Brendan Brown *
High inflation starts where political forces are too strong to permit tough tax and monetary policy adjustments, such as preventing a currency collapse. In today’s global financial market, there is erratic concern that the US is heading towards this point, albeit on a very uncertain date, as evidenced by the waves of attacks on the US dollar last spring, summer and fall. In reality, however, the level of long-term inflationary threat in Europe is higher than in the United States.
Any significant corrective action in Europe sufficient to stem the future threat of high consumer price inflation would unleash forces that could potentially sweep away the current status quo of political and economic power. Therefore, whatever the immediate cause of the acceleration in inflation, we must expect that the consensus of the political elite – Berlin with full agreement – will decide to give up.
Currency depreciation is likely to be an important part of the dynamic process of high inflation emerging in Europe, as has indeed often happened in the laboratory of history. This lab lesson does indeed apply to the United States and, not least, to the origins of the greatest peacetime inflation that began in the early to mid-1960s.
The story began with economic miracles in Europe (France, Italy, Germany) and Japan. The Fed, as the monetary hegemon of the Bretton Woods system, should have allowed interest rates to rise sharply, as they would under a secure monetary regime. Instead, the Fed, determined to get the Kennedy administration to abandon its 1950s bans, has monitored its monetary policy to keep interest rates low. As consumer price inflation was high in 1965, lagging behind asset inflation, the Fed did indeed start allowing rates to rise, even at times suddenly. However, consistently bold action would dramatically increase the cost of public sector borrowing, which was soaring at the time when the Johnson administration fought the Vietnam War and adopted the social programs of the Great Society.
Fed chief William McChesney Martin had neither the appetite nor the political basis to go on a course of confrontation with the Johnson administration, and in any case was of the opinion that his institution was “independent within government” rather than “independent from government.” The dollar was allegedly sick, as evidenced by the rise in free gold prices since the spring of 1968 and the revaluation of the Deutsche mark the following year.
The scenario of high consumer price inflation in the US, which many are now thinking about for years to come, is unlikely to include economic miracles outside the US as it did in the 1960s. Perhaps a key part of this story could have been the resilient economic power of the private sector, which requires much higher rates and which the Fed cannot provide.
A downturn in the growth cycle or even a recession in 2022/23 could interrupt travel to this destination for a while. But when high CPI inflation eventually emerges, there is likely to be strong resistance to higher conventional taxes or cuts in government spending. Also, with so much outstanding corporate and mortgage debt, the screams will be huge against any corrective cash action that means higher interest rates. Thus, the Fed may well agree to “throw all the trouble away.”
However, this conclusion is not unambiguous. There are alternative, less plausible scenarios where forces opposing such cynicism could win a political majority, and the Fed has many technical options to “normalize” monetary conditions. As an illustration, the Fed may liquidate its vast portfolio of Treasuries within a short period as part of an operation to restore the monetary base to an effective anchor role.
This is not the case in Europe. Here “too late to return” is a phrase whose infamous fame goes back to Emperor Franz Joseph’s refusal in late July 1914 to soften Vienna’s ultimatum to Belgrade. A century later, it will almost certainly be too late to return to the plummeting euro. Every time the European economy takes a sustained recovery from a pandemic, the ECB will not allow rates to rise in line with any incipient rise in consumer price inflation.
A look at the ECB’s balance sheet explains the alleged tenacity. By the end of 2021, it will reach 80 percent of the eurozone’s GDP, compared to the Fed’s balance sheet of just under 40 percent. While the Fed’s balance sheet consists almost entirely of US government loans (mostly Treasury bonds) and government-sponsored mortgage debt, the ECB is made up mostly of junk or border debris, including huge stocks of weak sovereign debt (Italy # 1). … Loans to the de facto bankrupt banking sector account for a third of all ECB assets. In addition, the central banks of Italy and Spain have borrowed more than € 1 trillion under the so-called TARGET2 system from the Bundesbank, the main lender on the other side.
Consider a thought experiment in which the ECB embarked on a course to normalize monetary policy, causing market interest rates to rise 200 basis points across the board and decline, say, 25 percent as the first phase of a monetary recovery. as an anchor to the system. Weak banks simply could not pay the ECB an added interest rate on their huge debt, given their lack of room to raise rates on their loans to weak governments and corporations. Either way, they would have had to get subsidies to pay interest – but how can critically weak sovereign countries afford it, other than by printing money from the ECB? Resentment from the Lean North and EU laws against state aid will hamper action.
The Green-CDU (Christian Democratic Union) coalition in Berlin, which according to current polls may appear in elections this fall, would not want to destroy the European Economic and Monetary Union (EMU). Maintaining the status quo means making it clear to the ECB to keep rates low (currently below zero) and spare us all these traumas. In a similar vein, imagine the stress of the system if the Bundesbank required the Bank of Italy to pay interest on its debit balance under TARGET2, or if the ECB had to liquidate 20 percent of its Italian government debt as an anchor to rebuild the monetary base. as part of a general reduction. Better to just let inflation rise.
The dynamics of inflation will critically depend on the behavior of the euro. If by then the United States will contain monetary radicalism in the context of accelerating inflation, then the fall of the European currency could really take your breath away. Even if the political forces in Germany opposed to high inflation gather strength under such circumstances, it will not slow down the fall of the euro. In any scenario of the collapse of the EMU, including opening the way to a new firm euro, the ECB is in the first place threatened with liquidation.
Brendan Brown is a founding partner of Macro Hedge Advisors (www.macrohedgeadvisors.com) and a senior fellow at the Hudson Institute. As an international monetary and financial economist, consultant and author, he served as Head of Economic Research at Mitsubishi UFJ Financial Group. He is also an Associate Research Fellow at the Mises Institute. He is the author The Age of Crises in Europe under Dollar Hegemony: Dialogue on the Global Tyranny of Unreliable Money with Philip Simonno. His other books include Arguments against 2 percent inflation (Palgrave, 2018) and he is the publisher of Money Scenarios, The Euro Collapse: How Asset Price Inflation Destroys the Wealth of Nations and The Global Curse of the Federal Reserve System: A Manifesto for the Second Monetarist Revolution.
Source: article published by the MISES Institute.