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  A Dangerous Cocktail: Europe Grapples with Threat of Stagflation

A Dangerous Cocktail Europe Grapples with Threat of Stagflation

By Christian Reiermann

Part 2: Curbing Inflationary Expectations

That hasn't happened yet. The scenario hasn't turned from possible to likely yet, and there is still time left to act. Stagflation confronts the central banks, in particular, with a problem that is very difficult to resolve. To reestablish price stability, they should in fact raise interest rates, because in addition to distorting price structures on the markets, inflation is especially hard on those with low incomes. They are forced to spend most of their money, and yet rising prices mean that they can afford less and less. Besides, their meager savings are also worth less and less.

On the other hand, central banks should lower interest rates to bolster an ailing economy. Of course, interest rates cannot be raised and lowered at the same time. When in doubt, the European Central Bank (ECB) has traditionally decided in favor of preserving price stability. It is already expected to raise key interest rates from 4 to 4.25 percent later this week.

The step is intended to offset rising prices. It makes borrowing more expensive, which in turn tends to limit the volume of money in circulation. ECB President Jean-Claude Trichet and his colleagues feel compelled to intervene, because prices are rising at a significantly faster pace than the rate the Frankfurt-based central bank considers compatible with its concept of price stability: 2 percent.

The ECB's goal is to curb the inflationary expectations of citizens and companies. Sometimes inflation happens purely because everyone expects it to happen. Then employees demand higher wages and companies feel compelled to raise prices to offset higher wage costs, which in turn prompts employees to demand even higher wages.

The Frankfurt central bankers' likely action has already been met with reservations from within the governing coalition in Berlin. "The ECB must consider that it could be sending the wrong message by raising interest rates, because higher rates could trigger a cyclical effect as the economy weakens," says Finance Minister Steinbrück. Plainly put, higher interest rates would accelerate the downturn. According to an official in the Economics Ministery, which is headed by Economics Minister Michael Glos (CDU): "We want interest rates to remain low, so that growth continues."

Rainer Wend, the SPD's business issues spokesman in the German parliament, believes that raising interest rates is unnecessary at this time. "The ECB should keep rates stable so as not to additionally jeopardize growth." Ludwig Stiegler, the deputy floor leader of the SPD's parliamentary group, hopes that the ECB will rethink its decision, given the current economic forecasts and developments on the markets. "In this situation, one shouldn't take steps that will clearly make things worse," he says. "I hope that the majority on the ECB board will remain reasonable."

Critics see the ECB's analysis as downright wrong. "We have a completely different underlying situation today than we did 30 years ago," says Gustav Adolf Horn of the Macroeconomic Policy Institute, a group with ties to labor unions. According to Horn, at that time inflationary pressure was coming directly from the economies, the result of factors like unduly rising wages. Nowadays, however, the triggers are external, says Horn, adding: "A central bank can do nothing about rising oil prices."

When adjusted for price increases in the energy sector, inflation ends up at only 1.7 percent. "This is quite clearly compatible with the ECB's target," says Horn.

As is common in the world of economists, such an assessment is not left unchallenged. "Price levels are rising because there is too much money in circulation," says Thorsten Polleit, chief economist with the investment bank Barclays Capital in Frankfurt. According to Polleit, the ECB and, to an even greater extent, the US Federal Reserve (Fed), flooded the markets with money in recent years. Now all this excess liquidity is seeping into the overall price structure. For this reason, Polleit argues, it is a mistake to adjust inflation for the costs of energy and commodities.

Stagflation Almost a Reality in the US

When prices for oil and wheat rise, says Polleit, bakers are forced to charge more for their bread to cover higher costs. Using economic models to back up his thesis, Polleit argues that to control the accumulated inflation potential, interest rates would have to go up by about 6 percent in Europe.

The ECB is a long way from raising rates by that much. It is unlikely to follow this Thursday's rate increase by more than one additional increase this year. The central bank is already walking a fine line. High interest rates lead to more stable prices, with a time delay of six to nine months, but they can also hamper growth in the short term. When borrowing becomes more expensive, people consume less and companies postpone or abandon capital improvements.

The German government's economic experts are still hopeful that a true recession, in which the economy actually shrinks, will not materialize. They too will reduce their growth forecast for next year from 1.2 percent to only 1 percent. In their medium-term forecast, which will be published in late July and is approved by both the Economics and Finance Ministries, they predict a continuation of the recovery for 2010 and the years after that. By then, say the experts, the economy will be growing at an annual rate of 1.5 percent again.

Of course, things could move in a completely different direction, because of the obvious risks to the global economy. The credit crisis hasn't been weathered yet, despite bankers' and politicians' periodic claims to the contrary. New losses amounting to billions of euros on the banks' balance sheets come to light with much the same regularity.

Stagflation is already almost a reality in the United States, where inflation has topped 4 percent and growth is weak. The ongoing rise in prices across the Atlantic is also a consequence of the low-interest-rate policy that the Fed pursued for years. It could soon find itself forced to raise rates again to keep inflation under control.

Fed Chairman Ben Bernanke is in a difficult position. If he remains too cautious, prices will continue to rise. But higher interest rates could send the US economy into recession once and for all -- with drastic consequences for the world economy.

Too much liquidity in the market is also the cause of inflation in the emerging nations. But they are a long way from stagnation. In fact, the opposite is the case. The economies in these countries are still chugging along at full steam. In many cases, their industries are operating at capacity, while consumption continues to rise among affluent segments of the population. Both factors -- growth and consumption -- drive up prices. In recent years the central banks of these countries, from China to Saudi Arabia, have been forced to keep pumping more money into the markets.

In these countries, the monetary systems are at fault. They have unilaterally pegged their currencies, like the Chinese renminbi or the Saudi Arabian riyal, to the dollar, using a stable exchange rate. Stagnation in the US economy now forces them to buy dollars in large amounts to maintain their fixed exchange rates. But this puts more domestic money into circulation than is prudent.

The new money fuels these countries' booming economies even further, which in turn drives up inflation. A loose monetary policy, combined with fixed exchange rates, is a fatal mix. The longer these countries perpetuate this mechanism, the greater their problems become. They have, in fact, only one choice if they hope to break this price spiral: They must stop pegging their currencies to the dollar and allow them to be revalued.

This would enable these countries to set their own interest rates and effectively fight inflation, a move that would also benefit Europe. The renminbi rising against the dollar would remove appreciation pressure on the euro, which has borne almost the entire burden itself until now.

A less expensive euro would benefit the European economy. It would make European goods more competitive once again, thus stabilizing the economy in the euro zone.

Translated from the German by Christopher Sultan