Gunther Schnabl: Inflation and Other Consequences of the ECB’s Monetary Policy

University of Leipzig
Faculty of Business and Economics
Institute for Economic Policy
Prof. Dr. Gunther Schnabl
Inflation and Other Consequences of the ECB’s
Monetary Policy
CEQLS Lecture
Bratislava, 23.5.2022
May 2022 Prof. Dr. Gunther Schnabl, Institute for Economic Policy 1

1. Introduction
2. Hayek’s Monetary Overinvestment Theory
3. Asymmetric Monetary and Fiscal Policies
4. Inflation, Growth and Distribution
5. Outlook
References
Hayek, Friedrich 1935: Prices and Production. 2nd ed. Augustus M.
Kelley, Clifton, NJ.
Mayer, Thomas / Schnabl, Gunther 2021: Reasons for the Demise of
the Interest: Savings Glut and Secular Stagnation or Central Bank
Policy? Quarterly Journal of Austrian Economics 24, 1, 3-40.
Schnabl, Gunther 2019: Central Banking and Crisis Management from
the Perspective of Austrian Business Cycle Theory. The Oxford
Handbook of the Economics of Central Banking, 551-584.
Contents

3
1. Corona-Crisis, Climate-Crisis, Ukraine-Crisis
May 2022 Prof. Dr. Gunther Schnabl, Institute for Economic Policy
Two Types of Crisis
• The Government responds to economic crisis or financial crisis.
• Forward-looking: The government foresees a crisis and takes
preventive action. The resulting economic crisis triggers economic
stabilization measures (corona-virus crisis, climate crisis).
Economic Policy Response Patterns
• Rescue credit and recapitalization (debt-financed),
• economic stimulus programs (debt-financed),
• monetary expansion (purchases of government bonds).
Institutional Changes
• Monetary policy rules ignored,
• debt-rules (temporarily) suspended (Germany, EU),
• revival of industrial and structural policy.

4
ECB Crisis Management

2. Hayek‘s Monetary Overinvestment Theory
Wicksell, Mises, Schumpeter and Hayek
• The overinvestment theories of Wicksell (1898), Mises (1912),
Schumpeter (1912) and Hayek (1929)
• explain business cycles with distorted relative prices on capital
markets.
Interest Rate Concepts
• ii = internal interest rate: real return on investment.
• in = natural interest rate: long-term equilibrium rate (S=I).
• icb = central bank rate: interest rate set by the central bank rate.
• ic = interest rate set by the banking sector for credits.
• Under normal conditions: icb=ic (for parsimony).

Starting Points of the Cycle
Innovation (exogenous) (Schumpeter 1912; Hayek 1929, 1935)
• Technical innovations increase the internal interest rate of
investment. The investment curve shifs to the right.
• Innovation in the financial market (US mortgage market), new
markets (dotcom), emerging markets (China, Central and Eastern
Europe), etc. can trigger overinvestment cycles.
Interest Rate Cut
• Domestic interest rate cuts by central banks (Japan, US, euro area)
drive innovation and irrational exuberance.
• Foreign monetary impulses lead to capital inflows, growing
investment and financial market exuberance (East Asian "tiger
states", southern, central and eastern Europe 2001-2007).

The Upswing
i
S
Iii1
Iii2
I2
I, S
I1 = S1
S2
in2
in1 = icb1=ic1
= icb2 = ic2
positive interest margin
Starting point: Innovation (Schumpter, Hayek), central bank mistakes
(Wicksell, Mises, Hayek), financial market competition (Hayek).
I2 > S2

8
Turnaround and Downswing
Starting point: Interest rate increase or changing mood of banks.
i
S
Iii3
Iii2
I3
I, S
S3
icb3=ic3
in3
negative interest margin
S3 > I3

3. Asymmetric Monetary and Fiscal Policies
Type 1 Monetary Policy Mistake
• During the upswing the central bank keeps the interest rate below
the natural interest rate (for too long) (in2>icb2),
• which triggers (new) overinvestment cycles.
Type 2 Monetary Policy Mistake (World Economic Crisis)
• The interest rate is held too high during the downswing (in3<icb3),
• which aggravates the crisis.
In Practice (Jackson Hole Consensus)
• Type 2 monetary policy mistakes are avoided.
• Type 1 monetary policy mistakes prevail.
• Type 2 monetary policy mistakes tend to be transformed into type
1 monetary policy mistakes.

G3 Short-term Interest Rates
Source: Refinitiv, IFS; arithmetic averages.
-4
-2
0
2
4
6
8
10
12
14
1980 1985 1990 1995 2000 2005 2010 2015 2020
Percent
Nominal
Real

General Government Debt of EMU
Source: European Commission.
40
50
60
70
80
90
100
1999 2002 2005 2008 2011 2014 2017 2020
Percent
of
GDP

G3 Central Bank Balance Sheets
Source: BoJ, Fed, ECB.
0
20
40
60
80
100
120
140
0
10
20
30
40
50
60
70
80
1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
Percent
of
GDP
Percent
of
GDP
ECB (l.h.s.)
FED (l.h.s.)
BoJ (r.h.s.)

