Will the state support cause inflation?

Erasmus School of Economics

In order to finance the financial support to states, the European Central Bank (ECB) has rapidly started printing extra money. Casper de Vries, Professor of Monetary Economics at Erasmus School of Economics, gives his view on the current situation and the likelihood of inflation. 

750 billion euros

Between 2015 and 2018, the ECB has already generated around 2600 billion euros of new money in order to boost the economy. As a result of the corona crisis, the economy came to a halt. In order to keep the economy running, the ECB decided to put an extra 750 billion euros in the economy. This makes it easier for companies to obtain credit and to continue paying wages and rent. The printed money also allows governments to borrow at lower interest rates.

Indications for inflation

After the announcement of the support packages for companies in March, interest rates started to rise throughout Europe. However, this trend came to an end when the ECB announced its newly-printed 750 billion. At the same time, this announcement served as an indication of inflation. Europe has been struggling with persistent low inflation rates in recent years. New money often stayed with the ECB because many companies simply did not need new credit. According to de Vries, there is a saying which describes this phenomenon: 'They say: you can drag a horse to a bowl of water, but that doesn't mean that it will start drinking.’

Causes of low inflation

The new money that did end up in the economy, did not end up in the right places. Most people used the money to invest in shares or buy houses, instead of spending the money on electronics or other consumer goods. ‘So as a central bank you bring your horse to a bowl of water because you think it should start drinking, and then it decides to eat grass instead.’ Other causes of low inflation are cheap competition from China, the rise of flex workers and migrant workers and the ageing population.

Domino effect

The difference with recent years is that the new money is now actually flowing into the economy. ‘During lockdown, consumers spend less. As a result, prices will temporarily drop. Or people save to create a buffer, which means they also spend less. But after the crisis? Then inflation could suddenly rise considerably’, says de Vries. And rising inflation will cause a domino effect: The faster the price of products rises, the more people are inclined to buy them as quickly as possible.

Addiction

Normally, the ECB can halt inflation by reselling the government bonds they have bought from commercial banks. By doing so, the ECB gets back those euros it had pumped into the economy. De Vries thinks, however, that retrieving this money will be very difficult. ‘You can compare the ECB policy of the past five years with some kind of addiction. Part of the economy has become accustomed to stimulating policies. Certain countries with a high national debt, such as Italy, in particular, will immediately run into problems when interest rates rise again,' says de Vries.

Professor
More information

The full article from Trouw, 9 June 2020, can be found here (in Dutch). 

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