Europe Will Not Benefit From An Inflation Spike

Authored by Daniel Lacalle,

Inflationists are happy. Inflation expectations rise to five-year highs and some rub their hands with the idea that their grand plan to create inflation by decree is going to be a success.

Inflation, the tax of the poor, applauded by no consumer anywhere ever.

The discourse of inflationists is simple and, therefore, farcical. If inflation increases, the debt “deflates”, entering into a process of deleveraging as liabilities of states, companies and families loses value each year. “If inflation rises to 4%, every year, we have 4% less debt,” I was told in a television program. I thought “great, and if it’s 50% in two years we have no debt.” A joke.

The problem of the Eurozone is very different and will not be “solved” by inflation.

The Eurozone’s debt repayment capacity has weakened due to accumulated deficits, deterioration in cash flows, and the creditworthiness of public and private agents.

The problem with the simplistic argument of consensus inflationism is that it does not happen. There must be a warning of the risk of “trusting” in an inflationary exit to the liquidity trap.

• With rising inflation, real interest rates and interest expenses rise, in countries that do not reduce debt in absolute terms because deficits are structural.

• Tax revenues do not grow with inflation because overcapacity remains, most of the inflation increase comes from higher energy and input prices, and this creates weakness of margins. Anyone who thinks that real wages are going to grow at or above inflation when productivity growth s close to zero and with the stock of unemployment that still exists in the eurozone, including furloughed jobs, must be joking.

• Input costs increase more than sales, because of overcapacity, aging population, and higher imported oil, copper and zinc prices. Imports rise, and the ability to pass-through to final prices diminishes.

• “Existing” debt -stock- reduces its value due to inflation, but deficits and interest expenses may rise.

Low prices actually helped to cement the Eurozone recovery after the 2009 crisis. If it were not for low CPI, it would have been much more challenging for families to endure the bubble-led crisis and subsequent real salary decrease and unemployment rise.

Anyone who thinks that inflation would have prevented the crisis is ignoring the factors behind the Eurozone recession. The questionable Phillips curve link between CPI and unemployment was debunked decades before.

Of course, the inflationist alchemist is confident that these risks – which they cannot deny – will be canceled-out by the European Central Bank’s monetary policy, which will have to repurchase everything that is issued to prevent real rates from rising alongside inflation.

When artificially manipulated rates fall below real inflation, credit growth collapses, real productive investment falls and, with it, the velocity of money. In fact, the only investment and credit that is encouraged by this policy is high risk and very short-term oriented to compensate for the difference between reality and manipulated rates.

Families in Europe have managed to reduce their indebtedness admirably in these years. And the vast majority of their wealth is in deposits. If we think that an aging population is going to buy more in real terms because prices rise, we have not learned anything from the evidence of the past. But some will say that this time is different.

The problem with the Eurozone is that it is trying to solve structural problems with any measure except the one that fixes the perverse incentive that perpetuates stagnation. The constant transmission of wealth from the efficient and the saver to the indebted and inefficient.

The EU tries to fix the economy without touching the mechanisms that slow it down. High government spending, low productivity, and poor competitiveness.