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Raising interest rates to fight inflation is a crazy idea

by Jens Berger and Guido Speckmann
Monetarism was conceived in the 1960s as a kind of liberal answer to the teachings of John Maynard Keynes, tracing back directly to the neoliberal mastermind Milton Friedman. The core of the monetarist doctrine is that the money supply mono-causally determines the value of money.
Raising key interest rates to fight inflation? What a crazy idea
by Jens Berger
[This article posted on 9/14/2022 is translated from the German on the Internet,]

Last week, the ECB (European Central Bank) raised its key interest rate from 0.5 to 1.25 percent. "Historic" is the increase of 0.75 percentage points, but still far from enough - at least that's what most financial journalists and some often quoted economists think. This is astonishing. The fact that a central bank is using the key interest rate to make loans more expensive at the beginning of a severe recession will weaken the economy even further. But it is supposedly about fighting inflation. Here, however, things get confused. Apparently, many opinion leaders still haven't understood how inflation arises and what the causes of the current price increases are. An increase in the key interest rate will not have any significant impact on this. By Jens Berger.

It is not easy to explain the relationships between key interest rates, money supply and inflation in a way that is comprehensible even to non-economists. Since a technical article that only a few readers understand goes against the NachDenkSeiten's self-image of being understood by as many readers as possible, I am going a bit further in this article and trying my best to argue in a generally understandable way. So please understand that I do not illuminate all marginal aspects and use technical terms in a simplified way.

The heresy of monetarism

In order to understand the different views, it is helpful to first understand what makes central bankers and those financial journalists who are now calling for interest rate hikes tick. Two economists, three opinions - this is how one could summarize the theoretical discussion about the origin of inflation. Closely related to "neoliberalism" is the economic school of the so-called monetarists. Monetarism was conceived in the 1960s as a kind of liberal answer to the teachings of John Maynard Keynes, tracing back directly to the neoliberal mastermind Milton Friedman. The core of the monetarist doctrine is that the money supply monocausally determines the value of money. Even today, one often hears that the money supply and the quantity of goods should always develop uniformly in an ideal economy. If the money supply increases more than the quantity of goods, supply and demand would diverge and prices would rise.

According to the monetarists, the central bank can also "control" the value of money directly via money supply policy. If, for example, it allows the key interest rate to rise - so the doctrine goes - less money will be in demand, the money supply will fall, and thus inflation will also fall. Conversely, a reduction in the key interest rate is said to lead to stronger demand for credit, money is "created," the money supply - and thus inflation - increase. Incidentally, it was the German Bundesbank that was the first central bank in the world to introduce an active price stability policy by means of money supply control in 1974.

From now on, an independent monetary policy of the Bundesbank was possible, and this required new theoretical concepts. This practical challenge coincided with the "monetarist revolution" triggered by the work of Milton Friedman. On December 5, 1974, the Bundesbank became the first central bank in the world to announce a monetary target for the following year.
From "The Annual Reports of the German Council of Economic Experts in the Mirror of Politics," Ottmar Issing, 2003.

Thus, while the Chicago Boys were implementing Milton Friedman's neoliberal lessons in Pinochet's Chile, Friedman's monetary policy lessons were first introduced at the same time in, of all places, the Federal Republic of Germany. To this day, the Bundesbank is considered a "stronghold" of the monetarists, and there is probably no country in which the economics faculties of the universities are so much in the hands of the monetarists as Germany. Who is surprised, then, that a great many financial journalists who studied at those same universities also hold monetarist positions?

However, monetarism has a major "flaw." Its core statement is simply not empirically valid and never has been. Actually, the differences between the measured money supply and observed price increases in recent decades should silence monetarists. In the U.S., for example, the M3 money supply grew by an average of 9.1% per year between 1997 and the 2008 financial crisis, while the consumer price index CPI grew by an average of only 2.7% per year. The same development was also observed with a slight time lag in the euro area. There, the M3 money supply increased by an average of 8.2% per year between 2001 and the start of the financial crisis in late summer 2008, while consumer prices rose by only 2.3% in each case over the same period. After the financial crisis, the development in both major currency areas - albeit at a lower level - looked similar. While the money supply grew rapidly in the world's two largest currency areas, real price increases apparently lagged far behind. Incidentally, the growth rate of the money supply literally collapsed at the beginning of 2021 and has halved since then. At the same time, deflation developed into inflation of 7.9% today. According to the theory of the monetarists, exactly the opposite should have happened.

