In their June 30th preliminary estimate, Eurostat reports that euro-zone inflation will be down to 5.5%. This is a significant decline from the 10.6% top in October last year, but it still exceeds U.S. inflation, which dropped to 3.0% in June.
The euro zone reached its inflation peak four months later than the 9.1% inflation top for the U.S. economy. However, despite the laggardly return to a more reasonable inflation rate, Europe in general and the euro zone in particular can look forward to more acceptable rates in the near future. The European Central Bank thinks that euro zone inflation in 2024 will be 3.0%, followed by 2.2% in 2025.
All other things equal, I believe that the return to low inflation will happen more quickly, as the economies in the euro zone are having notorious problems with economic growth. A stagnant economy is more likely to have low or no inflation than a growing economy. The one factor that could upset this outlook is if the ECB would abandon their current, comparatively conservative monetary policy. If they stick to their current policy, the currency union will see its inflation fall below 2.5% before the end of this year.
Unfortunately, I don’t think the ECB will maintain its monetary conservatism for much longer. As I explained back in April, there is a good chance that the ECB will downplay its fight against inflation and thereby ignore the compelling evidence that its own money printing caused the recent inflation episode. Instead, the ECB could return to buying sovereign debt; when a large enough number of member states run big enough deficits, I noted,
the ECB will come to the ‘rescue’ with newly printed cash. It will not be an independent choice by the central bank, but a de facto request from the EU
because this constitutes the path of least resistance for indebted governments. The only other option is Greek-style austerity, which I noted would “bring out the worst of a country’s democracy” and cause social unrest as well as a flight to the political extremes.
Of the two options, austerity or monetary expansion, the ECB will choose the latter.
I stand by this prediction, which means that I also maintain that there is an elevated risk for stagflation in Europe in the next 18-24 months. This is a situation where the economy experiences high inflation and high unemployment at the same time. If the ECB returns to its previous policy of accommodating budget deficits, i.e., printing money to buy government debt, then the next recession will have both the stagflation ingredients.
The link between money printing and inflation is strong, and it takes its most potent form when the central bank uses its newly printed money to buy sovereign debt. As we carefully demonstrate in Gmeiner, R and Larson, S: “The Fiscal Transmission Mechanism of Inflation” (American Business Review, 2023) this is why we saw such an eruption of inflation immediately after the pandemic. Both the Federal Reserve and the ECB bought an inordinate amount of treasury securities, and they pumped trillions of dollars and euros through government budgets out into the economy.
Since the exact mechanism for transmitting newly minted cash into inflation is explained in the aforementioned article, I will only give a brief summary here:
- The government budget is in deficit. The finance ministry (the treasury) sells debt instruments—sovereign debt—but investors demand higher rates than the treasury is currently paying.
- The central bank decides to intervene. It mints new currency and uses it to buy treasury securities.
- Government spends the money on its regular programs, more than 70% of which is cash handouts or in-kind services under the welfare state. No work is required for people to benefit from that spending.
- Thanks to the no-work requirement, the newly printed cash, which is transmitted into the pockets of consumers, competes for a constant set of resources in the economy. This leads to inflation.
These four steps all took place in the euro zone during and after the 2020 pandemic. The numbers reported in Figure 1 below represent the number of euros in circulation per €1 (an ‘upside down’ version of the velocity of money). As is evident from Figure 1, the ECB has been engaging in monetary expansion already from the start of the euro zone, but up until 2020 the expansion was relatively steady:
- In 2016-2019, M1 euro-zone money supply expanded by 8% per year, on average;
- From the first quarter of 2020 to the first quarter of 2021, the ECB increased its money supply by 14.5%.
This translated into a radical increase in the money-to-GDP ratio reported in Figure 1:
Figure 1
Sources of raw data: ECB (money), Eurostat (GDP)
The pandemic-related bump includes the ECB’s widespread purchases of sovereign debt across the euro zone.
Next, we add inflation to the mix. Using a broader monetary measurement, M3, Figure 2 compares money printing to inflation. The M3 measurement has both advantages and drawbacks; in our current context, it gives the practical image of how liquidity—the broadest concept of money—is used throughout the economy.
The correlation between the change in M3 money supply (green) and inflation (red) is for the most part lagged by a year, with the monetary expansion preceding the rise in inflation, and vice versa. However, the correlation is never as strong as when the ECB starts purchasing government debt in 2020:
Figure 2
Sources of raw data: ECB (money), Eurostat (inflation)
With a strong correlation between money printing and inflation, and the causality well explained (again, for more in-depth analysis, see the aforementioned paper on the transmission mechanisms), we must ask the inevitable question: how can we avoid outbreaks of monetary inflation in the future?
Simply answering ‘don’t print so much money’ is inadequate: there is always a reason why central banks print money, and that reason is almost without exception external to the monetary authority. Therefore, in order to prevent future episodes like the one we are now on the back end of, we need to take seriously the role that government deficits play in causing inflation.
