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The ECB Ignores The Threat Of Hyperinflation

Economics / HyperInflation Nov 05, 2013 - 05:34 PM GMT

By: Andrew_McKillop


What the market expects from Mario Draghi is more of the same QE. The shock fall in annual eurozone inflation to an official rate of just 0.7% in October put the spotlight back on the European Central Bank and its equally-official “target rate” of inflation, of 2%. But Mario Draghi has shown almost no interest in the subject except for one-liners such as: "You can buy more stuff” when inflation is low or zero, his reply to journalists' questions in a June interview on his unsurprising announcement that QE would continue “but didn't seem to be working”.

The market now expects the ECB to further cut interest rates, otherwise investors could lose faith. One major problem for the ECB is rates are already at extreme lows and with no surprise at all – sovereign debt is rising in all countries - not only in the so-called “troubled countries” of the PIIGS

Further problems for the ECB come from the direct results of its “QE to infinity” binge. Interest rates on sovereign borrowing – even in the “troubled countries” – have fallen. European banks operating across the eurozone have piled into the game of “debt transfer” well in advance of any formal Federal European debt pooling process, or concept. Due to the cocktail of Infinite QE mingled with austerity policies, very slow EU-wide growth, an overvalued euro, and other growth-chopping real world factors making a mockery of ECB pro domo annnoucements on “prosperity just around the corner”, one major but highly unanticipated effect has been a rapid shift to deflation in all the “troubled countries”, now spreading to “healthy countries”. This can only reduce the economic growth outlook going forward.

The ECB did not expect deflation in the “troubled countries” or anywhere else. Also, it therefore didn't expect this to more than compensate the effect of falling nominal interest rates. Increased real costs of debt servicing was the direct result. The ECB is therefore faced with dangerous “heterogeneity” in the eurozone. The troubled countries are being pushed into deflation before the rest, now accelerated by rising real debt servicing costs. As the EU-wide economy slows down, and sovereign debt rises, the additional threat of increasing interest rates will emerge, unless the ECB cuts them.

If the ECB does not react, the troubled countries will therefore find themselves in an even worse situation of “the deflation trap”.

 What can it do? The solution that would be most effective, but is probably unacceptable for the ECB, would be to act like the US Fed and especially the Bank of Japan: massive direct purchases of government bonds, starting with those of the PIIGS, rather than operating “behind the back” and in the shadows of the private banks.  The ECB would strive harder to generate “inflation expectations” and follow this by actually raising inflation across the eurozone, starting with the troubled countries. It would have to push down interest more than just a symbolic 0.25% cut but the probability of it running that policy and strategy is close to zero. As it repeatedly states, it has no remit for direct bond purchases. It claims it defends “strong money” as well as what it calls “disinflation”.

The conclusion is simple. The troubled countries, to start with, will become mired in deflation and their economic growth will decline further, which is the total opposite of the carefully-nurtured and endlessly-repeated “media and political consensus”  that the PIIGS are exiting the crisis.

As we know, a quarter-point rate cut to 0.25% would only have a marginal economic impact. Its value instead would be only political. The ECB's inflation-busting credentials are well known, exactly like those of other western central banks. For years, the call to cut inflation was judged by the ECB as far more important than chasing growth. However, its sudden conversion to actively seeking inflation is no surprise, due to its “surfeit of success” cutting inflation. The threat of deflation was however unexpected and even today, ECB staff forecast 2014 eurozone inflation of 1.3%, while Mr. Draghi brushes aside questions about the risks of low inflation, or even outright deflation, due to it being an unwelcome surprise. Deflation was “not on the radar” for the ECB.

The European Union's official economists, November 5, said that subdued growth will keep the bloc's unemployment rate near record highs through 2015, as private-sector debt cutting and continued government austerity continue to weigh on house purchases, other consumer spending and business investment. The Commission's report predicts the eurozone will in 2013 suffer its third year of economic contraction in five years. The bloc's economy is hoped to grow next year at 1.1%, as years of recession in the “troubled countries” taper down, replaced by fitful growth that could leave these countries with unemployment rates well above 15% for years.

The sudden appearance of deflation in official eurozone data, far more intense than ECB and Commission economists expected, is a real challenge. Eurozone deflation is now even worse than that of Japan. Greece has had negative inflation since March, Spain has now joined it, and in Italy the CPI is heading towards zero. Not only does low inflation slow debt reduction by driving up real interest rates, but the still massively overvalued euro poses a threat to any hopes for export-led growth recovery.

Although the euro at around $1.34 is well off its recent highs around $1.38 this is not enough to restore export-led growth for Germany's “eurozone powerhouse” economy. For the other economies the challenge is even higher, for one simple reason due to years of low or declining business investment, deindustrialisation, and delocalization outside Europe.

The OECD in its most-recent report on social, economic and human wellbeing in member countries firstly noted that the US has clawed back to a 2% gain in the 6 years since 2007, in average household incomes but in the eurozone both incomes and employment have fallen since 2008.  GDP per capita and household incomes are now more than 4% lower than pre-crisis levels. Within Europe, the “troubled countries” were of course the hardest hit, with household disposable incomes in Greece down 10% each year in both 2010 and 2011.

Since the crisis intensified in 2008, the OECD says, Europe has suffered a series of negative impacts broader than any other OECD region, so deep it affects peoples' trust in institutions and the way democracy works, as well as the degree to which they expect “family and social solidarity” to work for them. For the OECD,  "An increasing body of research suggests that the crisis is eroding the political and institutional capital of many countries, particularly in those where the crisis has been most severe."