The situation is similar with the key interest rate. If you look at the development of the key interest rate and the price increase, you can see at most one connection: The key interest rate follows the price development. But that is not surprising, since both the Fed and the ECB today follow the monetarist dogma and adjust the key interest rate to inflation. You can think of it in non-economic terms like this: When it rains, I open my umbrella. The umbrella is a reaction to the rain. But not the other way around! If the sun is shining and I open my umbrella, the weather will not care.

This comparison is catchy, but of course also exaggerated. Of course, the key interest rate also has an influence on price increases. But rather indirectly via aggregate demand and nowhere near as much as central banks like to claim. If a company asks for loans for investments, it also creates jobs directly or indirectly, which also increases aggregate demand. The more loans are demanded by the real economy, the more money ultimately ends up in the private sector to demand goods and services. The money supply is thus a necessary - but by no means sufficient - condition for price increases.

Actually, one might now think that the monetarists would gather for a crisis meeting in their ivory tower and declare their theory a failure. The opposite is the case. You know how it is: If the theory doesn't match reality - all the worse for reality!

How does inflation come about?

If the explanation of the Monetaristen is wrong, how does it come then to price increases? This question can probably be explained much easier and better with common sense than with economic models. First, in simplified terms, there are four possible triggers of price increases - demand, supply, costs and exchange rates.


If you want to understand how inflation is generated, you could, for example, put yourself in the role of the landlord of an ice cream parlor. He is an entrepreneur and wants to make money. But he is also in competition and depends on people buying his ice cream. Such a landlord could increase the price of his ice cream if the tables in front of his ice cream parlor are always very busy. However, he can only realize this price increase if his guests are also able and willing to pay higher prices. In terms of the economy as a whole, therefore, both wage trends and employment levels play a key role in price increases. Only when more people have more money in their pockets are they also willing and able to spend more money. Another condition for the success of his price increase is the market. If he is the only one to increase his prices and the competition does not follow suit, his customers will leave. However, if the increasing willingness to pay exists on a broad scale, suppliers on a broad scale will also see the opportunities to increase prices.

the supply

It is a principle of economics that price results from supply and demand. Supply can also be the determining factor in price increases and inflation. The connection between a noticeably tight supply and rising prices can be observed, for example, in housing rents. In areas where demand for housing is already high, rents continue to rise because supply cannot easily be increased - examples of this are sought-after neighborhoods in major cities or their famous "Speckgürtel". The landlord can raise the price because of the short supply; until demand falls to the point where supply and demand coincide. However, this "supply inflation" is rather the exception. Most of the time, supply is variable and it is demand that determines the price of a product or service.

We are currently experiencing an exception to this rule. Due to the global corona measures, there was a disruption in the supply chains. This resulted in a noticeable drop in production for certain products. Supply has been tightened. This can be felt, for example, in the case of new cars and high-quality bicycles, whose components or their preliminary products often come from China and Taiwan and did not reach German producers in the desired quantities as a result of the lockdowns there, including disruptions in the global transport of goods. But if a bicycle manufacturer can now only sell fewer products in the face of steady demand, he can - like the landlord in the popular district - squeeze demand by charging a higher price and increase his margins in the process.

the cost

Put simply, the price always reflects the cost plus the margin of the supplier. Demand-driven price increases are primarily about maximizing margins. But if costs are rising and our host wants to at least maintain his margins, he is also forced to raise prices. For him, costs can be the rent for his ice cream parlor, the wages of his employees, or the cost of raw materials and energy. What does not make much difference on a business level is, however, very significant for the overall economic issue.

Here is a small example: If the landlord, and with him the entire economy, has higher wage costs, he has to raise prices, but his customers are also wage earners on the other side and have more money in their pockets as a result of the rising wage costs, which are their labor income on the other side. This is where economists then speak of a wage-price spiral. Rising wages drive up prices, so that in the end people have more money in their pockets but cannot afford more.

The situation is quite different with "external factors" such as energy prices. The host's energy costs are the income of the energy companies, and since Germany imports a large part of its energy sources, a large part of the money even ends up abroad. So it can generate here in the domestic economy but no demand. The price rises and the customer still has as much money as before in his pocket. So he can afford less.

The exchange rates

In the case of our host, the exchange rates play a rather minor role. Certainly, the raw materials he uses become more expensive when the euro loses value against the currency of the economic area from which he obtains these raw materials. The exchange rate problem is more significant for industrial companies that import a large proportion of their raw materials or intermediate products from other currency areas. The euro fell by around 20 percent against the dollar last year. This has also significantly increased procurement costs for these companies, and if they want to keep their margins stable, they have to raise prices accordingly. Here, too, the customer ends up with just as much money in his pocket, but for which he can afford less.

