Why Germans shouldn’t fear inflation and debt

With inflation rates rising in many parts of the globe, Marcel Fratzscher, President of the German Institute for Economic Research (DIW Berlin), offers a counterintuitive view on inflation and debt in Germany: they can be a good thing.

[You can read his full blog post from May 14, 2021 here (in German).]

[Text in blue below has been translated from German by Randal Gernaat.]

It should come as no surprise to even the casual observer of the German economy that inflation remains a perennial concern among business leaders and politicians, and even many individual savers in that country. In a recent blog post, Mr. Fratzscher makes his case as to why these fears are largely misplaced. And why Germans should not be afraid of inflation and debt, but rather should perhaps welcome a little of both.

He starts by pointing out that in Germany, ”for decades a favorite pastime of some politicians and businesspeople has been to create fear around the specter of inflation eating away at people’s savings and harming the economy.” As Europe starts to slowly emerge from the Covid-19 pandemic, some of these same people are raising alarms about high levels of government spending and loose European Central Bank (ECB) monetary policy.

Focusing on inflation (or the fear of future inflation) is exactly the wrong thing to do at this moment, argues Fratzscher. ”Rising prices or government debt should not be our primary concern in the middle of the pandemic, but rather the irreparable damage that a restrictive monetary and fiscal policy would cause, namely a high number of bankruptcies and high unemployment. But also, perhaps more importantly, a drop in the investments needed to secure sustainable German competitiveness.” He asserts there are rational reasons inflation is ticking up at the moment (increasing oil prices, transportation costs, etc.). But harmful inflation generally only occurs when an economy overheats, where ”businesses are investing heavily, wages are rising and consumption is growing so that demand is significantly higher than supply.” In fact, as Fratzscher points out, ”at the moment we are experiencing the exact opposite: Europe and Germany have a very sizable output gap.”

Looking more closely at the numbers, Fratzscher admits that inflation in Germany in 2021 may indeed rise above the ECB’s 2% target. But he goes on to argue that, “even 3% or 4% inflation isn’t a level that would necessarily be considered harmful devaluation. It would only be a partial and temporary rebalancing and a necessary adjustment of relative prices after many years of too little inflation, including in Germany.” And contrary to conventional wisdom, higher inflation will actually help businesses, many of whom “took on large amounts of debt during the pandemic and must now generate additional revenues in order to be able to reduce their debt load and make new investments. Higher inflation will make it easier for them to service their debt.”

In the US, the Biden administration has passed huge economic recovery packages - much larger than what has been done in Europe, even though the output gap in the US is much lower than in Europe. A bigger concern then for Mr. Fratzscher is that Europe and Germany, who have been hit hardest economically by the pandemic, will be left behind. “A less competitive German economy and export sector would put many good jobs here at risk. The proper response by Germany and Europe to the courageous US stimulus package ... must be to pursue a more expansive fiscal policy. This would help the economy through the crisis and encourage urgently needed future investments in economic transformation with a focus on climate change mitigation, digital technology and innovation.”

As he points out, one of the worst ways to conduct economic policy is through fear. Imaginary fears of inflation are no exception.