Monetary Overhang in the Euro Area
Source: ECB.
100
200
300
400
500
600
700
1999 2004 2009 2014 2019
Index:
1999:Q1=100
M1 Real GDP

Definitions of Inflation
• “Prices do not stay constant, they are always rising and declining. An increase
in the money supply – inflation properly defined – has a tendency to raise them
in general.” (Rothbard)
• “A large increase in the money supply would have the accompanying effects -
like price increases.” (Mises).
• “In the euro area, the Harmonised Index of Consumer Prices (HICP) is used
to measure consumer price inflation. That means the change over time in the
prices of consumer goods and services purchased by euro area households.”
(ECB).
Types of Inflation
• Official consumer price inflation,
• asset price inflation (stocks),
• real estate price inflation,
• hidden inflation: (quality adjustment, weight adjustment),
• perceived inflation.
4. Inflation, Growth and Distribution Effects

Consumer and Asset Price Inflation
Source: Refinitiv.
0
50
100
150
200
250
300
350
400
1/1/99 1/1/03 1/1/07 1/1/11 1/1/15 1/1/19
Index
1999:01
=
100
Euro Area HICP
Eurostoxx 50
DAX
Dow Jones Industrials

Wandering Bubbles (Schnabl and Hoffmann 2008)
Source: IMF, FTSE, China Statistical Office.
0
200
400
600
800
1000
1200
1400
1600
1800
2000
0
50
100
150
200
250
300
350
400
450
500
1980 1985 1990 1995 2000 2005 2010 2015 2020
Index:
1994=100
Index:
1994=100
(Malaysia:
1990=100)
Nareit (linke Achse)
Japan, Nikkei (linke Achse)
Malaysia (linke Achse)
NASDAQ (rechte Achse)

Consumer Price Inflation in the Euro Area
Source: ECB, Destatis.
-4
-2
0
2
4
6
8
10
1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
Prozent
Deutschland
Euroraum
EZB Referenzwert
Spain

Perceived Inflation in the Euro Area
Source: European Commission.
-2
0
2
4
6
8
10
12
14
16
2004 2007 2010 2013 2016 2019 2022
Percent
Officially measured inflation (HICP)
Perceived inflation (median)

Monetary Policy and Raw Material Prices
• Low interest rates boost aggregate demand and the demand for
energy and raw materials.
• Weakening confidence in fiat currencies triggers a flight into
tangible assets (stocks, real estate, raw materials).
• As raw materials are traded in dollars (and euros), the exporters
hold large dollar (and euro) reserves. Because inflation in the
United States and the euro area devalues these assets in real terms,
there is an incentive lift prices of raw materials.
• If inflation expectations become permanent, hoarding sets in.
• If the euro depreciates against the dollar, raw material prices in
euro rise.
Reminiscent of the 1970s?
• Inflation started earlier (Vietnam war).
• This caused political instability and war (Yom Kippur)
• Raw material exporters increased prices (OPEC),
• which reinforced political instability globally.
Monetary Policy, Energy Prices, War and Inflation

Financial Repression (McKinnon 1973)
• Interest rate controls and state-directed capital allocation.
• Allocation function of interest rate disturbed.
• Interest rate margins of banks depressed (negative interest rates).
• Conditional liquidity provision by the ECB (TLTROs).
• Declining demand for credit by enterprises (credit crunch).
Negative Growth Effects (Hoffmann and Schnabl 2006)
• Interest rate increases in crises depressed.
• Rescue measures in case of crisis
• and gradually declining financing costs,
• reduce pressure on corporations to increase efficiency.
• Quasi “Soft Budget Constraints” (Kornai 1986).
• Zombification and
• declining aggregate productivity gains.
Long-term Growth Effects

Credit Allocation in the Market Economy
Savings Credit
Households Banks Corporations
6%
4%
2%
credit interest rate
deposit rate

Future EU/ECB Credit Allocation?
Credit Credit
ECB Banks Corporations
-0,5%
-1%

Soft Budget Constraint (Kornai 1986)
Source: OECD.
€
€

Trade Conflict Channel
• Monetary policies have strong distribution effects.
• Political discontent among voters is growing.
• This makes them open for politicians stressing national interest.
• Trade barriers become a widely acknowledged policy tool.
• Via retorsion measures trade impediments spread globally.
Regulation Channel
• Regulations are usually justified with consumer protection.
• They have redistribution effects across sectors (lobbyism).
• In sectors, which are negatively affected by regulation,
unemployment emerges.
• As governments subsidize enterprises, they can prevent
unemployment.
• Regulations for international production and transport flourish.
Monetary Policy and Deglobalization

Distribution Effects
From Creditor to Debtor / From Private to Public
• Via financial repression.
From Enterprise Sector to Financial Sector
• Via inflation of financial markets, repressing consumption.
From Poor to Rich
• Via asset price inflation, financial repression.
From Young to Old
• Via nominal wage repression, increasing real estate prices.
From Small to Large Enterprises / Financial Institutions
• Via capital market financing versus bank-based financing.
From Periphery to Economic Centres
• Via concentration effects of monetary policy.
From Current Account Surplus to Deficit Countries
• Via current account surpluses and TARGET2-balances.