What influence do money supply and the key interest rate have on these three factors?

If the monetarist explanation that prices can be explained monocausally by the development of the money supply were correct, there would have to be a logical explanation for the three factors mentioned. Is that so?

Let's start with demand. Do you have more money in your pocket because key interest rates are falling or the money supply is rising? No, of course not. At least not necessarily. It's not as if central banks "print money," as monetarists like to put it. Money is created when the government, businesses or the private sector borrow. Now, what matters is what these loans are taken out for. If, for example, the state has taken on debt because of the Coronalockdowns in order to pay out bridge money to tradesmen, the ordinary citizen will not have a single cent more in his pocket as a result. So the landlord of the ice cream parlor can't raise his price, there are no price increases. By the way, a very large part of the increased money supply is due to the inflated financial sector. However, all the bets in the form of derivatives, for which the banks and financial companies need outside capital - i.e. loans - also do not have the slightest effect on the filling level of their wallets. So to what extent the money supply has an influence on demand is something that probably only the monetarists know. There is no plausible explanation.

Likewise, the money supply offers no explanation for the price increases that can be observed due to a lack of supply. Supply chains collapsed because of Corona measures, not because of the money supply or any interest rates.

It is the same with the cost factor. Are wages rising because credit is cheaper and more frequently used? Of course not. Strictly speaking, the reverse effect could even be explained here. If the key interest rate falls and loans become cheaper, the financial costs of the economy also fall, which could pass this on to customers as price reductions. To what extent the money supply or the key interest rate should have any effect on raw material and energy costs is also logically inexplicable.

That leaves the factor of exchange rates, and here there is indeed a connection. Our dear money - especially if we have it managed by financial institutions - is truly volatile. If, for example, interest rates rise in the dollar zone, this is interesting for asset managers and many an interest-bearing investment moves from the euro to the dollar zone. This changes supply and demand between the two currencies. The more money flows into the dollar area, the more the value of the dollar rises against the euro. The effects of these exchange rate fluctuations (see above) also spill over into the real economy, making imports more expensive. This in turn leads to rising costs and ultimately to rising prices.

Interest rate-related exchange rate effects are therefore present. However, it is difficult to quantify how large they are, and they have nothing to do with the money supply, either directly or indirectly.

What influence do the four factors and the money supply have on current inflation?

If we look at the current price increases, they can be explained quite well by the three factors mentioned. The demand factor is out of the question here. No baker raises the bread price, because the customers have straight so much money in the bag and he can realize now higher margins. It is primarily costs that drive prices. And here, it is no longer possible to make a clear distinction between the factors mentioned. In addition to the effects from the disruption of supply chains as a result of the Corona measures, energy costs in particular are the big driver of the current price increases. And this directly at the gas pump or for electricity and gas consumption, as well as indirectly, since energy costs are sometimes very massively included in product prices. If the baker now pays four times as much to operate his ovens, he is forced to pass on the higher costs to the price. The ice cream café operator in the above example has a similar situation. If he has to pay significantly more money for cooling his ice cream containers and heating his café, and he wants to maintain his margin, he has to raise his prices. Ultimately, the "energy costs" factor is present to varying degrees in almost all products and services on which we spend money.

Incidentally, the exchange rates have a reinforcing effect here, since the vast majority of raw materials - including energy sources - are priced and invoiced in dollars. However, exchange rate fluctuations cannot be transferred 1:1 here either, since global demand is also aggregated and exchange rates also have an influence on demand. Unfortunately, "energy" in particular is a commodity that - as economists say - has only a very low price elasticity of demand; demand therefore decreases only slightly when prices rise.

The price increase across the board can therefore be explained almost monocausally via these factors triggered by supply chain problems and energy prices. At this point, at the latest, one must seriously ask whether the monetarists cannot see this or do not want to see it.

What are they actually trying to achieve by raising interest rates?

Polemically, one could ask at this point whether a single cubic meter more of gas will enter the German pipeline network if the ECB raises the key interest rate. Even after thinking about it for a while, I can't think of any plausible interaction. The key interest rate also has zero influence on the supply chain problem.

However, an increase in the key interest rate can cool down an overheated economy in order to mitigate the consequences of the typical economic boom and bust cycles. Ideally, this should be done counter-cyclically. In other words, the key interest rate could well be raised during an upswing, while it should be lowered during a downturn.

