Inflation : Irish Energy Blog proven correct, Major Economists Wrong

Last October, I wrote an article predicting that inflation would not be temporary :

Irish Energy Blog: Why Inflation will not be Temporary

Almost every other major economist at the time was predicting that inflation would be temporary or "transitory" :

"The European Central Bank still sees a recent rise in euro zone inflation to above its 2% target as temporary and expects price pressures to ease next year, ECB President Christine Lagarde said on Thursday"  [Oct 21].

"Inflation "is expected to dissipate over time, as supply disruption eases, global demand rebalances, and energy prices stop rising," with a peak likely in April next year, the BoE said in an announcement in which it vowed to train its eye on "medium-term prospects for inflation" and ignore "factors that are likely to be transient."    [Nov 21]

Jan 22 :

"The word "transitory" seems to be gone from the lexicon but European Central Bank (ECB) chief economist Philip Lane is sticking to his guns, insisting the current burst of inflation is merely a temporary Covid phenomenon that will peel away later this year".

It appears that the people who's job it is to understand inflation do not understand it. In very simple terms, this is how it works :

Inflation is too much money chasing too few goods. 

It does not matter the cause of supply shortages. 

You must not increase the money supply during supply or production shortages.  

If a country has four production facilities and three close down, then printing money will cause a surge in inflation because the money supply has increased when production supply has decreased in this case by 75%. The monetary policy was the opposite of what needed to happen. 

It does not matter the reason for the three plant closures - bad weather, pandemic, war, fuel shortage, aliens etc - the effect is the same, viz, a reduction in production. 

Yet, this is exactly what economies all across the world did during the Covid lockdowns - they printed massive quantities of money during a period of very low output (and low interest rates). While the lockdowns were destructive in themselves, printing money simultaneously was like throwing petrol on the fire and for that reason I don't see an end to the inflation crisis for quite a few years. 

The Green Europe and Unsustainable Finances Paradox

 

The graph below shows the total balance sheet assets of three of the world's major banks - the Fed in America, European Central Bank and Bank of Japan. It is noteworthy for many reasons. Firstly, the ECB has overtaken the other two with total assets of $9.6 trillion. Most of this is due to quantitative easing (QE) or money printing. 

The ECB has been engaging in large scale QE since 2015, long before the covid pandemic. Which is odd since most of Europe's economies were strong then. Certainly, here in Ireland, house prices were rising again, as were rents by 2015 and 2016. At the end of 2016, the government brought in rent controls to cap rent increases. Also in early 2016, the European Commission expected Ireland to be the fastest growing economy in Europe. Yet, Ireland was been flooded with this cheap ECB money which the government was only too happy to take and spend in an economy beginning to heat up (on a side note - it didnt fix the health service did it ?). 

As the pandemic hit in March 2020, the ECB went even further than US and Japan and printed enormous amounts of euros to the extent that they practically doubled their balance sheet. Although there are other factors impacting inflation right now, I believe this to be one of the main reasons, if not the most significant. Over half of this new money has gone to government bonds, a record amount of central bank financing of government debt. Normally, the government would have to go to the market to trade their bonds. But we are far away from normal in this age of negative interest rates. Now the central bank prints the new money to buy government bonds that presumably most of the market would not touch.

What is remarkable about all this is that, in a Europe completely captured by the green movement,  government finances have been allowed to reach such epic unsustainable proportions. Surely, government spending should be reduced so as to reduce consumption. Enabling countries to spend beyond their means and deferring the cost of excessive consumption should be the last thing that green politicians should want. It's true, that some of this spending has gone on renewable infrastructure such as wind turbines and pylons (about € 1 trillion) . But these technologies require large amounts of rare earths and metals to produce and so contribute to more consumption and more mining of the planet. Instead, the preferred method to reduce consumption is through taxation. The problem with taxing fuel and electricity is that it results in yet more government spending as the poor and working class become even poorer and are unable to pay for necessities like fuel and electricity. The government then gets locked into a spending cycle where pressure comes on it to increase social welfare supports and just recently the Irish government has planned to give every household €100 off their electricity bill. The cycle of taxation - borrow / spend - inflation - tax - borrow - inflation continues.

If we were really serious about sustainability then we would get our finances in order first. By encouraging people to save instead of spend, we slow that economic growth that eco warriors claim is destroying our planet. We put the future on a firm sustainable footing. But instead we have created the exact opposite environment of low / negative interest rates where people are unable to save and governments spend beyond their wildest dreams. 

It is incredible to me that green politicians are not aware of this simple paradox. Or perhaps that old saying "money talks" is more relevant than ever and still overrides all of the green buzzwords that politicians love to use. 

Why Inflation will not be Temporary

 

The current conventional wisdom is that inflation in Ireland will only be temporary as the economy recovers from the covid lockdowns. But this can only be the case if there was deflation during the lockdowns which the re-opening induced inflation would now be negating. The only deflation that occurred during the lockdowns that I can remember was petrol prices. Core consumer items such as food, electricity bills and rent did not fall or at least not in any noticeable way. A period of deflation is not equivalent with an economy being closed down. A rental freeze is not deflation. This is the mistake the economic experts are making. They also have not taken into account the effects of the large government spending. 

When a hotel or other business is shutdown, its prices do not reduce, the service simply ceases to exist. In fact, inflation will likely occur. Say two hotels close down in a region leaving only one hotel open. This will lead to a period of inflation as the remaining hotel raises its prices to take advantage of the increased demand and reduced supply. The difference between this scenario and the lockdown was that  during the lockdown all three hotels were shutdown meaning there was no deflationary pressure. Then when the hotels opened, they could charge high prices because people had a lot of savings. This was an unintended consequence of the high level of unemployment support.  And the same happened with rent, an opportunity was missed during lockdown to bring about rental deflation through a smaller Pandemic Unemployment Benefit. Instead, the government went along with the calls from the most populist spending cheer-leaders.  

