inflation Conundrum. CESifo WorkingPaper 9821.
McKinnon, Ronald (1973): Money and Capital in Economic Growth and Development. The Brookings Institution, Washington D.C.