The Russian invasion of Ukraine has thrown the world into a state of uncertainty. For the Ukrainians, the situation is of course catastrophic, with lives lost, livelihoods shattered, and basic functions of society disrupted.
Repercussions beyond Ukraine’s borders are nowhere nearly as serious as they are for those at the frontline, but the heightened level of uncertainty will nevertheless take a toll, especially on the economy. Rising uncertainty about the future will cause a decline in consumer spending and business investments, with higher unemployment and social costs as a result.
With the fallout of the Ukrainian war still unknown, economic forecasting has become even more important than usual. One of the most pressing questions on the economic horizon relates to inflation: will it rise or fall? Even a moderate increase in inflation can be the difference that pushes a successful business over the edge into bankruptcy or forces a family to sell their car or move to a smaller home.
For many businesses, financial and other planning of operations and investments often depend on economic forecasts. Sadly, having worked as a Ph.D. economist for more than 20 years, I cannot outright recommend anyone to rely on the economics profession in times of great uncertainty. Economists in general do not have a stellar record for predicting the future; ironically, given how thoroughly economists are trained in quantitative methods, their ability to predict the future is better when times are good and people are confident about the future, than in times of great uncertainty.
Inflation is a good example of poor economic forecasting. In early 2021, economists from both the Federal Reserve, the Bank of England, and the European Central Bank (ECB) in unison predicted only very modest increases in inflation for the year. Levels of 5-8%, which we are now living with, were beyond the realm of the imaginable.
This poor track record persists, and one reason is a widespread reluctance among economists to rely on economic theory. In fact, there is a tendency—especially among central-bank economists—to shy away from economic theory. We are already living with the consequences, as neither the Federal Reserve nor the ECB has been able to keep inflation even close to their long-term targets.
As a case in point, with euro-zone inflation having risen from 0.9% to 5.1% in one year, the ECB continues to resist the use of economic theory as a basis for its inflation outlook. In a recent interview with Frankfurter Allgemeine Zeitung, republished on February 23rd by the European Central Bank, economist and ECB board member Philip Lane says outright that monetarist theory, the most powerful explanation of inflation that economics has produced, has nothing to do with current euro-zone inflation.
Monetarism, the theory according to which excessive money supply causes inflation, is not popular with Lane. Regarding monetarism, he says,
people have too much money in their bank accounts, leading to a big surge in consumption and investment, which drives prices up. We are not seeing that.
When a central banker dismisses monetarism, it is almost of paradigmatic importance as it signals an openness toward more monetary expansion. This is even more noteworthy, given that Lane is in good company here with Federal Reserve Chairman Jerome Powell. This attitude toward monetarism can help us understand the poor inflation forecasting by both the ECB and the Federal Reserve. Neither central bank has been even close in their recent inflation outlooks.
By denying the significance of monetarism, ECB board member Philip Lane refuses to recognize even the basic mechanics of this economic theory. Those mechanics are best understood as “transmission mechanisms,” or channels through which newly printed money makes its way out in the economy and causes inflation.
In the quote above, Philip Lane gave an example of a transmission mechanism, but that is only one example. Government spending is at least as important: when government runs a budget deficit and borrows money from the central bank, the bank responds by printing money. Government spends that money in ways that have direct inflationary consequences.
This is what economists refer to as “monetized debt” or “monetized deficits.” Yet Philip Lane does not even mention government as a transmission mechanism from money supply to inflation. In doing so, he puts himself in a precarious situation: on the one hand, he has done his best to deny the idea that monetary expansion creates inflation; on the other hand, he cannot deny that the ECB (his employer) has printed exorbitant amounts of money over the past two years:
The pandemic led to very high demand for liquidity and the ECB had two options: either meet that demand and allow a big expansion in liquidity in the system or have a large increase in capital market interest rates, which would have added a financial problem on top of the pandemic problem.
Here is where Lane’s dismissal of economic theory loses steam and runs aground. He produces a strange contradiction, an elementary one that self-respecting economists should always avoid. But it is worth looking at, since it helps explain why Lane—and by extension the ECB itself—cannot properly assess the threat that inflation represents today.
The key word is “liquidity.” Lane suggests that the pandemic itself drove up demand for “liquidity,” by which he means money. During the pandemic, when large swaths of the European economy were shut down by government, private-sector economic activity declined. Consumers spent less money, businesses reduced investments and payroll. This led to a decline in demand for money.
But if money demand fell, why would the ECB have printed so much more of it?
