Is inflation looming on the horizon ?
The sovereign crisis is jumping from one surprise to another, as each monetary shock leads to solutions that were inconceivable three years ago. Iceland's monetary implosion, the Greek default and the seizure of bank deposits in Cyprus are all likely to be part of the new financial paradigm. In southern countries, we might see further restructuring of public debt, nationalisation and capital controls until an inflation spike ends the erosion of public debt, creating an unmanageable situation. We already know that public debt must be brought down by 30%, a requirement that, in these recessionary conditions, cannot be solved swiftly by taxation alone.
In the medium term, intuition tells us that the European economy faces stagflation, a combination of economic stagnation with persistent unemployment and moderate inflation.
Even if it were not a political choice, stagflation would be the mixed result of economic and monetary measures, namely austerity and monetary creation programmes, respectively.
What would this stagflation be like? Sovereign solvency issues aside, it would very much be the same as in the 1970s: anaemic growth combined with a slight decrease in productivity growth, high structural unemployment (typical to structural economic imbalances), underutilisation of production capacity, weak corporate profit forecasts, low to moderate investment expenditures, significant public deficits pushing interest rates higher and drying up credit flows for private investments, trade deficits and deindustrialisation across the board.
Inflation would in no way be a desirable solution due to the risk of a feedback loop and an increase in nominal state expenditure, but it is emerging as an intuitive consequence, or even the direct result, of public indebtedness.
Certain American economists have even developed a singular theory that the banking and sovereign crisis is the consequence of a period of excessive disinflation (excessively low inflation). According to them, this period of "great moderation" lasted from 1985 to 2005 and saw globalization and access to pools of cheap labour conceal the reality of repayments of private and public debt. Demand increases did not trigger an inflation crisis because Western countries found the supply needed and absorbed the imbalance in their trade deficits.
This inflation could lead to an interest rate rise. Higher interest rates could also result from a crowding-out effect, in which private savings fall below acceptable levels as the government taps into them. While this effect is not apparent during periods of monetary expansion, it follows as a common consequence of such periods. That being said, we are also witnessing the repatriation of public debt, as an increasing share is now financed by national savings. This phenomenon, described as "financial repression", goes hand in hand with stricter supervision of the finance sector by the prudential authorities, is characterised by artificially low interest rates and could prevent an interest rate hike.
Factors other than inflationary pressures can exert upward pressure on interest rates as well, including investment requirements (particularly in the field of infrastructure) in developed and developing countries, or a decrease in household savings rates in economies approaching a certain level of development.
Why is an inflation scenario intuitive while so many economists raise the spectre of deflation? Because the creation of money ex nihilo, as carried out by central banks, instils a future threat as repayments are anything but certain. Evidently, recent measures have been aimed at creating money without adding capital. These actions are probably concealing delayed inflation, which has the expansion of monetary injections and central bank balance sheets as a symptom.
Nevertheless, a stock of public debt, whose orderly absorption seems unlikely, is tantamount to a shift of savings and therefore to a stock of money. Inflation is a less painful monetary solution as it spreads economic adjustments over time, at least if its effects are absorbed by the economic agents in a socially fair way. At the end of the day, inflation does not make anyone wealthier, it just moves the burden of past indebtedness from creditors to debtors (mostly public, i.e. the economic agents that make up most of the population). This makes it a catalyst for the generational and social rebalancing of wealth.
The problem is that inflation is refusing to take off despite the central banks' massive flooding of the market with new money. It even appears to be falling as the money creation is having a negative impact on gold and raw materials. This would mean we have fallen into Keynes' liquidity trap, where money is hoarded instead of being invested or spent, finally leading to deflation.
The failure of monetary creation is a big problem, a tragedy even, because it means the world could be sinking into a long recession. In other words, the lack of inflation would reflect the slow decay of the productive economy. How could we get out of this sterile economic zone? Most probably, by increasing the importance of the state in the economy, i.e. by increasing public debt and its refinancing by the monetary authorities. The lack of inflation could also accelerate the implementation of political measures to light the spark of inflation itself (budgetary deficits and monetary creation).
In conclusion, the spiral of depressions and waves of inflation may have already started. As inflation starts to appear on the radar, interest rates will rise and the relative market value of public debt will fall. Current long-term sovereign interest rates seem too low, as they do not incorporate an adequate inflation premium or the possibility of public debt restructuring in certain countries in Southern Europe. Therefore, if austerity policies continue to be pursued against a backdrop of recession, the solvency of certain states will be damaged, increasing their risk profile and interest rates. On the other hand, if the European monetary authorities correctly decided to accelerate debt monetisation, this would also result in an interest rate hike in the shape of an inflation premium.
Inflation is the lesser evil. If it fails to take off, even more monetary creation will be needed to escape the liquidity trap and avert potential deflation. In other words, the lack of inflation should trigger monetary creation... to spark inflation. The opposite scenario, with a strong currency and a low-inflation economy, would lead to the sort of political and social turmoil history books have taught us to be wary of.
