_ Yuri Kofner, economist, MIWI Institute. Munich, 29 April 2022.
Hyperinflation or stagflation?
In 1922-23 Germany experienced the socio-economic turbulences of hyperinflation, which paved the way for the horrors of Nazism in Europe.
According to the US-American economist, Phillip D. Cagan, inflation rates of 50 percent month on month and above can be described as hyper inflationary.
Now, exactly 100 years later, inflation is again reaching watermarks not reached since the 1973 oil crisis and with some indicators, such as energy price inflation and producer price inflation, pointing towards actual hyperinflation.
Inflation structure and forecast
But can the current high price increase in Germany and the Eurozone correctly be described as hyperinflation? Or would it be more accurate do talk about a longer lasting period of stagflation?
In its spring forecast the Kiel Institute predicts the inflation rate in Germany to reach 5.8 percent in 2022. For 2023 an improvement to 3.4 percent is predicted and for 2024 a return to normal rates of 2 percent.  In March 2022 the CPI already reached 7.3 percent.
As the economist Daniel Stelter notes, the German federal government was quick to blame the current price explosion on the ware in Ukraine, just as quick, as before it blamed all economic problems on the Corona virus. Yet it should not be forgotten that just as the government Corona restrictions only exaggerated the economic decline caused by 16 years of nanny-state policies, inflation rates were 3.1 percent in 2021 and even 5.1 percent in February 2022, when the effects of he Ukraine ware didn’t have time to kick in.
The main components of the current price hike are energy price increases, which reached a staggering 39.5 percent in March 2022 (prices for heating oil reached hyperinflationary 59.6 percent in February 2022), and, much more alarming, producer price inflation at 25.9 percent in February 2022 – a mark not reached since the founding of the republic in 1949.
This is indeed very worrisome, since the producer price index is a good early indicator for overall inflation a few months down the road. Usually, producer price inflation is not passed on to consumers one-to-one, since companies try to absorb it by reducing their profit margin in order not to lose competitiveness. However, two years of Corona restrictions have largely eaten up entrepreneurial equities, making it much harder for companies to tighten their EBIT.
It should be noted that housing price inflation, which is notoriously not part of the ECB’s consumer price index, but is significant for the long run price trend, reached 10 percent in Q4 2021.
In March 2022, food products have become more expensive by “only” 6.2 percent. Here, higher inflation rates are likely to kick in later this year after the first harvest, since, worryingly, fertilizer prices have tripled from 300 USD per tonne to over 1,200 USD per tonne in February 2022,  and the price for diesel fuel, one third the domestic consumption of which is imported from Russia, has almost doubled to 2.16 euros per litre year-on-year. According to simulations by the Kiel Institute, the war in Ukraine could increase grain prices in Germany by 2 percent.
Three main factors for the current and coming inflation
The main factors for the current high inflation in Germany can be divided into three categories – external, domestic (caused by government policy decisions) and ECB monetary policy.
Indeed, the war in Ukraine skyrocketed prices for energy carriers imported to Europe. In 2021, Russia provided 55 percent of natural gas imports to Germany, over one third of raw oil imports and over one quarter of coal imports.
Between March 2020 and March 2022, the trading price of one MWh of natural gas increased tenfold from 25 USD to 250 USD. In February 2022 one oil barrel Brent traded at 125 USD, while the average price during 2013-2019 was half – at around 60 USD.
However, one should not forget, that the war in Ukraine only exacerbated the already very high gas prices: already in December 2021 one MWh natural gas was sold for 146 euros.
Also, during the global financial crisis of 2008 the oil price was still 30 USD higher than in March 2022. Yet in Germany the average fuel price was only 1.34 euros per litre of diesel and 1.40 euros per litre of gasoline, whereas in March 2022 they reached 2.34 and 2.19 euros per litre respectively.
According to a review by the German Council on Economic Affairs, leading national research institutes estimate the counterfactual effect of an embargo/delivery stop of Russian energy carriers to increase the inflation rate by 200 to 250 basis points.
