Inflation the New Anti-Deficit Policy

Want some euros? There is plenty of them around, and there is going to be even more. The European Central Bank is considering a massive expansion of money supply to fight deflation, which is undoubtedly the enemy of a recovery. Deflation means that falling consumer prices depress the profitability of today’s production and investments. This is the last thing you want to add to the macroeconomic mix in a recession, where profit margins are slim to begin with.

However, the ECB wants inflation for another purpose as well, namely to close the budget deficit gaps that persistently plague Europe’s welfare states. This raises two questions:

  • How smart is this strategy?
  • Even if it was smart, could the ECB provoke inflation just by printing money?

Let’s address the latter question first. Printing money does not necessarily help. Consider this chart:

euroflation 2

At least in the past four years, Europe has experienced an inverse relationship between the supply of M1 money and inflation. This simple statistical observation raises a few questions regarding the ability of the European Central Bank to boost inflation by printing money. Yet, as this article from The Telegraph explains, the leadership of the ECB does not seem to have any qualms about putting the monetary printing presses to work:

Investors are betting the ECB will cut interest rates next month, paving the way for potential further steps such as a bond-buying programme, after its president Mario Draghi said on Thursday the bank was ready to act in June if updated inflation forecasts merit it, reports Bloomberg’s David Ingles.

There was a time when a statement like this from a central bank meant it was ready to act to curb inflation. Now the mindset in central banking is more or less the opposite, with Janet Yellen at the Federal Reserve seeming impervious to the worries about inflation. Admittedly, she has no choice but to continue the Fed’s QE program, but at the same time she has a history of talking dovishly about inflation. It is not inconceivable that she, while essentially being forced to continue QE, harbors a secret wish for higher inflation in the U.S. economy. If so, it is not beyond the realm of the probable that if Congress took decisive steps to rein in the federal debt, and thus eliminate a major reason for the Federal Reserve to print money, Yellen would actually continue printing money just to keep inflation up.

Her counterpart at the European Central Bank, Mario Draghi, is apparently also comfortable with trying to provoke inflation. However, both he and Janet Yellen are playing with fire. Once inflation goes beyond a certain point it grows legs of its own.

The Telegraph again:

European Central Bank President Mario Draghi strongly hinted Thursday that the eurozone’s top monetary authority could take action next month to counter persistently low inflation and strengthen the recovery … The bank’s 24-member rate council refrained from loosening its monetary policy on Thursday. But Draghi said it “would be comfortable with acting next time,” in June, when it will have new staff inflation forecasts.

And now for the question whether or not it is wise to use inflation to fight budget deficits. Buried in the article is a statement that appears to come directly from the smoke-filled back rooms in the ECB headquarters:

Low inflation is a concern because it makes it harder for people and governments to reduce debt.

It is a very safe bet that Mario Draghi, just like Janet Yellen, would like to see inflation precisely because of its effect on government revenue. If that is indeed where we are heading, then it means that influential policy makers would use inflation as a third measure to save the welfare state, after taxes and deficit spending. As you move out that scale, from taxes to inflation, the destructive force of the government-funding measure increases. If our policy makers are indeed so married to the welfare state’s entitlement programs, then we are in for a long, long ride through a landscape of economic stagnation and industrial poverty.

Not even the United States can withstand the pressure from a growing welfare state if our government resorts to inflation to pay for it.

It remains to be seen if that will happen. We still have pretty strong safety zones between us and the European disaster. Those safety zones are essentially constructed by the absence of the worst forms of entitlement programs (general income security being one of them) and a checks-and-balances government that can still fend of the worst excesses of government expansionism. This may prove enough to protect us from succumbing to a European welfare state, which essentially is a slowly detonating socioeconomic counterpart of the hydrogen bomb.

So far we have survived the – admittedly large – elements of the welfare state that we have had to deal with. However, this does not mean we are immune forever. We need to understand in depth that it was big government, not the financial industry, that brought Europe to its knees. Only then will we understand how futile, irresponsible and outright dangerous it is to let inflation loose in our economy.

If the Europeans want to create inflation, there is nothing we can or should do about it. It would mean that they have made the ultimate choice – the welfare state at all cost – but it does not mean that we must make the same choice.

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