Interview with Karl-Friedrich Israel: “The euro has been an inflationary currency since its inception”

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BrusselsReport.eu
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Antonis Giannakopoulos interviews Dr. Karl-Friedrich Israel, a frequent commentator on Eurozone economics. Dr. Israel is an assistant professor at the department of economics and business administration at the Université Catholique de l’Ouest in Angers, France.  Previously, he previously as a postdoctoral researcher at the Institute for Economic Policy at Leipzig University in Germany. He obtained his doctorate degree in economics from the University of Angers in France in 2017, researching the costs and benefits of central banking. His research interests are macroeconomics, the history of economic thought, economic methodology, econometrics, and Austrian economics.

Antonis Giannakopoulos: “First of all, what is your take on the current state of the Euro? How has the ECB performed since the Covid Crisis in early 2020?” 

Karl-Friedrich Israel: “In my view, the monetary policy of the Eurosystem is extremely harmful, and in its current form it is unsustainable. During the Covid-19 pandemic, the Eurosystem has doubled down on its expansionary policy path, employing measures of unconventional monetary easing. These measures had been initiated after the Great Recession, but in fact, the Euro, since its inception, has always been a rather inflationary currency. The overall money stock M1 has been multiplied by a factor of 6.7, from € 1,726 bn in 1999, when the euro was introduced as an accounting currency, to € 11,489 bn at the end of April 2022.

The high rates of consumer price inflation that we can observe in recent months are only the tip of the iceberg. In fact, there have been very persistent and overproportionate rates of price inflation outside of consumer goods markets for many years, most notably in real estate markets, but also in stock markets. In fact, despite the lockdowns and the outbreak of the war in Ukraine, the German stock market DAX, for example, has increased by an average annual rate of 4.7% since January 2020. It is very unlikely that this reflects actual or anticipated real productivity gains. It is mostly driven by inflationary monetary policy.”

Dax Index chart

 

 

 

Antonis Giannakopoulos: “Some policy makers in Brussels claim that our recent economic troubles and high inflation are the result of the Russian invasion of Ukraine. Does this hold any truth?”

Karl-Friedrich Israel: “As always, there is some truth to this claim. Indeed, if a war results in a negative supply shock, that is, a decrease in the supply for certain goods and services, we can expect an increase in prices of these goods and servies. In the case of Ukraine, food markets could be affected, since Ukraine is a major exporter of grain and other foods. However, it is wrong to blame the general increase of prices on the war in Ukraine. Price inflation rates have been significantly above two percent in many other markets before the outbreak of the war. The main driver is expansionary monetary policy.”

Antonis Giannakopoulos: “We always hear about inflation in the news nowadays. Could you tell us why inflation is harmful to our economy, and how it distorts productivity and price signals?” 

Karl-Friedrich Israel: “According to mainstream economics, a moderate rate of price inflation of about 2% per year is not harmful, but even desirable. It is argued that price deflation is particularly harmful, and would hamper economic growth. I do not share this opinion. In fact, it is quite shocking that nobody has ever brought forward a convincing theoretical argument for why that is supposed to be true, nor does the empirical evidence support this position. The position is mainly supported by referring to historical events like the Great Depression of the 1930s, during which there was indeed a considerable degree of price deflation. However, this was the consequence and not the cause of the crisis.

Price deflation as such is not harmful. It is a natural effect of economic growth. Unless we expand our money stock at a sufficiently high rate, prices for goods and services would gradually fall. This would be the way in which the benefits of economic growth permeate through society, by reducing the price level and the general cost of living. If we decide to offset this mechanism by expanding the money stock, it matters a great deal how we do it. Conventional monetary policy operates through credit markets, that is, new money is entering the economy in the form of credit, which goes hand in hand with a reduction of interest rates.

This has many different effects on the macroeconomic level. For one thing, it reduces the costs of credit finance relative to equity finance. There will therefore be more credit finance than would otherwise be the case, which tends to increase the fragility of the economy. The economy becomes overall more prone to economic crises, because credit finance leads to contagion effects. If unexpected losses occur and if debtors are no longer able to service their loans, than this can also put creditors in distress. Excessive credit finance increases systemic risk and tends to amplify economic downturns.