The reason is simple: government. Since the private sector of the economy was being regulated into a virtual standstill, the flow of tax revenue into government coffers declined as well. Government still had to maintain its spending promises through the welfare state, and in many instances even expanded those promises.
Here is the reason why demand for money increased: government needed to fund large deficits. The ECB was a cheap, convenient source for that money.
Any student of monetarism knows that sooner or later, a major monetary expansion will cause inflation. Philip Lane, and by extension the ECB, tries instead to explain inflation as being rooted in import prices. Due to high demand for imports, the reasoning goes, prices went up at the “port of entry” where imports reach the domestic economy.
However, there was no reason for import prices to rise and trigger inflation. Due to the artificial economic shutdown in 2020 and partly in 2021, the European economy lowered its demand for imports; if anything, this would lead to import-price deflation.
The reason why import prices have increased is found in a combination of two factors: the money printing that kept government spending up, and the restrictions placed on the domestic economy. The latter affected the logistical chain that brings imported products to consumers.
It is also worth noting that oil prices can cause inflation on their own. A number of factors contributed here, from President Joe Biden’s efforts to stop the expansion of oil production in the United States to the tendency among investors to speculate in oil and other commodities in times of uncertainty.
All in all, a combination of domestic restrictions on economic activity, speculation in the headwind of uncertainty, and the overall nature of energy market, created inflationary pressure where under normal economic circumstances none would have existed.
However, as mentioned, this is only part of the inflation story. Demand for energy, or any other product, would not have remained at inflation-triggering levels, were it not for new money being pumped out into the economy by government.
It is not difficult to see how government fulfilled the function of a liquidity pump. There is a compelling correlation between budget deficits and the ECB’s monetary expansion. In the seven quarters from Q1 2020 through Q3 2021 (the latest for which Eurostat publishes data), the governments of the 19 euro-zone members borrowed a total of €1.37 trillion. This is 28% more than during the first seven quarters of the Great Recession of 2009 and 2010.
Now, compare these accumulated deficits with the ECB’s monetary expansion during that period of time. Focusing on M1, the narrowest measure, in the seven-quarter pandemic period the ECB increased money supply by €1.88 trillion. This more than three times the expansion during the Great Recession episode, when the ECB ‘only’ grew M1 money supply by €565 billion.
During the Great Recession, money supply expanded by 53% of the accumulated deficits. In other words, even if all that expansion had been allocated toward monetizing deficits, its effects on inflation would have been limited. By contrast, during the pandemic, the ECB’s money printing was 38% bigger than the accumulated deficits. There was also a more concerted effort to make sure every euro of that extra money supply went toward financing government deficits.
As mentioned, money does not become inflation unless it has a way to make it into the pockets of people who can spend it. This is called a “transmission mechanism” which in the case of government consists of social-welfare or entitlement programs. When tax revenue is short, these programs are funded by the sales of treasury securities. When the ECB buys those securities, it pays with newly printed money.
The cash entitlements pay out the newly printed money to individual citizens under a variety of programs, from unemployment benefits and social welfare to discretionary stimulus checks (as in the United States during the pandemic). This money is then spent by consumers, either to pay for current expenditures or on durable-goods items (as, again, was the case with the U.S. stimulus checks).
Under in-kind entitlements, government uses the newly printed money to buy services for eligible citizens. These services can range from subsidized housing, where government pays all or part of the rent, to health care. To provide these services, government buys products and labor: the products consist of, e.g., equipment for hospitals and paychecks for doctors and nurses.
Over time, this deficit spending causes inflation, and there is a simple way to understand why, using the terms “value in” and “value out.” When I buy a bottle of iced tea at the store, I take value out of the economy. That value was produced by someone, who brewed the tea, bottled it and shipped it. All the labor and the parts going into that bottle and its content add up to the value of the product I buy from the store.
Normally, in order to buy that bottle, I need to put value into the economy by producing something that someone pays me for. However, when government uses newly printed cash to pay out entitlements to people, there is no value going into the economy to compensate for the spending that the new money pays for. The imbalance between “value in” and “value out” causes prices to rise.
In short: monetary inflation.
Due to the origin of the inflation—a decision made by government—there is no market-based, self-regulating mechanism to curb the rise in prices. The longer the monetary pump keeps blowing more liquidity into the economy, the higher and more persistent inflation will be.
Faster monetary expansion drives more inflation.
So long as our central bankers refuse to admit this fundamental law of economics, we are at risk of continued high inflation. For this reason alone, not regarding the uncertainties related to the war on Ukraine, I worry that we may see high inflation in both Europe and America for the duration of this year.