To be sure, the OECD says that despite the economic decline, several European countries remain among the most-democratic and stable places to live, alongside Australia, Canada and New Zealand. However, several eurozone countries and especially the “troubled countries” are falling back into a group that includes about 60% of the OECD's 34 member countries defined as having “average levels of well-being”, including the U.S. and Japan. For some of the “troubled countries”, such as Greece, Spain  and Cyprus the OECD now ranks them as part of a group defined as having “relatively low levels of well-being”, alongside Turkey, Brazil and Mexico.

Unlike the US or Japan the fixation with inflation, arguably a major reason why the ECB has only now reacted to outright deflation in Europe, has been a historic cause of past and previous European economic policies. Even today, if you ask almost any German if inflation or deflation is the bigger threat to Europe, the answer will be an emphatic "inflation”. The Germans have a particular sensitivity to inflation and are prepared to react to any threat as soon as it even hints in the data. The historical connection between rampant inflation and the rise of the Nazi Party in the 1930s is etched into the German psyche, and by “contagion effect” into European Commission and Eurozone deciders' mindsets. Because of this real world factor, and ironically, the ECB may be prepared to go even further than other western central banks with its inflation-seeking QE. The sequels will be a shock.

It has taken at least 4 years for the ECB to start getting more concerned that inflation targets are consistently undershot but this is no surprise given the near-decade-long deflationary action by the ECB and even its founding policy and mission statement, among which “strong money'  heavily features. Certainly until 2010-2011, the key term “disinflation” featured in ECB thinking about what was, in reality, deflation. At the height of the deflation trench in 2009, similar to today's deflation curve, then ECB chairman J-C Trichet said:
“There is presently no threat of deflation”. When speaking to a committee of the European Parliament, 14 February, he called it disinflation, saying: “We are currently witnessing a process of disinflation, driven in particular by a sharp decline in commodity prices.”. He called that a “welcome development,” because of the belief that cheaper food, energy and raw materials “can only spur growth”.

The missing words were “mutatis mutandis” but even if we forgot our Latin the proof of what Trichet said being untrue was already strong in 2009 and is repeating again, today, especially in the eurozone where the combination of “strong money” and “disinflation” - very ironically packaged as “Keynesian fiscal and economics” - have wrecked the outlook for recovery. Much worse, the mid-term potential for high rates of inflation, or even hyperinflation in Europe has been wilfully ignored and sidelined.

One reason to argue for this is the extremely rapid fall or collapse into deflation, this year. In less than 9 months, the pace of inflation almost halved since January 2013 to a near-four-year low of 1.1% in September, then 0.7% in October, figures contested by many economists and finance professionals for example at Natixis France, as too high. The rebound potential is high or “symmetrical” due to the economic damage wrought by a second collapse into deflation in such a short period. Put another way, the supposed and hoped-for competitive advantage of deflation, aiding an export-led recovery for the eurozone and European Union, will not happen and is negated by the overvalued euro and the cumulative damage done by recession-plus-deflation. The ECB's QE is equally cumulative - and dangerous. Although the figures are meaningless or at best hard to understand, and controversial, ECB action since 2008 has produced about 4 to 5 trillion euros of cash “waiting to run riot”.

Even in the inflation and competitiveness benchmark country, Germany, it is now moving rapidly to an internal price deflation process every bit as sharp as the fall in prices in the “troubled economies” with exactly the same net impact – falling economic growth. The problem emerging now in Europe, even more so than the US or Japan, is a continent-wide asset sell down, resulting in QE “chaff euros” finally being wrung out of bank balance sheets, and released into the real economy. The situation in this regard is totally different from the 1930s Great Depression, which was long-term deflationary with no QE.

We can be sure and certain the ECB, like the US Fed and BOJ rejects any and all economic reason. It also rejects the figures on how much QE it has so far operated. It publishes what are now fanciful and exaggerated data for eurozone inflation rates. It rejects any argument that sustainable and effective corrective action needs the recognition of decades of wasted and mis-allocated capital, which on a cumulative basis can only make the economy stall and then contract.

Exactly like the other central banks of the western world, it argues that deleveraging is the same thing as disinflation, in other words that if everybody – private persons, enterprises, states – takes on more debt this means more inflation at some time or another, and then it acts in total denial of this! The ECB facilitates and encourages further sovereign debt but like the other central banks its knows there are only three ways debt can be extinguished
Pay it down in accordance with the original debt contract. Or default on it. Or inflate it away.

Today at last, the ECB is waking up to reality. Due to excessive previous debt, the deflation that ECB-speak calls “disinflation” is a normal and natural outcome, but can only mean less economic growth. Creating more debt under those circumstances is outright folly, to be sure “excused” by Keynesian mumbo-jumbo, but folly all the same. The biggest threat under those strange circumstances becomes the formerly impossible “wild card” of strong inflation, followed by hyperinflation.

Here, we exit the economics domain and move into the all-political domain, because the real menace – after a hyperinflationary breakdown – will be very deep recession. Literally 1930s-style recession. The risks of this will be denied to the literal last moment. The political class controls the central banks or at least likes to pretend it does and inflation is very, very attractive to the political class, not only because of the Keynesian illusion. Down to earth daily needs of big government are eased when inflation rises. After “shooting for 2% inflation”, the new one-liner of central bankers everywhere, the surge to 20% will of course be a big shock and surprise due to its violence and rapidity.

In Europe and especially the eurozone, today, we are watching the dogged attempt to create inflation, to be followed by po-faced shock and surprise when it then so rapidly surges and morphs into hyperinflation. All along the way, this will never be admitted as being remotely possible, by the ECB and by politicians, making it unfortunately all the more possible.

By Andrew McKillop


Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2013 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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