Moreover, an artificially low level of interest rates tends to keep firms alive that would otherwise go bankrupt. This can be considered to be a good thing in the short run, but in the long run it undermines incentives to reform and become economically more efficient. Firms become lazy. They turn into so-called “zombie firms” that only survive because of artificially cheap credit. This leads to capital and labor being bound up in these relatively unproductive businesses. They are not released and made available for other more productive uses in the economy. In that sense, low-interest-rate policies tend to undermine economic growth and competition. For a dynamic market economy, it is crucial to let unproductive businesses fail. If we don’t, we can save some jobs in the short run, but only at the expense of long-term prosperity.”

 

Antonis Giannakopoulos: “So how can we return back to price stability and low inflation?” 

Karl-Friedrich Israel: “In my opinion, it would be ideal to get politics completely out of the monetary system. This is, however, very difficult to pull off, because our economies have become more and more dependent on the continuation of loose monetary policy and artificially low interest rates. If we were to let interest rates increase again, then a lot of firms and countries would go bankrupt, which would provoke a massive liquidation crisis with some painful adjustments. I still believe it would be worthwhile to go through such an adjustment period, because it would allow us to return to a sustainable and healthy growth path afterwards. The money supply and interest rates should then not be manipulated by political interventions. Interest rates should form like meaningful market prices that indicate the scarcity of loanable funds. They should rise when people save less and fall when people save more. It should not be up to politics to alter interest rates.”

Antonis Giannakopoulos: “As a German economist, what were your thoughts on the Greek economy during the financial crisis? Do you think it was a mistake to keep Greece within the Eurozone?”

Karl-Friedrich Israel: “I think that the Greek people are paying a very high price for bad politics both at the national and the European level. The fundamental problem of Greece today is that the country’s wages and labor market regulations are out of proportion with labor productivity. Look at other countries, like for example Poland, which is not part of the Euro area. It has much lower wage levels and is therefore more competitive while it has a much smaller unemployment problem.

Part of what explains the overblown wage level in Greece is expansionary monetary policy within the Euro area. A lot of financial capital has flooded Southern European markets prior to the Great Recession, and it has propped up wages disproportionately. When the crisis hit, rescue programs were made available, not exclusively to help Greece, but mostly to rescue banks that were highly exposed to the risk of a Greek sovereign default. These programs prevented a hard adjustment and have perpetuated the imbalance.

Ireland is another country that was in a very similar situation as Greece, but it was able to implement reforms early on. It is today in a much better position than Greece. Ireland is part of the Euro area just like Greece, so I do not believe that Greece should have left. Greece could have implemented reforms while being part of the Euro area just like Ireland did.

Antonis Giannakopoulos: “Most people see the Euro as a pure monetary project, while others, like me, see it as a political tool, intended for increased centralization of power in Brussels and Frankfurt. What are your thoughts on this?” 

Karl-Friedrich Israel: “Well, I agree with you. The monetary union and its common monetary policy have caused massive problems and imbalances. It is argued that we now also need some degree of harmonization in fiscal policies to get rid of these imbalances. That’s a smokescreen. Without the bad monetary policies implemented over more than two decades, a lot of the problems would be nonexistent.

We could have all the benefits of a common market, free trade, labor and capital mobility in a decentralized system of fiscal competition combined with a hard common currency. But politics is very unlikely to give up the possibility of expanding the money stock at will. And one thing is for sure, this possibility will be used and abused, causing problems at the economic and social level, which will then be taken as justification for further interventions and more centralization of political power.”

Antonis Giannakopoulos: “A final comment on what the future holds for the Euro and the EU in general”

Karl-Friedrich Israel: “I do not like to make predictions like that. What the future brings depends on unforeseeable factors. It is possible that the EU slowly but surely engages into more and more government regulation and political centralization, reacting to every crisis with more unconventional monetary policies, thereby completely abrogating the market mechanism.

If inflation does not get completely out of control, this could very well go on for a while. This would mean a slow drift towards a more and more centrally controlled economy. The big enabler in this process are central banks and their monetary policies. My hope, however, is that people realize that there are very high costs to such a development. I hope that they are willing to implement reforms towards more decentralization, a genuine market order with respect for the principle of subsidiarity, and most importantly, a monetary system undisturbed by political abuse.”

This interview was originally published by Pnykapress.gr a student website in Greece

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