According to the Bundesbank, a gas embargo would have a significant negative impact on the economy. The inflation rate would be 160 basis points higher in 2022, 200 basis points in 2023 and 90 basis points in 2024. According to Michael Hüther, President of IW Cologne, industrial production would come to a standstill for 2.5 years. As a result, according to Stefan Kooths, President of IfW Kiel, manufacturing output could fall by 50 percent and the total GDP loss could even reach 17 percent.
Another external inflationary factor were the supply bottlenecks for raw materials and preliminary products, which arose in early 2021 due to various factors, including: economic recovery in the USA and Asia after the lockdowns were lifted there; the start of large post-Corona fiscal stimulus programs; the blockage of the Suez Canal, recuring port closures in China.
In 2021 the supply bottlenecks already had cost the German economy over 25 bln euros, according to estimates by the Kiel Institute.
Decoupling trades relation with Russia due to the war in Ukraine could decrease German GDP by 0.4 percent, according to simulations by Felbermayr et al. (2022). However, since Germany is quite dependant on Russia for imports of certain industrial metals – Nickel (44 percent), palladium (26 percent), chrome (23 percent), cadmium (14 percent), which is an important input for the national automotive and high-tech industry, a trade stop with Russia could again have much more far-reaching events. The Russian invasion has also disrupted supply chains with Ukraine, leading to production standstills of BMW and Mercedes plants, since they depend on cable imports from Ukraine.
Domestic policy choices
As said above, the federal government was quick to blame external factors as the only cause for inflation. However, the main reasons lie indeed in domestic policy choices, especially in four areas: energy and climate policy, red tape, the corona restrictions and neglecting long-run demographic changes.
Climate and energy policy
Climate policy costs German citizens and companies billions of euros each year. The energy turnaround, i.e. the push towards volatile weather dependant solar and wind power generation is not only being financed by the so-called EEG surcharge on electricity prices, which cost 31 bln euros in 2021 and will likely cost 48.2 bln euros by 2025, but also increased the expenditure on grid stability measures to 1.1 bln euros yearly (1.7 bln euros in 2025). Taxation makes up over half of the consumer electricity price, which over the past two decades doubled for households and tripled for industry: from 14 to 31.4 cents per KWh and from 6 to 18.6 cents per KWh, respectively. As a result, by now Germany has the highest electricity prices worldwide. And, according to the Prognos think tank, due to the energy turnaround electricity prices will increase by a further 50 percent by 2025.
The CDU-led government of the past 16 years and now the so-called “traffic light” government (SPD, Greens, FDP) is increasingly moving away from the ordoliberal principle of non-interference and towards a dirigiste industrial policy of picking and heavily subsidising certain technologies and productions processes. According to the Kiel Institute, state subsidies increased by 30 percent between 2012 and 2020. In 2020 they reached almost 2,500 euros per capita. The coalition agreement of the traffic light government foresees an increase in subsidies op to 237.5 bln euros per year, which is tantamount to near 7 percent of GDP. These subsidies are insofar a problem that the pour investments into sectors and products, which in the end might not bring the desired economic output. Over the past decade, German economic growth has slowed to near 1 percent per annum. In the coming decade it is likely to be below that. Increasing money supply without accommodation growth, ceteris paribus, increase inflation.
The climate policy in the form of CO2 pricing is in itself a direct driver of inflation. According to a recent study by KfW Research, the introduction of the national CO2 tax in 2021 increased the CPI by 63 basis points year-on-year, so was responsible for over 20 percent of inflation in 2021 (3.1 percent overall). In 2022, due to the national CO2 tax, fuel prices will increase by 7.4 cents per litre, heating oil by 8 cents per litre and natural gas by 0.6 cents per litre compared to 2020. By raising the CO2 tax to 65 euros per tonne of CO2 by 2026, the inflation rate will be 149 basis points higher than in a scenario without it.