However, it is no secret that we are currently at the beginning of a major economic downturn; in other words, at precisely the time when interest rates should actually be lowered in order to cushion the recession. However, even if it wanted to, the ECB would not have this opportunity at all, as it has kept key interest rates at far too low a level since the financial crisis, despite a normal economic trend. For purely real economic reasons, it should actually have raised the key rate again as early as 2010 and no later than 2013, when the eurozone economy had picked up speed again - albeit slightly - after the financial crisis. However, this did not happen out of deference to banks with ailing loan portfolios and euro states with high sovereign debt ratios. And this circumstance harbors enormous crisis potential, because for the highly indebted states in particular, it could now come as thick as a brick if interest rates "return." Italy's public debt ratio is over 150 percent. A return to a normal interest rate of, say, four percent would mean that the Italian government would have to pay six percent of its GDP each year just to service the interest. That is currently 114 billion euros. And Italy is not alone. So we are faced with a mountain of economic problems, of which price increases are still one of the smaller problems. And it doesn't look like the ECB (European Central Bank) has any solutions to these problems.


Why are prices rising?

Once again, the "wage-price spiral" smokescreen is being fired in the inflation debate. But what about profit inflation?

By Guido Speckmann
[This article posted on 8/16/2022 is translated from the German on the Internet,]

Tubes run over a roof presumably of a high-rise building
Energy prices are consistently identified as the main driver of inflation. But that's not all. Photo: Victor / Unsplash

These are the worries you want to have: In February, the chief financial officer of British petroleum company bp, Murray Auchincloss, joked that he didn't even know what to do with all the money his group was making. In fact, it's not just the energy companies' profits that are bubbling up; other companies are also reporting record sales and profits. German listed corporations, for example, earned more than ever before in the first quarter. "The 40 Dax groups alone posted earnings before interest and taxes of 52.4 billion euros, a good 20 percent more than in the strong previous year," notes Handelsblatt. The report goes on to say that thanks to a high order backlog and still strong demand, most companies managed to more than pass on higher prices - and rake in rapidly rising profits.

A remarkable statement. Because here it is stated in plain language that the large corporations are using the prices, which have already been rising since 2021, to increase their profits. The Bundesbank had already drawn attention to this in December 2021: higher costs due to supply and transport bottlenecks would be passed on to consumers and profit margins would be expanded in the event of strong demand.

Perspectives that are rarely heard in the current discussion about inflation. Of course, since the Russian invasion of Ukraine and a possible gas embargo, energy prices have been identified by most as the main driver of current price increases. But at least the focus of the German discussion is the dithering European Central Bank (ECB), which has failed for far too long to raise the key interest rate. And the employees, who must now please exercise wage restraint, because too high wage agreements would set the so-called wage-price spiral in motion. Accordingly, companies would react to high wage agreements with price increases, the unions with renewed high agreements, and so on and so forth.

This has little to do with the reality of current price increases. Even the president of the employers' association, Rainer Dulger, stated this soberly on the occasion of the first meeting on "concerted action" in the Chancellor's Office: Wages are not currently driving inflation. The Economic and Social Research Institute of the Hans Böckler Foundation estimates that real wages will fall by 2.9 percent in the EU and in Germany in the current year.

Instead of talking about a wage-price spiral, it would be more appropriate to talk about a profit-price spiral or profit inflation. In the U.S., a debate about the role of large corporations in price increases already flared up a few months ago. A new word was even invented for it: Greedflation, derived from the English greed = greed.

Not all inflation is the same

Inflation can have various causes, which is why economists distinguish between supply-side and demand-side inflation. These, in turn, can also be further differentiated. For instance, there are wage cost, cost tax and imported cost inflations or market power or profit inflations.

In neoclassical and monetarist mainstream economics, the main explanation is that inflation is caused by an excessively large money supply and thus by demand exceeding supply. This also explains the targeting of the ECB, which has pursued a loose monetary policy for far too long after the financial and euro crisis.

Wages are not currently driving inflation.
Employer President Rainer Dulger

But that hardly helps explain why inflation rates have only been rising since last year, even though the ECB has been pursuing a low interest rate policy since 2008. In 2021, the main cause was the strengthening global economy after the first Corona year in combination with torn supply chains. Already in the fall, there was talk of an energy crisis in the EU. In the current year, the uncertainties for energy supply as a result of the Russian war and the sanctions policy of the West are added to this reason.

The cause of the inflation is therefore primarily the increased prices for energy on the globalized markets. In this country (and in many others), we are dealing with so-called imported cost inflation, as Germany is dependent on energy imports. And since gas is indispensable as a raw material for numerous industries, starting with energy companies, prices are rising across the board. This is because in an inflationary environment, other companies also seize the opportunity to raise prices.