Another point that is missed is that many businesses may never re-open again. This will bring further inflationary pressure as supply reduces. 

As you can see from the graph above, the sharpest fall in prices was in November 2020 when year on year deflation reached -1.5%. This was the sharpest fall in a decade. In less than 12 months however , the inflation has skyrocketed to +3.7%.

While there are other factors impacting inflation right now, such as our high dependence on global supply chains, the high levels of pandemic payments paid out last year are part of the reason why Ireland has inflation above the EU average and even above UK's inflation rate of 3.2%. People saved up, then spent most of it in-between the lockdowns leaving little pressure on businesses to drop their prices. Little haggling took place with landlords who should have been under severe pressure to drop their rents during a period of very little house moving by job hunters both within Ireland and those coming from abroad. 

But as every economist should know but seems to have forgotten, all this money had to be printed, which was happening at a high rate prior to the pandemic anyway. Too much money printing or quantitative easing (or whatever you want to call it) , and the inflation snail eventually catches up with you. Too much money ends up chasing too few goods.  And then the snail begins to look like a rabbit. 

The Financial Wonderland of Covid-19

According to economic experts, Ireland does not have to worry about paying back the massive borrowings that were needed to fund the endless lockdowns : 

“Government debt does not have to be paid back, particularly the kind that sits minding its own business in the vaults of the ECB” - Chris Johns, Irish Times

 The problem with that is Article 123(1) of the Treaty on the Functioning of the EU :

 

 This means that it is illegal for any Member State to use the ECB as a bank overdraft facility.  The only reason why we can afford the luxury of endless lockdowns is our access to lots of free money. The Irish government have already borrowed €20 billion interest free this year and they plan to borrow another € 20 billion next year.   This is in addition to around €35 billion borrowed at very low interest rates since 2015 from the ECB's PSPP programme, prior to the covid "pandemic". So the free money bonanza that has enveloped the EU is not a new thing as some commentators have argued. 

All this free money being created by the ECB has resulted in the ECB becoming the largest single creditor of the member states in recent years. The German Council of Economic Experts have warned that this could present a threat to monetary policy independence in the long term.

In 2008, after the banking crash, the debt laden on to the backs of the Irish was paid back through taxation. This makes the situation at present different as there is no pressure to increase taxes. 

The natural effect of all this free money is massive inflation but we have not seen any sign of that yet (it may help to reduce government debt by de-valuing the euro). What is the most likely outcome - my guess is that we will see some inflation next year but more importantly negative interest rates will skyrocket so that most of the extra cash lying around on deposit will be recouped.   

There is already a similar precedent for this in the EU banking system, when deposits were confiscated in Cyprus in 2013 in what became known as a bail in. 

So as Mr Johns maintains, the ECB may well continue to play ball by printing infinite quantities of free money but the price will be an eradication of savings, either through inflation or negative interest rates or a combination of both. It will also mean that the EU will once again bend and mold its own laws laid down in it's treaties. This further erosion of the rule of law will sow yet more discontent within the union. 

The Government's Spending on Covid Crisis is not Proportionate

The acting finance minister, Pascal Donohoe, said yesterday that the Covid 19 crisis has so far cost Ireland €13 billion and that Ireland will have a national deficit of €30 billion by the end of the year. The Taoiseach, Leo Varadkar, also said that Ireland cannot borrow cheap money forever. As the ECB prints more money, inflation will become even higher in Ireland and prices of goods will rise. Since natural levels of deflation have been prevented in Ireland since 2015 by the actions of the ECB, this means Ireland and the EU are starting at a higher inflationary point than would have been otherwise without the ECB bond buying, and is therefore on the road to very high rates of inflation. Negative interest rates may well be here to stay. High inflation may well suit the Government because it will make it easier to pay their previous debts, but it means savers and workers will continue to be robbed.

At the beginning of the crisis, the government generously paid out covid unemployment payments of €350 per week, almost double that of conventional jobseekers payments. It has since materialized that 40% of those on the covid payment were earning less than €300 in employment. Meanwhile, on the covid subsidy scheme, where employers are subsidized to keep employees on the payroll, employers cannot pay employees more than their average pay and still qualify for the subsidy.   So the schemes were very badly thought out. There is also some fraud occurring where payments were made to non resident people. 

425,000 people are on the employers subsidy scheme and 600,000 are in receipt of the covid unemployment benefit. Before the crisis, there was about 2.3 million people in the workforce. So about 44% of the workforce are now in receipt of government supports. In the UK, there was 28 million people in the workforce before the crisis. Now, 6.4 million people have been furloughed - the equivalent government subsidy scheme for those affected by the covid crisis and another 2 million self employed people are receiving supports from another scheme. That is a total of 30% of the workforce. 

So Ireland has one and a half times the equivalent numbers on covid unemployment schemes as the UK has. This means that the Irish government should be phasing out the support payments. However, it is only the British government which is talking about winding down their schemes to reduce the cost to the exchequer. 

This was partly a reaction to the Bank of England warnings about the UK facing the worst recession in 300 years.  Meanwhile, in Ireland, there is strong opposition to any talk of protecting the taxpayer in all this. Leprechaun economics dictates that we must go blindly into the night and not prepare for a recession. Faith in the ECB money printing machines has never been better. And anyway, sure equality measures will ensure that we will all be equally poor. Except, of course, the few at the top who benefit from high inflation.