Another cost -, and thus price driver is the excessive bureaucratic burden in Germany. Between 2010 and 2022 the number of federal laws and ordinances increased by 5.7 percent. By 2021 administrative costs of the German state reached 7 bln euros yearly. Red tape costs the German economy 4 bln euros or 0.1 percent of GDP each year. According to calculations by the DIHK, in March 2020, shortly before the Corona restrictions, the excessive bureaucracy cost a typical company around 2.5 percent of its turnover.
The corona restrictions acted as inflation drivers through two channels: Firstly, the lockdowns, mask mandates and 3G rules decreased consumer demand at the time of implementation, however they also led to a significant build-up of the savings rate of private households from 10.8 percent in 2019 to 15 percent in 2021, reaching 16.1 percent in 2020. The accumulated savings then turned into higher consumption and thus inflation levels when restrictions were lifted.
On the supply side, the corona restrictions have disrupted value chains and led to supply side inflationary shock. According to IW Köln and DIHK, the corona restrictions cost between 350 and 413 billion euros in added value in 2020 and 2021, which divided by two years corresponds to around 0.5 percent of annual GDP.
In the long-term, demographic ageing of the German population will also increase the inflationary level. By 2030, the number of over 65-year-olds, i.e., of retirees will increase by around 4 percent. Since pensioners save less and consume more, with a smaller working-age population (-4.5 percent) backing them, the inflation rate may be 193 basis points higher by 2030. This assessment is backed by the economist Charles Goodhart and Manoj Pradhan in their monograph “The Great Demographic Reversal”, where thy forecast inflation levels in the eurozone to climb above 10 percent after most corona restrictions are lifted.
Another inflationary channel related to Germany’s demographic decline is the current and worsening skilled labour shortage. In December 2021 the skilled labour gap reached 465,000. By 2030 this number could reach 5 million. This shortage will push wages and thus inflation.
The situation is exacerbated by populistic interventions in the labour market. The increase in the minimum wage to 12 euros planned by the traffic light government will fuel the already tense wage-price spiral. According to calculations by the Hans Böckler Foundation, the inflation rate will be 25 basis points higher in 2023 than without the wage increase.
Next to purely external and domestic factors affecting the current and future inflation, stands the ultra-expansive monetary policy of the European Central Bank (ECB), which is both an external factor and a domestic policy choice, since Berlin voluntarily gave away its national sovereignty over monetary policy to the ECB.
In the aftermath of the (ongoing) euro crisis the ECB’s fixed interest rate dropped below 0.5 percent and reached 0 percent in 2016, where it stayed since. More importantly, its interest rate on deposit facilities reached 0 percent in 2012 and in 2014 dropped below 0 reaching minus 0.5 percent from 2019 onwards.
This negative interest rate monetary policy had three effects: Firstly, the ECB is de facto conducting prohibited state financing. Due to the negative interest rate the German federal government saves 49.2 bln euros yearly in interest payments on government debt. At the same time, since in 2021 the real interest rate in Germany was already – 2.3 percent, domestic savers lost 116 bln euros in 2021, which is tantamount to a wealth loss of 1,400 euros per person.
Due to the ECB’s expansive monetary policy, especially its quantitative easing programms, the money supply M3 in the euro area increased from December 2019 to February 2022 by 20.1 percent, reaching 15.6 trillion euros. From December 2011 the increase was even 60.1 percent. As of July 2021, the ECB held 42 percent of Germany’s sovereign debt, which is 900 basis points above the usually allowed threshold of one-third of national state debt. Using Corona as a pretext, and now the war in Ukraine, this important limitation was “temporarily” lifted as so many other firsts in EU fiscal and monetary policy, e.g., the NGEU.
Between 2011 and 2021 the consolidated balance sheet of the European Central Bank increased from 28 percent of the euro areas GDP (2.73 vs 9.8 trln euros) to 70 percent (8.57 vs 12.26 trln euros). The German economist Dr. Markus Krall predicts the euro system to collapse at the moment when seigniorage capital to exceed the euro area’s gross domestic product.
