On September 21, I attended a hearing of the Bundestag’s Finance Committee on the question of who should take responsibility for the high rates of price increases currently being measured. The Bundestag itself sums up this hearing under the title “ECB’s responsibility for inflation disputed” (found here). This is a misleading address. Under the current institutional circumstances, it is completely indisputable that the ECB has to take political responsibility, but that absolutely does not mean that the ECB caused the price increases, nor does it mean that it has to fight them with interest rate hikes.
But that is a subtle distinction on my part, some observers will say, because responsibility now means taking action against the violation of one’s own objective, and that is exactly what the ECB is currently doing with the means at its disposal. Consequently, one might as well dispense with this distinction. If this were the case, however, it would only mean that the one-sided assignment of responsibility for price stability to the central bank, which has been considered correct in many Western countries for several decades, is fundamentally wrong.
Causal therapy or curing symptoms?
This touches on a very fundamental question, namely the significance of cause therapy in complex systems such as an economy. In medicine, even the layman knows that merely curing symptoms can be nonsensical and dangerous if one is in the dark about the causes of a disease. In economics, this rather trivial insight has been completely lost because it has developed into a subject that can no longer deal at all with the concrete temporal processes in the complex and dynamically developing system of the economy.
Anyone who looks at all phenomena in the world from the point of view of market equilibria has no need for temporal processes and thus no need for causality; after all, he knows that too high prices mean too much in terms of money, no matter in what way and for what reasons prices have risen in some markets. With the simple statement that inflation is always and everywhere a monetary phenomenon, the supreme monetarist Milton Friedman described this thinking many decades ago. Without saying specifically what inflation is and what distinguishes it from temporary price increases, this statement makes no sense at all anyway, but it is dangerous because it suggests simple solutions that do not exist in reality.
The constant money supply as the ideal?
How absurd monetarist thinking is can easily be shown by the argument that is now emerging again and again, which – as was the case at the Bundestag hearing – amounts to claiming that it was only because of the massive “accumulation of money” by central banks in recent years that prices have been able to rise as sharply as they are currently. Only because the money supply was already very large, so the steep thesis, could the energy price increases lead to a general price increase.
If the central banks had kept money really tight (or if money supply had even remained constant), other prices would have had to fall when energy prices rose (according to ZDF, Der Spiegel, and Professors Günter Schnabl and Fritz Söllner at the hearing a few weeks ago). Consequently, monetary policy is not the direct cause, but still the “real cause”.
Mind you, even all those who fully agree with the restrictive ECB policy (such as Peter Bofinger and the President of the Deutsche Bundesbank, Joachim Nagel), without explicitly using this argument, must implicitly rely on it, because otherwise their position is nonsensical from the outset. Combating temporary rates of price increases, which have nothing to do with the money supply, with monetary policy restrictions is, especially in a period of economic weakness, dangerous. It is the aforementioned dangerous, because unthinking, curing of the mere symptom (which is shown in this Financial Times article and here).
The Monetarist Confusion
The confusion about the role of money supply and monetary policy is also expressed very vividly in a statement made to the Guardian by Kwasi Kwarteng, the new UK finance minister. He says “Something’s gone wrong” when a central bank has a price target of two percent and suddenly faces a rate of price increases in the double digits. Kwarteng apparently believes it must have something to do with the organization of the Bank of England if one misses the set target by so much.
Behind this, again, is the belief that the “money” relevant for inflation can be controlled in such a way that inflation, if one excludes manual errors by the central bank, is impossible. This is nonsense. Nothing’s gone wrong, except that there is an untenable theory of inflation called monetarism that can’t seem to get out of some academic and policy minds, even though it has never played any practical role in monetary policy .
Behind monetarism is nothing but the so-called quantity equation. However, M × V = P × Y, as the equation is often written (with M as money, V as the velocity of money in circulation, P the price level, and Y as real national income), is not a theory but an identity. Indeed, V is the variable that, by definition, provides for the equalization of the quantities, because there is always an (unknown) multiple of the money supply that “finances” the right-hand side, nominal GDP (or some other income quantity). The only statement that can be taken from this equation is “All transactions in a money economy are financed in one way or another.”
Obviously, the left-hand side is tremendously flexible because, after all, a multiple of a money supply generated by the central bank is always used for financing. How efficiently the economy handles money and thus how many times a money supply is turned over is something monetary policy has no influence on and it cannot know in advance. The milkmaid calculations with the growth rate of (what) money compared to the growth rate of the real economy, as they have also been read out in the Bundestag, therefore lack any basis.
One has to make unbelievably absurd assumptions (which, however, is often easy for economists because they always know the “right result” in advance) to arrive at the statement that strict control of a certain money supply could prevent prices in an economy from rising far above the inflation target.
But the statement that inflation is always financed is also empty, because on the right hand side, you cannot separate what is financed, i.e. the inflation rate on the one hand and real income on the other, at all. Monetary policy cannot say whether a particular action hits prices or hits quantities. If monetary policy raises interest rates, it is almost always at the direct expense of investment and thus at the expense of the quantity produced. Whether and how prices react to this in turn depends on many factors that monetary policy cannot influence.