Japan: Nominal Wages and Employment
Quelle: 総務省, Japan: Ministry of Internal Affairs and Communication.
38
43
48
53
58
100
105
110
115
120
125
130
Q2 1980 Q2 1987 Q2 1994 Q2 2001 Q2 2008 Q2 2015
Millions
Index
(100=1980)
Real wages
Total employment (rhs)

USA: Stock Prices and Income Inequality
Quelle: Thomson Reuters, Top Income Database.
10
12
14
16
18
20
22
24
0
20
40
60
80
100
120
140
160
180
1950 1960 1970 1980 1990 2000 2010 2020
Percent
Index
2015=100
NYSE (l.h.s.)
Top 1% Income Share, USA (r.h.s.)

5. Implications for E(M)U and Exit Options
The Creeping Transformation of the Economic System
• The monetary policy the ECB favours government expenditure
and regulation,
• which implies a gradual move away from market principles
(liability) towards principles as they prevailed in the socialist
planning economies.
• The wealth position of growing parts of the population is
deteriorating, distribution conflicts rise and political polarization
occurs.
Exit Strategies
• Monetary stabilisation is the prerequisite for economic and political
stabilisation.
• A decisive gradual increase of interest rates would be an exit
strategy based on the current monetary system (Paul Volcker).
• Alternative monetary systems outside the reach of policy makers
(Hayek 1976) are a new gold, or a bitcoin standard.

Thank you very much for your attention!
Twitter: @Gunther Schnabl

Long-term Interest Rates in Germany and USA
Source: Thomsen Reuters.
-2
0
2
4
6
8
10
12
14
16
1980 1985 1990 1995 2000 2005 2010 2015 2020
Percent
United States
Germany

Real Estate Prices in a Dyfunctional Monetary Union
Source: OECD.
100
120
140
160
180
200
220
240
260
280
1999 2001 2003 2005 2007 2009 2011 2013 2015 2017 2019 2021
Index
(Q1
1999
=
100)
Euroraum
Spanien
Deutschland

The Upswing Explained
• Innovations in the real and financial sector or the discovery of new
markets stimulate investment (from Iii1 to Iii2).
• A credit boom is triggered when the additional capital demand of
enterprises is satisfied at unchanged interest rates (ic1 = icb1 = ic2),
which mimics an increase in savings (future consumption).
• The credit expansion leads to increasing investment at unchanged
interest rates.
• The natural interest rate increases (from in1 to in2).
• Idle capacities are used. Then, with higher investment, demand for
labor and thereby wages increase.
• Higher demand for consumer goods does not meet sufficient
supply as capacities are bound in the investment goods sector.
• As prices rise, higher profits are signaled, which triggers additional
investment.
• The perceived positive wealth effect of rising asset prices further
stimulates consumption and asset purchases of the household
sector, financed by low interest rates.

33
Turnaround and Downswing Explained
• Rising prices and declining real wages motivate more labor-
intensive production reducing capital requirements per unit of
consumption output. Overall investment declines (Ricardo effect).
• Asset prices and consumer prices reach unsustainable limits. Credit
is tightened by the banking sector, or the central bank raises its
policy rate to fight inflation.
• With the central bank and capital market interest rates rising to
icb3=ic3, the threshold for the profitability of all previous and
future investment projects is lifted.
• Investment projects have to be dismantled (from Iii2 to Iii3) as a
cumulative downward process sets in. The natural rate of interest
declines to n3.
• The crisis is aggravated as the central bank keeps the policy rate
above the natural rate (icb3 > in3) and/or panic in financial markets
makes banks reluctant to provide credit (ic3 > in3).
• Bankruptcies and declining prices and wages are the basis for the
recovery (cleansing effect, Schumpeter 1912).

Concepts of Natural Interest Rates
Böhm-Bawerk (1890)
• The natural interest rate reflects the time preference of individuals.
Wicksell (1898: 102)
• “There is a certain rate of interest on loans which is neutral in respect to
commodity prices, and tends neither to raise nor to lower them.”
Hayek (1935)
• “It is the rate that tells the truth about the availability of resources for meeting
present and future consumer demands, allowing production plans to be kept in
line with the preferred pattern of consumption.”
Woodford (2003)
• The natural level of output is defined as the steady state value of
output (subject to stochastic shocks) under fully flexible prices and
the natural rate of interest is the real rate that prevails if output is
equal to its flexible price level.

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