Even more certain is fact that this excessive money supply in the form of cheap and thus easily available credits leads to a zombification of the business landscape – 15 to 20 percent of German companies are ineffective, uncompetitive and non-innovative zombie companies – and thus to a period of very slow economic growth (below 1 percent y.o.y. as described above) – stagnation. Together with the rising inflation, this decade is expected to be one of stagflation in Europe.
What can and should be done against the current high inflation and the coming stagflation? Well, let’s first look at what ought not to be done. Unfortunately, most of what should not be done is currently being implemented by the German federal government.
Wrong counter measures
Firstly, the government should try not to put new financial burdens on the economy. However, the new paradoxically called “relief” package does exactly that. E.g., it proscribes the “climate friendly” heating standards in building and the forced exchange of radiators. According to calculations by the Federal Ministry for Education and Research, the “green” compulsory modernization of the heating systems will cost at least 200 euros per square meter.
Secondly, the government should refrain from pumping even more money into the system without it creating real economic growth, especially in the form of subsidies in climate protection. Unfortunately, as his first official act as finance minister Christian Lindner from the FDP issued a supplementary budget by converting 60 billion euros into the climate and transformation fund.
Thirdly, in order to partially alleviate the drastically risen energy prices and climate policy burden, the traffic light government is granting a one-off payment in 2022 (300 euros per person) and is planning the introduction of a so-called climate money as a cash payment to private households. However, the government should actually refrain from doing so, since, these transfers do not solve the above mentioned inflation factors, do not produce more growth, will be eaten up by the price rise itself and, most worrisome, will in themselves even add to the current inflation. E.g., the introduction of climate money will be similar to that of so-called “helicopter money” and thus boost the inflation rate even further. Based on econometric studies by Martin P. et al (2021), one can assume that the introduction of this climate (helicopter) money will fuel inflation by at least another 15 basis points.
Right counter measures
The government’s counter measures to inflation and stagflation can be divided in measures with immediate effects and long-term measures.
Short-term counter measures
The potential short-term measures against inflation are limited in range and can by subdivided into three main areas: tax reductions, reducing red tape and monetary policy.
Tax reductions have several benefits: they can be implemented by the government, i.e., are under its control; and with immediate effect; they are more likely to have anti-inflationary effects as opposed to social transfers; and they leave the real sector “more net from gross”.
Reducing VAT from the current 19 to 15 percent would relieve the economy by 37.1 bln euros (1.1 percent of GDP) and each citizen by 448 euros.
Reducing various tax components on electricity prices, e.g., the energy tax, the electricity tax, the renewables surcharge and the CO2 levy, to the permitted EU minimum would reduce the electricity costs for industry from the current 27 euro cents per KWh (January 2022) to 23 euro cents per KWh and for households from 36 to 32 cents per KWh. The tax reduction would be 45 and 40 percent respectively.
Reducing VAT, energy tax and the CO2 levy on fuel prices to the allowed EU minimum would lower the price for one litre of diesel from the current 2,01 euros to 1,496 euros and for one litre of gasoline from 1.944 to 1.298 euros. The tax component would be reduced from 47 to 29 percent and from 57 to 36 percent respectively.
Other anti-inflationary tax reliefs could include raising the income tax allowance or lowering the broadcasting fee, the property tax, the property transfer tax, the trade tax, the corporate tax, as well as various import duties, e.g., on agricultural products.
Another measure with immediate effect would be reducing the bureaucratic burden on the economy. First of all, this would mean not introducing any more Corona restrictions. Even without a lockdown, the test and mask mandates alone have cost Germany 64 bln euros (771 euros per capita) in the second half of 2021.
Secondly, reducing red tape in order to make it easier to start a business, to make it easier to receive a building permit and generally less regulations would relief the German economy by 13.2 bln euros yearly or 160 euros per person.
