Monetary Policy in America Is a Mess. Things Are Even Worse in Europe.

High inflation takes off where political forces are too strong to permit the implementation of harsh remedial measures with respect to taxation and monetary policy such as to prevent an implosion of the national currency. In the contemporary global financial marketplace, there has been fluctuating concern about the US heading toward this point, albeit at a highly uncertain date, as evidenced by waves of attack last spring, summer, and autumn on the US dollar. In reality, though, the long-run inflation threat level is higher in Europe than the US. 

Any substantial European remedial action sufficient to arrest in the future a threatened emergence of high consumer price inflation would unleash forces which could potentially sweep away the present status quo of political and economic power. Hence, whatever the immediate cause of the inflation acceleration, we should expect a consensus of policymaking elites—Berlin in full acquiescence—to kick the can down the road.

Currency depreciation is likely to be a crucial part of the dynamic process of high inflation emerging in Europe, as has indeed been the case so often in the laboratory of history. That laboratory lesson indeed applies to the US, and importantly to the origins of the greatest peacetime inflation, which started in the early to mid-1960s.

The story started with the economic miracles in Europe (France, Italy, Germany) and Japan. The Fed, as the monetary hegemon within the Bretton Woods System, should have allowed interest rates to rise sharply as would have occurred under a sound money regime. Instead, the Fed in tune with the aim of the Kennedy administration to repudiate the stop-go policies of the 1950s, steered monetary policy such as to keep interest rates low. As high consumer price inflation emerged from 1965, with a lag behind asset inflation, the Fed did start to let rates rise, even abruptly at times. Sustained bold action, however, would have pushed up dramatically the cost of public sector borrowing, which was then bulging as the Johnson administration waged war in Vietnam and enacted the social programs of the Great Society. 

Fed chief William McChesney Martin had no appetite or political basis to embark on a collision course with the Johnson administration, and anyway he espoused the view that his institution was “independent within government” not “independent of government.” The dollar was ostensibly ailing, as illustrated by a rising free price of gold from spring 1968 and the DM revaluation of the following year.

The high consumer price inflation scenario for the US which many have in mind now for the years ahead is unlikely to feature economic miracles outside the US as in the 1960s. Plausibly, a key part of the story could be sustained private sector economic strength, which calls for much higher rates and which the Fed cannot deliver.

A growth cycle downturn or even recession in 2022/23 might interrupt the journey for some time to this destination. But when high CPI inflation eventually emerges, opposition to higher conventional taxation or cutting public expenditure is likely to be strong. Also, with so much corporate and mortgage debt outstanding, howls would be tremendous against any remedial monetary action which would mean higher interest rates. Hence the Fed may well settle for “kicking the can down the road.”

That conclusion, though, is not certain. There are alternative less likely scenarios where forces opposed to such cynicism could win the political majority, and the Fed has plenty of technical scope to “normalize” monetary conditions. As illustration, the Fed could liquidate Its vast portfolio of Treasury securities over a short period as part of an operation to restore monetary base to an effective anchor role.

It is quite different in Europe. There, “it is too late to go back” is a phrase whose infamy goes all the way back to Emperor Franz-Josef’s refusal in late July 1914 to soften Vienna’s ultimatum to Belgrade. A century plus later, it will almost certainly be too late to go back with respect to the degraded euro. Whenever the European economy gets into a sustained recovery track out of the pandemic, the ECB will not allow rates to rise in line with any incipient rise of consumer price inflation. 

A look at the ECB balance sheet explains the hypothesized obduracy. By the end of 2021, this is headed to 80 percent of eurozone GDP, versus the Fed’s balance sheet at just under 40 percent. Whereas the Fed’s balance sheet is made up almost entirely of loans to the US government (mainly Treasuries) and government-sponsored mortgage debt, the ECB’s consists largely of junk or borderline junk, including vast holdings of weak sovereign debt (no. 1 Italy). Loans to a virtually bankrupt banking sector amount to a third of total ECB assets. On top of that, the Italian and Spanish central banks have borrowed over €1 trillion of debt within the so-called TARGET2 system with the Bundesbank, the chief creditor on the other side. 

Let’s go through the thought experiment of the ECB embarking on a monetary normalization course which would have as consequence market interest rates rising 200 basis points across the board and slimming down the balance sheet by, say, 25 percent as a first stage to reestablish monetary base as anchor to the system. The weak banks could simply not pay the added interest rate cost to the ECB on their vast indebtedness given their lack of scope to raise rates on their loans to weak sovereigns and corporates. One way or another they would have to get subsidies to pay the interest—but how can critically weak sovereigns afford this except via ECB money printing? Resentment from the “frugal north” and EU laws against state aid would impede action.

A Green-CDU (Christian Democratic Union) coalition in Berlin such as is likely to emerge from this autumn’s elections according to present polling would have no wish to break European Economic and Monetary Union (EMU) up. Holding the status quo together means giving a nod to the ECB to keep rates down (at present subzero) and spare us all these traumas. In the same vein, just imagine the system stress if the Bundesbank demanded that the Banca d’Italia pay interest on its debit balance within TARGET2, or if the ECB toward restoring monetary base as anchor had to liquidate 20 percent of its Italian government debt holdings as part of a general cutback. Better just to allow inflation to rise.

The dynamics of the inflation path would depend crucially on the behavior of the euro. If the US is by then reining back monetary radicalism in the context of accelerating inflation, then Europe’s currency fall could indeed be breathtaking. Even if political forces in Germany against high inflation gather power under such circumstances, that would not slow the fall of the euro. In any breakup scenario for the EMU, including the opening of a path to a new hard euro, the ECB faces liquidation first.