Why is inflation a never ending process
Expert interview with Prof. Dr. Gunther Schnabl
philoro: The ECB has cut the key interest rate to a historically low level and at the same time initiated a bond purchase program of 1.1 trillion. Inflation should now have huge blossoms. Why is inflation not noticeably affecting the public?
Schnabl: What we are currently observing is an increase in inflation, not in consumer goods, but in assets. The prices for stocks, real estate, and in some cases raw materials and gold, are rising sharply. However, this is not measured by the central bank in the consumer price index, which is the basis for monetary policy. With regard to Germany in particular, it is currently the equity and real estate markets where we are seeing a very sharp rise in prices. Via the excesses on the asset markets, the negative effects of the ultra-loose monetary policy reach the people even without inflation.
philoro: So we cannot speak of a sustained economic upswing, since the large amount of ECB money only inflates the prices of assets
Schnabl: There is clearly a structural break in the transmission of monetary policy. Traditionally, we have assumed that the central bank will provide additional credit to commercial banks. This increased credit volume is used to finance corporate investments or to grant consumer loans. Wages and prices rise with a delay.
Today, however, it seems that the extra volume of credit given to banks tends to stay in the financial sector and increasingly flow into assets. For example, more property purchases are being financed, so property prices are rising. Share prices also shoot up, and price bubbles appear. Both developments have only a very limited impact on consumer prices or only very late. Because the central bank therefore only tightens the credit volume very late, large speculative bubbles can form on the asset markets. When these burst, major crises occur without consumer prices ever rising.
philoro: What is the cause of this break, that cheap money is going into asset prices and not, for example, in corporate loans or start-up financing?
Schnabl: I can only speculate about that. From my point of view, there is a different insurance mechanism against risks. If you as a company take out a loan from a commercial bank to finance an investment, then you as an entrepreneur and indirectly also the bank bear the risk. If the investment fails, the entrepreneur has to cope with the losses, which can lead to a loan default for the bank.
In contrast, if you invest in the financial markets, i.e. in stocks or real estate, the ECB's security mechanisms will take effect when a crisis threatens. Interest rates are lowered immediately or assets are bought directly when asset prices fall. So you know that if you speculate in the financial markets, on the one hand you can privatize profits, on the other hand the risks of a total loss are low. As a result, investments in the real sector decrease and speculation in the financial sector increases.
philoro: Nevertheless, the policy of cheap money is being rigorously pursued as if there were no alternative, although it is obvious that bubbles are forming in the financial markets.
Schnabl: With the steady decline in interest rates, which is now a trend that has continued since the mid-1980s, the financial markets have grown steadily. As soon as they threaten to implode, more liquidity is injected. That was already the case under ex-Fed President Greenspan. Keyword: "Jackson Hole Consensus": The central banks claim in boom phases in the financial markets that they cannot recognize speculative exaggerations. That is why there is no mandate to counteract this. However, when prices in the financial markets fall sharply, then one sees a very clear mandate to intervene against this fall in prices. This is a one-sided monetary policy that acts like an insurance mechanism against losses in financial market speculation. You have to ask yourself why it is continued so consistently with immense negative side effects.
philoro: What are these negative side effects?
Schnabl: There are many of them. On the one hand - as Japan shows - the banking sector is gradually being nationalized as the banks are becoming dependent on the supply of cheap money from the central bank. The banks then continue existing loans to companies, even if the projects are no longer profitable. In doing so, the banks want to prevent their imbalances from becoming visible after the bubble burst. “Zombie banks” keep “zombie companies” with low productivity alive. In addition, more and more loans to companies are being replaced by loans to the highly indebted state. The zombie banks are using it to finance fewer and fewer new innovative investment projects.
Another decisive side effect is what is known as financial repression: secure forms of savings such as savings books, bank deposits or government bonds only earn very little or no interest at all due to the very expansionary monetary policy, despite the increasing risk. In particular, this undermines the old-age security of many people. Only those who bet on price gains on the asset markets can generate returns. This takes courage and sufficient knowledge, which the average middle-class household often does not have. The professionals in the financial markets usually have the edge here.
philoro: In your opinion, what would give banks an incentive to pass on more loans to the corporate sector again?
Schnabl: The logical consequence is an interest rate hike. That seems like an unusual economic policy recommendation, but I have two main reasons for this request.
The interest rate has a signaling function. This means that it must adequately indicate risks. Someone who has high risks also has to pay high interest. This signaling function is suspended if the central banks push interest rates towards zero. This means that a lot of capital flows into risky, speculative projects. Interest also has an allocation function, as it separates “good” investments from “bad” ones. With a high interest rate, as an entrepreneur, you would only make investments that also have a high expected return. If the interest rate is depressed, then that is an incentive to finance investments with a low expected return. A desired growth dynamic, which in the long term only assumes investment and innovation, will not be achieved.
If we turn this mechanism around now - that is, increase the interest rate - then the risks would again be adequately indicated. There would be an incentive again to speculate less and instead to make investments with high expected returns. The banks' traditional business model of financing investments would be restored. With increasing productivity, wages for broad sections of the population could also rise again.
philoro: Wouldn't an increase in interest rates put southern countries such as Spain, Italy and Greece under enormous financial pressure?
Schnabl: That is the crux of the current development. The long-term downward interest rate trend mentioned above has given many countries the incentive to build up debt and postpone reforms. If the ECB now raises the interest rate again, the interest burden on public budgets would multiply. There would be considerable turbulence in the government bond markets. The debtor states would have to restructure their indebtedness, cut spending and initiate reforms that are long overdue. The reforms would remove encrusted structures and make room for new things.
