Why does fiat money cause inflation?

Central banks flood of money after Corona: is the big inflation coming now?

During the corona crisis, the world's most important central banks took unprecedented first aid measures, providing liquidity for almost everything and almost everyone.

The method of brisk increase in money will have an impact on prices, also because the ECB, for example, cannot raise interest rates significantly.

In which areas are the greatest dangers to inflation lurking? Who will be the winners, who will be the losers? An analysis.

To paraphrase the notorious great thinkers Friedrich Engels and Karl Marx: A ghost is haunting Europe, the specter of inflation ...

The corona crisis has devastating consequences for the global economy, which is now obvious to everyone. "Contact bans" and curfews for a large part of humanity have collapsed the provision of goods and services on the supply side - and consumption on the demand side. In Germany and numerous other countries, millions of employees were sent on short-time work or dismissed without further ado.

The United States alone, the largest economy of all, has had about a million people in the past four weeksevery working day lost their jobs - now a total of 22 million. Countless companies will go bankrupt despite injections of funds and bailouts from their governments. The indebtedness of states and companies, at a historically unique level even before Corona, is climbing faster than ever before.

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To counteract and alleviate the worst economic turmoil of the COVID-19 pandemic, the world's most important central banks - above all America's Federal Reserve and its European counterpart, the European Central Bank (ECB) - have initiated unprecedented first aid measures . They provide liquidity for almost everything and almost everyone. There are good reasons for it. The two most important:

• Only with liquidity can the crisis spill over from the real economy to theFinancial sector prevent.

• Central banks did after it ten years agoBase rates have de facto given up on regulation, simply no other weapon in their arsenal that would work in the short term. They are figuratively what you would expect in Englishone-trick pony calls, a Hottehü circus horse that can only do a small number, but which is particularly nice: printing money.

During the course of the Great Financial Crisis (GFK), which began in the US mortgage market in the summer of 2007, central banks had "printed" money on a scale that the world would have considered impossible until then - and anyway dubious and banana republican. "Quantitative Easing", or QE for short, was what the US monetary authorities call themselves.

A central bank today no longer prints banknotes, it does it digitally

Although the term “money printing” doesn't really apply, because a central bank that wants to provide liquidity in the 21st century and expand the money supply no longer prints banknotes today. She does it digitally. Put simply, the central bank buys bonds from financial institutions and transfers them fresh fiat money conjured up from the air. Commercial banks pass on the fresh funds, for example through loans. In a currency system that is not anchored in any tangible asset such as gold, central banks can and are allowed to do so.

Actually, one should assume that this method of brisk increase in money would sooner or later be reflected in the inflation figures, which would cause prices to rise at a similarly brisk pace. But strangely enough, this happened in the years after the GFKNot. Although liquidity has increased spectacularly around the world for years, there appeared (and does not seem) to be "inflation". In Germany, for example, the largest EU economy, it was most recently 1.4 percent and only about half as high in the entire euro area. So mini-inflation, everything in the green area, one might think. Or is it not?

What is important is the difference between consumer price inflation and asset price inflation

At this point, the distinction betweenConsumer price inflation on the one hand andAsset price inflation on the other. In the case of consumer prices, that is to say the “inflation rate” usually quoted in the news, the inflation was negligible. (We leave out here that the methodology used to determine the consumer price index is controversial, for example with regard to the underlying shopping basket and the so-called hedonic calculation method.)

By contrast, asset prices - the prices of tangible assets and plant - recorded a different, more dynamic development. The Flossbach von Storch Research Institute in Cologne determined an annualized increase in asset prices of 7.6 percent for Germany at the end of 2019 (i.e. before Corona). At that time, that was 6.4 percentage points more than consumer prices, a good six times as much. The longer-term view paints a similar, albeit less extreme, picture. Since the beginning of 2015, according to the institute, the “long-term annual asset price inflation” has been 3.2 percent, and consumer price inflation 1.4 percent.

The value of stocks, fine wine and real estate soared, that's inflation too

So when central banks “print” money on a large scale, there is certainly an inflationary effect. Not necessarily at the bakery, supermarket or drugstore, but with assets. In the decade between GFK and the corona pandemic, the value of stocks, precious metals, and real estate of all kinds doubled and tripled. The prices of boring bonds that were considered to be particularly safe rose incessantly. And even the prices called for unconventional “tangible assets” such as vintage cars, top-quality wine and art went through the roof. Alsothe is inflation. The liquidity that the Fed, ECB and other central banks had been distributing for ten years had landed on assets.

The monetary pressure as a reaction to the current global economic crisis leaves the dimensions of the monetary policy measures in the course of the GFK far behind. The Fed's QE no longer knows any limits, it is “unlimited”, and the ECB does not do it any differently with a different choice of words. We are witnessing an unprecedented tsunami of fiat money that sloshes through the global economy and, figuratively speaking, will eventually hit land somewhere. The timeline is of particular importance.

