The End of Free Money

Hans-Werner Sinn

Project Syndicate, November 29th, 2021.

Surging inflation across the European Union should be a clear signal to policymakers and central bankers that the time to stop financing public-debt binges was yesterday. Most likely, the continent is heading into a period of stubborn inflation that will be familiar to anyone who lived through the 1970s.

Although the US Federal Reserve is now thinking about tapering its monthly asset purchases in light of increasing inflation figures, European Central Bank President Christine Lagarde continues to insist that no sustained inflation risk exists. The currently measured inflation, she says, is a temporary problem that will disappear once supply bottlenecks are overcome, so the ECB will not be changing its policies. It is like a coachman who refuses to tighten the reins when his horses are bolting, because they will eventually tire themselves out.

Never mind that, according to the Treaty of Maastricht, the ECB is obliged to ensure price stability under all circumstances. There is no provision for the possibility of letting prices run hot for a while. And, unlike the Fed, the ECB cannot legally seek to balance the goal of price stability with other monetary-policy objectives. The current supply bottlenecks owe much to the quarantine measures in ports – particularly, but not exclusively, in China. Arriving ships cannot unload their cargo and therefore also cannot be loaded with the intermediate products that Europe’s economy must be able to supply to its customers. Freight rates for international maritime transport have increased eightfold since 2019. But the bottlenecks also reflect the domestically imposed lockdowns in European economies last winter and spring, which led to shortages even of local timber and other building materials produced in Europe.

Hence, in a fall 2021 Ifo Institute survey, 70% of German manufacturers reported difficulties sourcing upstream products. For comparison, the highest that figure ever reached in 30 previous years of surveys was 20%. Ifo reckons that supply bottlenecks will cost Germany around €40 billion ($45 billion) of value added – equivalent to 1.15% of its GDP – in 2021. The supply bottlenecks have obviously been unamenable to the huge stimulus and rescue packages that the European governments implemented during the COVID-19 crisis. The German federal government, for example, enacted programs amounting to roughly 10% of German GDP if spread out over two years, and the European Union enacted additional programs amounting to 4.5% of EU GDP over two years. These programs were largely financed by new government debt, which in turn was immediately monetized by the ECB and thus was issued at ultra-low interest rates. Never before has Europe experienced stimulus programs on such a massive scale. But given the supply bottlenecks, policymakers were effectively slamming on the gas with the hand brake still on. The result was a particular form of economic overheating that economists call stagflation.

Inflation rates today are very high not only in the United States, where they stand at 6.2%, but also in Europe. As of October 2021, prices in the eurozone overall had increased 4.1% year on year; in Germany, the continent’s largest economy, prices were up 4.5%. And as if this wasn’t bad enough, the German Federal Statistical Office has just announced that annual industrial producer prices were up 18.4% in October. That is the highest increase since 1951, shortly after the Federal Republic of Germany was founded, exceeding even the peak monthly price increase during the 1970s oil crises (14.6% in June 1974). In contrast to the index for consumer goods, which measures only the prices of final products, industrial producer prices capture all intermediate stages of production. They therefore have a certain prognostic significance for consumer prices, even though the final products won’t show such extreme spikes. (Unlike the latter, they are not affected by changes in value-added taxes such as those occurring in Germany.) These new inflation figures are so extreme that the ECB’s position looks like willful denial. Germany is currently experiencing the strongest inflation in a lifetime. And the situation is not much better in other European countries. In September, France reported an 11.6% annual increase in industrial producer prices, and that figure stood at 15.6% in Italy, 18.1% in Finland, 21.4% in the Netherlands, and 23.6% in Spain. Worse, these increases do not look like a temporary phenomenon. Even though the supply bottlenecks will likely be overcome by next summer, trade unions will by then have increased their wage demands to account for this year’s inflation figures. That will trigger a spiral of rising prices and wages that may continue for several years. Purchases of consumer durables will be pulled forward, further accelerating inflation. Moreover, even when the first inflation wave starts to ebb, perhaps as early as next autumn, new dangers will loom. If the ECB hesitates to follow the US Federal Reserve’s foreseeable interest-rate hikes, the euro will depreciate, boosting import prices further. The baby-boom generation’s transition to retirement implies many additional consumers who no longer support production and therefore create an inflationary demand overhang. On the cost side, the phaseout of all fossil fuels – and of nuclear power plants in Germany – will be a major driver of price growth. It requires little imagination to see how Europe could end up back in a 1970s-like environment of stubborn inflation, which could last for the remainder of the decade and beyond.

Given these circumstances, European economies and the ECB must be given a clear signal to stop any further monetized debt binges. If policymakers want to siphon money from the economy for their aims, they should have to cut other expenditures by a comparable amount. If the rollback via interest rates no longer works because the ECB doesn’t play ball, it will be replaced by a direct crowding-out mechanism via the prices for goods. Either way, today’s inflationary surge marks the end of the pipe dream of resources created from nothing. The good life financed by the euro system’s printing press is over once and for all.

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