David Roberts

Reconciling eurozone inflation and a German budget surplus

David Roberts

Reichstag building

Despite the “best efforts” of the European Central Bank (ECB), core inflation in Europe has remained stubbornly low.

Actually, if you look at the chart below, that should be stubbornly stable. We have all seen the headlines proclaiming the death of inflation and the impending crisis in consumer spending as the Consumer Price Index (CPI) turns negative. We are told that without emergency monetary measures, prices would plunge and demand for all goods and services would collapse.

We know that is nonsense – while there is some empirical evidence that capital goods consumption and investment is tied to price expectation, most consumption is non-discretionary. Put it another way, if you know food prices will be 10% lower in a year, do you not eat until 2020? If your phone breaks today, do you wait for next year’s shiny new model and go “off grid” until then? No, you don’t.

Of course, it is only in recent months that average earnings have started rising above inflation, so unless the savings rate goes up, we should see either higher real growth or higher real prices. And yet, policy rates remain set for an emergency.

Eurozone core inflation has been incredibly stable – where is the emergency?

stable eurozone core inflation 

Source: Eurostat and JP Morgan

The longer it lasts, the more I struggle with quantitative easing (QE). I can understand how providing cheap capital can help “save” the system; however, given capital is an essential input to any business, we need to recognise QE may have material unintended consequences. One of those may well be to reduce inflation given it depresses the cost of capital so much.

A second, related problem comes from productivity. Cheap money has allowed poor companies to continue to operate and bad banks to remain solvent – this type of thing was what caused the Global Financial Crisis (GFC) in the first place. The European banking system has failed to properly address its balance sheet: even 10 years after the GFC, many financial institutions have failed to reform.

And what is a by-product of this inefficiency and overproduction? Too many goods produced too cheaply, a curb on inflation. Largely to support the banking system, ECB president Mario Draghi has kept rates at record lows. Rather than address the inherent weaknesses in the eurozone, inefficiency and poor capital allocation, QE has promoted them.

The US learned its lesson years ago: free market capital demands a fair return or else allocation is inefficient. It is little surprise economic activity and productivity in the US have greatly outstripped Europe since 2008 – and ECB policy continues to threaten global capital allocation. Although buying German Bunds at a yield of 0.2% appears insane, those assets can be “swapped” back to US dollars, generating a policy-busting 3.2% for American investors. Those lovely, positive real yields support US consumption, while European negative yields depress theirs.

Capital flows to German industry at incredibly cheap real rates and funding for the economy therefore remains extreme. As we all know however, consumers receive yield and income and spend them today; corporate returns on invested capital may only accrue in the long term and the benefit flow to pension funds.

Chancellor Merkel naturally recognises this. German inflation has been running near 2% for some time and given the strength of the labour market, it is surprising it has not been stronger. Of course, earnings have been slow to rise in this decade. Several economists are now forecasting 5% wage growth in Germany this year, which could put upward pressure on inflation.

Merkel though has taken a leaf from the Bundesbank book. What do you do if inflation is high and monetary policy is not working (in her case, outsourced to the ECB)? You cut fiscal expenditure.
For those worried that German growth is poor, please remember the government has a budget surplus of 1.7% of GDP. Mrs Merkel controls German GDP.

German fiscal policy offsets cheap money

german fiscal policy offsets cheap money

Source: Tradingeconomics.com and Federal Statistical Office

Now, in a properly integrated system, Germany would transfer this surplus to slow growth, deficit states in the eurozone. That, in effect, is what happens in the US at Federal level. I suggest for the euro experiment to move to the next stage, such capital transfers are essential. In a fixed exchange rate regime with varying levels of productivity, this is key.

In the short term, to avoid continued economic inefficiency and low inflation, Draghi really should be raising rates. Do that and the euro rises, reducing German exports and prompting Merkel to spend more money, much of which might just be spent in the internal, EU market.

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Friday, February 8, 2019, 10:42 AM