The global economy is currently experiencing a combination of a demand shock (nobody can buy big) and a supply shock (apart from basic supplies, there is hardly any production). This is the situation forConsumer prices a total ofshort term deflationary; Prices are falling. In particular, the drop in oil prices and other important raw material prices such as copper and iron ore are driving this trend. Added to this are the massive collapse in transport costs in world trade, such as the freight rates in overseas container transport. The Baltic Dry Index, on the other hand, which shows the costs of shipping raw materials, has plummeted by more than 80 percent since last autumn.

Long term In contrast, consumers around the world could see significantly higher inflation rates in consumer prices. The supply and supply chains in the western world have been operating in a just-in-time mode for years and are accordingly sensitive to irregularities. While in Europe and North America the notorious, essentially harmless KNP syndrome (toilet paper-noodle panic) has so far caused empty shelves, gaps could quickly appear in other segments of basic care: shortages.

As soon as the shutdown ends, the world could experience a demand shock

For example, the Department of Agriculture found that a dozen eggs in the United States temporarily cost more than $ 3 in April, compared with less than a dollar in early March. A multiplication in a month.The is consumer price inflation. As soon as the majority of humanity, who are currently forcibly isolating themselves at home, takes to the streets and into shops again, the world could experience a demand shock, a catch-up effect that will make American hens' eggs more expensive.

Would that be that bad? In “normal” times, should consumer prices begin to climb, central banks would quickly consider rate hikes in order to dampen economic dynamism, consumption and inflation. But the global financial system has been shaped by a different, new “normality” for a good decade, which makes such old-fashioned monetary policy measures impossible.

If the ECB were to raise interest rates, Greece and Italy would be bankrupt

For example, what would happen if the ECB wanted to raise interest rates to curb burgeoning consumer price inflation? In short: Greece and Italy, which despite uncontrolled national debt, have been paying mini interest thanks to the ECB, would go bankrupt within a very short time. That would mean the euro zone, European government bonds, German endowment life insurance companies, insurance companies and banks, the world financial system and Angela Merkel.

Whether consumer price inflation will soon land at four, six or eight percent is not decisive. The decisive factor is that the inflation rate rises, but the interest rateNot. This widens the gap between consumer price inflation and nominal interest rates, and the real interest rate (i.e. nominal interest rate minus inflation rate) is plunging even deeper into negative territory than it is now. That destroys the value of money efficiently. With a real interest rate of permanently minus four percent, a large part of the purchasing power has fizzled out after 20 years.

AlsoAsset prices are for world economic crisesshort term susceptible. They tend to correct for some time, and can even crash - for example the prices for real estate, stocks (see the corona stock market crash, which is frightening in its dynamics), even gold (in mid-March).Long term It looks different, however, as the decade between GFK and the corona crisis has shown. A tsumani of liquidity ensures asset price inflation, i.e. significantly rising share and bond prices, increases in the value of real estate of all kinds (in addition to living space, land and arable land) and precious metal prices.

Who is one of the winners and losers of inflation

Should this pattern repeat itself over the next few months and years, those in particular would become theLosers who have put their money (like most Germans) in "nominal" forms of investment. Anyone who keeps their savings in overnight money accounts, fixed deposits, savings accounts or in cash under the pillow for the sake of supposed security will quickly be expropriated by inflation. Bonds would also be massively endangered - and with it all those who use endowment life insurance policies who (have to) invest primarily in bonds.

To theWinners inflation would primarily belong to those who own “real” material assets, although they do not maintain their purchasing power perfectly, but they dorelative Well. These include physical precious metals (bars, coins), real estate and corporate investments (stocks, funds, ETFs). The biggest beneficiaries of inflation are, of course, debtors. Because when money is devalued, outstanding loans also take care of themselves - and quickly. Since states are the greatest debtor of all, governments will know how to use this convenient magic effect.

In the 19th century, when Marx and Engels had communist visions, nobody really wanted to believe in the spirits they were calling. That didn't change the fact that the communist-socialist complex of ideas was to become one of the leitmotifs of the 20th century worldwide - a “ghost” that turned out to be extremely real, in whose slipstream war, terror and mass poverty found its way. We would all do well to take the specter of inflation seriously today. It could be more than just a ghost.

Michael Braun Alexander is one of the most prominent financial journalists in Germany. He has been writing about the stock market and economics since 1995, including as a correspondent in Mumbai and New York as well as a columnist for Bild am Sonntag, and has published numerous books on all aspects of investment (When money dies, gold goes, really rich). He bought his first shares more than 30 years ago.