Greedflation and market power

In the U.S., according to Spiegel author Thomas Fricke, companies made more profit in the second half of 2021 than at any time since the early 1950s, with an after-tax profit rate of almost 15 percent. "According to calculations by the Economic Policy Institute, more than half of the increase in prices in the U.S. can be attributed to an expansion of corporate profits. In other words, if companies had not expanded profits, inflation would not have been even half as high in purely mathematical terms." The latest figure was 9.1 percent.

And in Europe? According to ECB estimates, the biggest contribution to inflation in the euro area at the end of 2021 also came from the surge in corporate profits, Fricke said.

The fact that corporations can increasingly use their pricing power also has to do with their market power. The greater their market power, the less competition they have, the easier it is for them to raise prices. And in the wake of years of neoliberal economic policies aimed at privatization and deregulation, many markets are characterized by oligopolies. A Roosevelt Institute study suggests this connection between prices, profits and power.

Speculation and algorithms

It is not only the market power of corporations, in Marx's terms the concentration and centralization of capital, that has increased in recent decades. The role of capital seeking high-yield investments in the financial markets has also been enormously strengthened by deregulation, privatization and over-accumulation in the so-called productive sector. More and more capital is flowing into the financial markets to make short-term profit. For example, also with speculation on oil, gas or food. (ak 671)

As early as 2006, a U.S. report had pointed to a "divergence between the abundant supply of crude oil and natural gas and record high prices," attributing this in part to speculative trading. Since then, the weight of speculative capital has increased, and it is also likely to have amplified, in particular, the rise in energy and food prices since February 24.

Is a new neoliberal rollback being prepared?

Just before the Russian invasion, for example, the Financial Times reported under the headline "Beware the algorithms driving up oil prices" that enormous amounts of capital were flowing into financial bets betting on an oil price of $100. While the trigger for rising prices was a tightening of supply due to the threat of war, the explosion in bets was due to the rise of automated and algorithm-based trading, it said.

In 2019, the Commodity Futures Trading Commission, which regulates futures and options markets in the U.S., had found that about 80 percent of energy trades were executed through automated inputs, up from 65 percent six years earlier. The problem: Algorithm-driven trading relies less on so-called fundamentals and more on short-term market movements. The result is a fuelling of herd behavior - and can be accompanied by violent price fluctuations in either direction. Human and computerized trading strategies are increasingly intertwined, he said, which can lead to unpredictable outcomes, "even more so when shocks occur, as we may see in Ukraine."

Liberalization of energy markets

What's more, energy markets in Europe have been liberalized since 1998. Instead of long-term supply contracts, the focus has been on spot markets. These are based on global prices. As a result, prices fluctuate more frequently because local or regional events are now immediately reflected on the trading markets. In the past, events in the U.S. or China hardly played a role in the European gas market, explains Sven Jordan of the gas company Wingas in Wirtschaftswoche. For financial investors focused on short-term investments, volatile prices are good because they increase profit margins.

Let's keep in mind: A wrong analysis of the causes of inflation leads to wrong countermeasures. Wage restraint means a loss of purchasing power and does not change the increased energy prices. Higher key ECB interest rates will not cause Putin to supply more gas and ease the situation on the gas markets. Higher interest rates will, however, make loans more expensive, lead to less investment, for example in renewable energies, which could make the German economy independent of the volatile prices for fossil energies, and stall the economy. Then there would be falling prices, but also less tax revenue and increased unemployment. Higher interest rates also conjure up a new euro crisis.

It is true that the German government used two instruments, the 9-euro ticket and the gasoline rebate, to bring the inflation rate down slightly in June and July. But they expire at the end of August. Then there is the threat of rising prices - especially since the gas levy will be added from October.

The question is: Why are the political and economic elites pursuing a policy that could end in recession and more poverty? It could be that, as in the 1970s, they want to exploit inflation to bring about a recession and drive up unemployment. In doing so, they could counter increased bargaining power of workers in advance. So surmises Thomas Fazi (, 6/22/2022), an Italian writer and journalist. A new neoliberal rollback, then. Counterargument: The workers are weakened anyway, the collective bargaining coverage in Germany is below 50 percent, in the 1970s it was more than 70 percent. But, according to Fazi, a shortage of skilled workers is emerging, not least due to the aging of the workforce, which should strengthen the unions' bargaining power. In addition, the trends toward de-globalization and relocation of production sites are increasing the demand for labor. These are not the worst conditions for revitalizing trade union struggles.

Guido Speckmann is an editor at ak.
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