ECB cannot escape history

As you may have heard, the governing council of the European Central Bank (ECB) met in Amsterdam last Thursday to announce a historic decision: for the first time in 11 years interest rates will go up. In May, inflation in the eurozone was 8,1%, but that is just the average. In Estonia inflation topped 20%. Especially food, gasoline and energy have become more expensive. As inflation far exceeds the ECB goal of 2%, interest rates will go up to combat inflation. As the regular reader will know, I have been warning about inflation for some time and therefore it is not surprising that people have asked me to weigh in on last Thursday’s events. What ECB president Lagarde announced was that in July the rate would rise from -0,5% to -0,25%. This rate hike will be followed up by another hike in September (to 0%, one would expect) and Lagarde expects further increases after that.

To be honest, I did not immediately know how to respond to this. ‘Too little, too late’ is a true statement but does not even begin to scratch the surface. The first thought in my mind was ‘where to start?’ I have warned about inflation for years, starting as early as January 2020 when the official eurozone inflation was 1,4%. Although a 1,4% annual increase in prices was well below the stated ECB goal of 2%, I had a different view on the matter. I believed then, as I still do now, that official inflation figures grossly underestimate the problem. The Organization for Economic Cooperation and Development (OECD), an association originally founded to carry out the Marshall Plan, first drafted its Consumer Price Index (CPI) in the late 1940s. Back then, large parts of Europe were still suffering from the effects of the Second World War. People were rebuilding their cities and restarting their economy after years of total war. It is not surprising that the most important elements in the CPI were physical goods: bags of cement and potatoes.

If you go into detail on today’s measurements, the CPI has not changed dramatically, while the economy certainly has. Due to globalization, physical goods could be imported more cheaply every year. On the other hand, those things that could not be imported became a far larger part of consumer expenses. The skyrocketing costs of houses, education and medical treatment are not sufficiently taken into account. This is my explanation for the ‘inflation paradox’ of the pre-Covid period: how is it possible that the CPI does not budge while the ECB carries out an extremely expansionary policy? My answer is that high inflation has been there for many years, and just recently became impossible to ignore even while wearing the blindfold of the CPI. Back in the pre-pandemic period, your writer already was puzzled by the ECBs continued practice of printing more money, even while the economy was growing, unemployment was very low and student debt exploded, while those with average incomes were squeezed out of the housing market. And this was all before Covid-19, before Christine Lagarde decided to insert a further €1,850 billion into the economy in response to the pandemic.

However, this statement of fact does not even touch upon the underlying political and moral aspects. Was the ECB’s policy just when it was giving out billions to the few, eroding the purchasing power of the many? Was it ever wise to leave such power to an institution that is not under democratic control? What does it say about the EU that the ECB is buying up government bonds, while the treaty explicitly forbids the ECB from doing this? What is the impact of this money printing on competition and innovation? What is the impact on the relationship between the free market and the state? What about the relationship between the Member State governments and the EU? All questions that are rarely asked, and never answered. I will not aim to answer any of these questions in this short article either. Nor will I bore you with figures and graphs. What I will do is take you back in time to two pivotal moments in history, one a few decades ago, the other more recent.

The last time inflation was as high as it is now was in the 1970s. In that decade, annualized inflation was 10%, a figure similar to that of today. Up until then, economists had believed that inflation was a by-product of an economy that was growing too fast: overheating. Interest rates could be raised to slow down an economy, while lower rates could be used to stimulate a declining or stable economy. What happened in the 1970s was a combination of stagnation and inflation that came to be called stagflation. Economists were astonished: how could this have happened? What happened was that the government had changed the rules of the game. In 1971 the government of the United States paved the way for more monetary expansion in what came to be known as the Nixon Shock. Before then, the USD was convertible into gold. This practically meant that the federal reserve was limited in its interest rate policy. The central bank could set the interest rate at 0%. This would simply encourage investors to take out 0% loans and then instantly convert their free dollars into hard gold.

The gold standard therefore limited the velocity at which the central bank could inject money into the economy. The European currencies all had the same rules and were convertible into USD. US president Nixon abolished the gold standard to enable the US government to borrow at lower rates, mainly to finance the costly Vietnam War. European governments also increased spending, mostly not on wars but on social programs. Both in academia and in politics it became clear that stagflation had been caused by spending too much. This would lead to a new political movement in the 1980s, spearheaded by Ronald Reagan and Margaret Thatcher and copied by many European leaders.

At the time though, explanations for the inflation were not sought in government expenditure and monetary expansion at all. In fact, the main topic in the news back then was the oil crisis. In those days, there were two oil crises. One in 1973 when the Arab nations decided to punish America for its support of Israel in the Yom Kippur war, and one in 1979 when the Iranian revolution interrupted the oil supply from that country. Then, as now, geopolitical explanations were top of mind, while the more structural causes of the problem were out of view, only to be understood years after. Similar to our current situation, there had been an unprecedented increase in monetary expansion. Today, the main culprits are expenditures to combat the fall-out of the Great Recession of 2007-8 and the pandemic of 2020-1. Where in 1971 the world economy was shocked by Nixon, in 2008 the world was shocked by federal reserve president Ben Bernanke. Taking inspiration from a similar policy by the Bank of Japan, Bernanke instituted the practice of Quantitative Easing (QE). A complicated word which means that the central banks buys assets directly. If the interest rate is already at or slightly below zero, the central bank has another instrument to increase the velocity of the economy: it will directly buy government and corporate bonds.

And yet there is one big difference between the 1970s and now. Although monetary policy became far more accommodative back then, interest rates were never lower than 3,5%. In fact, as inflation peaked in 1974, interest rates were already above 10%. In other words, the inflation train continued to roll on while the monetary machinist was pumping the breaks. Be aware: the operations of the ECB will take a long time to start working. And if history is any guidance, a raise of 0,25% will not nearly be enough. Even if the ECB will be able to stabilize the inflation rate in a few years’ time, your euros will have lost over 10% of their value each year. A raise in salaries to offset this will not be possible as this will only fan the flames of inflation.

Moreover, I am not convinced that the ECB will continue to raise interest rates. We have been in an environment of extremely low rates ever since the 2007-8 crisis. The last time the ECB increased rates was 11 years ago, and that is the other moment in history that I want to point out. In 2011 the interest rate rose in two steps from 0,25 to 0,75%. And shortly after, the euro crisis started. Many governments had become so dependent on loans that they could not handle even a small increase in interest rates without immediately becoming unable to make their debt payments. The lesson the ECB drew from its attempt at ‘normalization’ was that it would not be able to do so without an immediate sovereign debt crisis. Ever since 2011, the interest rate has only trended downwards. And therefore, I am not convinced the ECB will continue pumping the brakes. Especially as president Lagarde stated she wants to bring inflation down, but not cause a recession. Not a hopeful message for those concerned with higher prices as lower prices will ipso facto entail a recession.

When looking back at the 1970s there are a lot of parallels with the current day: structural causes are similar, but are overshadowed by geopolitical explanations. The ECB policy change of last week is a step in the right direction but too little too late. More recent history of 2011 does not give a hopeful picture that the ECB will continue in its stated direction. If it backtracks and decides to lower rates again, expand QE, or find a new way to increase the money supply, we may have to look even further back in time for guidance.