Some economists in Germany argue that the ECB cannot act against the current inflation hike, since its monetary policy is not a suited instrument against energy price related inflation. However, as we have seen above, the energy crisis only triggered the inflationary potential created by a decade of ultra-expansive monetary policy. Moreover, a recent DIW study shows that a rate hike by the ECB that lifts the yield on one-year Bunds by 25 basis points would reduce the German consumer price index by 0.2 percent. Heating and electricity costs would fall by around 2 percent, and the price of fuels such as petrol and diesel would fall by 4 percent. Thus, the ECB clearly could and should act now – the sooner the better.
Long-term counter measures
At least four policy areas can be identified to lower inflationary pressure in the long term: providing a cheap and stable energy supply, diversifying supply chains, increasing fertility and, of course, implementing a more restrictive monetary policy.
Firstly, the federal government should abandon its energy transition in favour of two volatile energy carriers – wind and solar power, and instead pursue a more technology-open energy mix including nuclear and coal power. According to research by Blümm (2021), the cheapest generation methods in Germany are: the prolongation of existing nuclear power plants (2.7 euro cents per KWh), hydropower (3 euro cents per KWh), building new nuclear power plants (4 euro cents per KWh) and coal power without the CO2 levy (5 euro cents per KWh).
A regression analysis shows that MIWI Institute shows that nuclear energy and hydropower are the cheapest methods of electricity generation in the EU. By increasing the share of nuclear and hydropower in the energy mix by 1 percent, the electricity price falls by an average of 1.3 to 1.4 euros per MWh.
Secondly, Germany should assist in the diversification of its supply chains in order to ease future supply bottlenecks. This can be done by both supporting the signature and ratification of free trade agreements, e.g., with Canada (CETA), the United States, Mercosur, the African Union, Australia, and so on, as well as by more investment into large transport logistics projects in order to have trade route alternatives. For example, according to a gravitation simulation by the Dutch Office for Economic Policy (CPB), the opening of the North Sea Route would lower inflation in Germany, ceteris paribus, by 11 basis points.
Thirdly, as seen above, ageing and a shrinking population exert long-term inflationary pressure. Thus, measure need to be taken to increase the current fertility rate from 1.54 to 2.1 birth per women. According to a Norwegian meta study from 2020, in Western developed countries the most effective policy measures to achieve this are: better childcare, universal transfers and subsidized assisted reproductive treatment.
Last but not least, if the ECB doesn’t return to a healthy, i.e., more restrictive monetary policy in the near future, Berlin should consider regaining national sovereignty over its monetary policy. According to MIWI economist Everaert (2022), potential options could include the passive or active withdrawal from the Euro area. Scharpf (2018) proposes the creation of a two-tier currency union.
Addendum: medium term counter measures
Another reason for the price explosions in the supermarket or at the gas station, which was not mentioned above, is the high level of market concentration in these sectors.
In 2020, grocery retail in Germany was an oligopoly dominated by four supermarket chains, which together control 67 percent of the industry.
While taxes indeed account for the lion’s share of consumer fuel prices – between 50 to 60 percent, compared to 2008, when crude oil prices were about USD 30 higher than today, consumer fuel prices were still significantly lower than they are today. This is due to the fact, the gas station and crude oil refining market is concentrated in the hands of a few oil majors, who also control 67 percent of the sector, and whose profit margins more than doubled between February and March 2022.
Also, German mobile phone providers torment their customers with long-term contracts and annual tariff increases since the domestic phone market is dominated by only three mobile phone providers.
Of course, large companies have their advantages that need to be considered – economies of scale, potentially high research expenditures or the provision of infrastructure.
However, the high concentration in various domestic markets is a problem that has been neglected by politicians in recent years and should be addressed by the government. It was not for nothing that Walter Eucken, Ludwig Erhard and co. saw not only a stable currency, but also a dynamic competitive framework as the backbone of the German social market economy.
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