What can and should monetary policy do?
It can do little, is the simple answer. Because monetary policy does not have a remotely direct line to inflation, it relies on very indirect effects that almost always have very large and potentially negative side effects. That is why the idea of prescribing inflation as the sole objective of monetary policy, especially that of a politically independent central bank, is misguided from the outset. This independence of central banks was a recommendation of monetarism, which believed that inflation could always be controlled purely technocratically by controlling an appropriate money supply. With the intellectual end of monetarism, this form of independence should also have been buried.
If, as in the U.S., the central bank is explicitly given the task of ensuring high employment and stable prices at the same time, we find ourselves in a completely different world. Monetary policy is then, formally independent or not, an integral part of overall economic policy, because no democratically elected government can refrain from considering the level and development of employment or unemployment as one of its very own goals and accordingly including it in overall economic policy. Monetary policy must then also, which should be a matter of course everywhere, closely monitor macroeconomic developments and thus always keep an eye on the side effects of its policy. It cannot retreat to the simple but completely absurd viewpoint, which is repeatedly advocated in Germany, that employment must be secured by others, while it itself is only responsible for price stability.
Once again, it is much better if a government clearly recognizes that inflation in the medium term is determined quite decisively by wage developments. It must then ensure that there is a coordination between the monetary policy it is responsible for and wage policy. In the past, such models existed with great success in Austria within the framework of the “social partnership,” but also Germany within the framework of concerted action between the government and the collective bargaining partners. China practices something similar, albeit dictated by a strong government. The decisive advantage is that only such a model can prolong phases of good economic activity and high employment without too rapid an acceleration of inflation driven by wages.
In any case, strict causal therapy is appropriate. Price increases that clearly occur after clearly identifiable shocks and are thus temporary must be accepted by monetary policy because they do not affect its real objective, the medium-term inflation trend, at all. Everything that needs to be done to cushion such shocks must come from the government. Even if its price target is exceeded in the short term, monetary policy must endeavor to keep the negative employment effects of these shocks within bounds, i.e. it must under no circumstances proceed restrictively with interest rate cuts, because this would not depress the inflation rate but add further negative shocks to the already existing restrictive effects of these shocks.
Only when attempts to coordinate economic policy and wage policy fail, i.e. when it becomes clear that wages are rising so sharply despite the threat of employment that a price-wage-price spiral could emerge, is monetary policy called into action to impose restrictions. Then, and only then, do we need an institution that is able, relatively independently of political calculations, to show the bargaining partners that their attempt to pass on to each other the burdens of the shocks, which are unalterable for society, cannot last.
Detours and deviations
Because the correlations are as described above, there is empirically no correlation between inflation and money supply. As shown some time ago with Friederike Spiecker, the two countries that have by far the largest extensions of their balance sheets (which is usually regarded as money supply expansion), Switzerland and Japan, also have the smallest price increases. My one-minute reference to this at the hearing (I had a total of only exactly five minutes because I was invited by the smallest group) was met by angry protests from the AfD and from Mr. Söllner.
The latter stooped to answering (he had a total of much more than five minutes because he was invited by a larger parliamentary group) that this was not a problem in Switzerland because the francs were held abroad, where they could not affect purchasing power. That is simply nonsense, because francs are not held abroad, but almost exclusively in Switzerland.
Even the argument that it is mainly foreigners who hold francs in Switzerland is wrong. Only a little over 200 billion of the approximately 1200 billion of Swiss franc assets are attributable to foreigners in one form or another (claims against Swiss banks including claims of foreign banks against the Swiss central bank are included in this figure). Whether and how much of this could have an inflationary impact is a completely different and, again, hardly answerable question. In principle, as even monetarists would concede, the way central bank money is created, e.g. through interventions in the foreign exchange market as in Switzerland or through interventions in the domestic capital market as in Euroland, has nothing to do with the effect of the money supply on inflation assumed by monetarism
Finally, in the current recessionary situation in Europe, it is completely nonsensical to pretend (as Christian Lindner keeps doing) that government borrowing has an inflationary effect. I have said it hundreds of times (albeit without any success with the prevailing doctrine in Germany) that government debt can only be properly assessed in the context of other fiscal balances. Since private households are currently building up high savings, companies will also expand their revenue surpluses in a recession, and Germany’s current account surplus (net foreign debt) is temporarily falling sharply because of the deterioration in the terms of trade (due to import price increases) , the finance minister has not only the possibility but even the task of significantly increasing government debt in order to prevent a deep recession.
In the absence of any macroeconomic thinking on the part of the finance minister and his advisors, however, it is no wonder that he keeps falling into the same traps. In Germany, however, this remains virtually inconsequential because the entire country, including 95 of its media outlets, have made themselves comfortable in the same little intellectual darkroom.