The Austrian School of Economics, of which Friedrich August von Hayek is the most prominent representative, would describe such a causal chain as a necessary purification process of the economic cycle. In the short term we would have to deal with a crisis, but in the long term a sustained economic recovery would follow. The opposite is the case if the ECB sticks to the zero interest rate policy with new purchases of government bonds and other securities. Then the structural distortions would be cemented and the world economy would be brought into never-ending stagnation. As in Japan, prosperity would be creeping out.
philoro: You lived in Japan for several years and carefully examined developments there. To what extent is the deflation dilemma there a projection of the future for the euro zone?
Schnabl: Japan and the euro area are two very different economic regions and also have different cultures. However, there are two important parallels with current developments. First of all, both crises were preceded by speculative exaggerations on stock and real estate markets, which were favored by “cheap money”. A speculative bubble formed in Japan from 1985 onwards, which burst in December 1989. In Europe, speculation began in many countries from 2001/2002. Here, too, it was borne by cheap money from the central bank, as the European Central Bank cut interest rates in response to the bursting of the dot-com bubble (year 2000). The bubble in many countries of the European Union burst in 2007/08.
In both cases, attempts are still being made to treat the crisis that triggered the bursting of the bubble with new cheap money. Germany has a special position in development. The exaggerations between 2001 and 2008 mainly took place in the peripheral countries of the EU, because Germany pursued a strict austerity policy. Now it's the other way around. While economic development on the periphery of Europe is stagnating, the cheap money from the ECB is causing exaggerations on the German stock and real estate markets. The big cuts will only come in Germany when the bubble bursts here.
philoro: The media are currently fearing people's fear of a crisis in the wake of an interest rate hike. When you talk about turbulence in the financial markets, how would we feel it in everyday life?
Schnabl: That is difficult to predict. A chain reaction in the financial markets will not leave the corporate sector and the labor market untouched. The price would be a crisis if we want to give interest back its allocation and signaling function in order to revive growth in the long term. It would also become apparent that future old-age security has long since been undermined. The fact is that we would start at a high level of prosperity and that the cuts in the large industrialized countries would therefore be easier for people to cope with than in many poor countries. Many people would be forced to retrain, just as the citizens of Eastern European countries did after the failure of the planned economy system of the Soviet Union.
The financial sector in particular, but also government spending, would have to be fundamentally consolidated. However, Europe is and will remain a technology and industrial location with a high level of education, which is why I am optimistic about a quick recovery. When, for example, the then Fed President Paul Volcker raised interest rates to up to 20% from the end of the 1970s in order to end the high-inflation phase of the 1970s, a painful adjustment process also began. However, the recession that followed was short and followed by a robust economic upturn.
philoro: So there will be more distribution conflicts, since we only have low growth and the cake that the masses have to share is smaller?
Schnabl: This is exactly where the political explosive lies. Since we are running into a long-lasting crisis with the creeping nationalization of the financial sector, in which we will not grow, the distribution conflicts are inevitably multiplying.
Monetary policy is driving asset prices up, which benefits the very high income groups in particular, as they hold a large proportion of stocks and real estate (and other assets). The costs of this process are passed on to the rest of the population during the crisis. Because the national debt is increasing as a result of the bailouts for banks, the governments have to reduce the wage level in the public sector and undermine social security. In the private sector, too, the great crisis is undermining the bargaining power of the trade unions, so that wages for large sections of the population are stagnating. More and more people are being forced into precarious jobs without old-age security. This process can be summarized under the terms wage and pension repression. In addition to financial repression, this is the most important channel through which the costs of the waves of speculation are transmitted to the citizens.
Even if most people do not understand the context of monetary policy, a simmering dissatisfaction is building. This is not only the case in the peripheral countries of the EU, but also noticeable in this country. For example in the new federal states, where the wage level is still significantly lower than in the old federal states. The fear of many people of slipping out of the middle class is growing. It manifests itself e.g. in demonstrations against immigration or Islam. However, the core of the problem is not recognized and therefore not addressed. Politicians are content with tinkering with the symptoms, for example with financial market regulation, rent brakes, minimum wages, etc. This creates a lot of bureaucracy without actually solving the problem.
philoro: In your opinion, what role could gold play in a modern economic and financial world?
Schnabl: Gold is an important raw material and an important store of value. A theoretical possibility of containing the excesses emanating from monetary policy would be to re-link international currencies such as the dollar and the euro to gold. We are currently a long way from that, especially from a political point of view.
philoro:Professor Dr. Schnabl, thank you for the interview.
Gero Grützner and Thomas Ströhla (philoro EDELMETALLE GmbH) conducted the interview
About Prof. Dr. Gunther Schnabl:
Prof. Dr. Gunther Schnabl did his doctorate and habilitation at the Universities of Tübingen, Tokyo, Stanford and Leuven and worked as an advisor at the ECB. Since 2006 he has headed the Institute for Economic Policy at the University of Leipzig, where he also works as a professor of economics. His research focuses on exchange rates, monetary policy, financial markets in emerging economies, and monetary overinvestment theories and crises.
About philoro EDELMETALLE GmbH:
philoro EDELMETALLE GmbH is an independent precious metal trading company with a European branch network in Germany, Austria, Hungary and Liechtenstein. The services cover the entire spectrum of investment in precious metals from buying and selling to storage as well as personal advice for private and institutional investors. philoro EDELMETALLE currently employs over 40 people at seven locations and operates an online shop. The company is characterized by high quality standards, professional advice and sustainable products.
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