Not all deficits have the same effect on inflation, simply because not all deficits are used the same way. If we run a deficit to fund a temporary military expansion, the inflationary transmission mechanism is limited in impact, though not insignificant. The money that is funneled from the central bank out into government spending reaches limited patches of the economy, i.e., the defense industry.
When the budget deficit funds a welfare state, the inflationary effect grows stronger. Not only is a welfare state deficit typically bigger than a ‘military’ deficit, but it also tends to be more persistent. It is the reason why the U.S. government has run budget deficits every year since at least 1969 (with only four exceptions during President Clinton’s second term) and why Europeans continue to struggle with deficits, despite much higher taxes than we have in America.
The unending streak of U.S. budget deficits begins right as Congress starts implementing new spending under the new, economically redistributive welfare state that they created in the mid-1960s together with President Lyndon Johnson. Since then, this welfare state has grown at a moderate pace, with annual deficits building the $32.5 trillion debt that the federal government has today.
Up until the pandemic in 2020, neither the American nor the European deficits caused any major inflation episodes. The reason is in the general absence of central-bank purchases of sovereign debt; to the extent it happened, those deficits funded such a limited share of the welfare state that the inflationary effect was too weak to ‘break out’. That all changed with the pandemic and its deficit monetization, on both sides of the Atlantic Ocean.
In other words, the best way to make sure that no economy experiences monetary inflation is to reform away the economically redistributive welfare state. We can replace it with a conservative version, which impacts the economy in a less intrusive and less inflationary way than the redistributive (and fundamentally socialist) welfare state does. Since the conservative welfare state still funnels money into the hands of some citizens, the mechanics for monetary inflation are indeed in place. However, they are considerably weaker than under the socialist version.
There is another advantage to a conservative welfare state, which is apparent in contrast to redistributive variants of American, Scandinavian, or standard European architecture. These welfare states increase their spending automatically in a recession while having less tax revenue to fund it. As a result, a deficit opens up quickly and early, increasing the possibility of monetization when spending is high relative to GDP, and the economy is particularly vulnerable to monetary inflation.
This is exactly what happened during the pandemic.
By contrast, a conservative welfare state largely maintains its spending levels through the business cycle; it does not provide entitlements on conditions that are dictated by, and inversely related to, the business cycle. Therefore, while still somewhat vulnerable to the inflation mechanism, it protects the economy much better against monetary inflation than does the socialist welfare state.
In short, reforms that reduce or eliminate the welfare state’s economic redistribution mechanism function will help protect the economy against inflation.
Another step, often suggested by conservatives, would be to reintroduce the gold standard. Many conservatives believe that the gold standard is a surefire way to keep inflation out of the economy.
I am sorry to say that this is not the case—in fact, under unfortunate circumstances, the gold standard can itself cause inflation. (I intend to return to this issue in a coming article.) Furthermore, to see why the gold standard is inconsequential in preventing monetary expansion, let us take a look at Figure 3. It reports the money stock in the U.S. economy as a ratio to GDP, i.e., the same measurement that we used for the euro zone in Figure 1.
To adapt to available statistics, we use the M2 measurement instead of M1. The reason is that a few years ago, the Federal Reserve made unbelievably stupid changes to its M1 time series data. With those changes, they effectively rendered their own M1 database useless for statistical analysis.
As the name suggests, M2 is bigger than M1 but more limited than M3. When compared to the quarterly GDP for the American economy, the Federal Reserve’s monetary policy is put on full display:
Figure 3
Sources of raw data: Federal Reserve (money), Bureau of Economic Analysis (GDP)
Up until 1971, the Federal Reserve pegged its money supply to the U.S. government’s gold reserve. If those who claim the gold standard holds back money supply were correct, we should have seen a rapid monetary expansion after 1971. That did not happen. On the contrary, the money supply remained largely constant in its relation to U.S. GDP. It even fell modestly when Paul Volcker took over as chairman of the Federal Reserve.
His successor Alan Greenspan, who chaired the Fed for almost 20 years, was even more conservative in his monetary policy. It is worth noting that both he and Volcker stayed away from buying large quantities of U.S. government debt. That changed when Ben Bernanke took over the helm of the Fed after Greenspan. He was quick to introduce his ‘quantitative easing’ program, which bluntly funneled newly printed cash straight into the federal government’s budget.
At that time, the proportion between the monetized deficit and total government spending in the U.S. economy was too limited for the deficit monetization to have an immediate, significant inflationary effect. That is not to say there was no effect; it just wasn’t strong enough to force the economy into a major inflation episode.
That happened instead when Jerome Powell took over after Bernanke’s successor Janet Yellen. Powell opened the monetary floodgates—and the rest is history.
In other words, the welfare state and its persistent budget deficits are a more ominous threat of inflation than the absence of the gold standard. If the ECB returns to money printing, it will be to once again save the euro zone’s deficit-ridden welfare states. That is the scenario that we really need to worry about.
