Hyperinflation causes a recession

Economic highlight: After Corona: big inflation or deflation?

Historically, major economic crises have often led to inflation or deflation. The type of crisis, especially whether the cause is a supply or demand shock, as well as the fiscal and monetary policy reactions are decisive for whether inflation or deflation occurs. Interestingly, in connection with the corona crisis, both scenarios are discussed, which indicates that this is a combination of supply and demand shock, but it is still unclear whether the supply or demand shock has a stronger effect on price level development. Expectations are also important; they drive essentially inflationary or deflationary processes. There are currently many changes in relative prices occurring. The prices of individual goods and groups of goods such as unprocessed food or energy have either risen or fallen due to temporary supply restrictions and shifts in demand (see Table 1). There is also a measurement problem: many of the goods in the shopping basket are no longer manufactured, and their price is, so to speak, infinitely high. The current inflation trend, most recently 0.1% of the harmonized consumer price index and 1.1% in the core rate, indicates a slight increase in prices.

Table 1
Eurozone: inflation ratea and their componentsb
 Weighting 2020May 2019Dec 2019Jan. 2020Feb 2020March 2020Apr. 2020May 2020
HICP overall index1000,01,21,31,41,20,70,30,1c
Overall index without       
Energy, food, alcoholic
Drinks & tobacco
Food, Alcoholic Beverages & Tobacco190,71,52,02,12,12,43,63,3c

HICP = Harmonized Index of Consumer Prices.

a In% compared to the previous year.

b Weighting in ‰.

c Estimated.

Source: Eurostat online data code prc_hicp_inw; prc_hicp_manr.

However, current price developments - based on changes in relative prices and level effects - must be strictly distinguished from medium-term inflation and deflation processes. In the case of a combination of supply and demand shocks, it depends on whether the aggregated supply or the aggregated demand recovers more quickly and how elastic both aggregates will be in the medium term. The duration of the production restrictions, the effectiveness of the economic stimulus programs as well as the effects of the increased national debt ratios and the additional liquidity provided play a role here.

In a simple quantitative theoretical scenario, the justification for inflation is that the shutdown reduces the supply of real goods and services, but the monetary demand remains the same due to the additionally provided liquidity, which should lead to a price increase. However, the following is more relevant for possible inflation processes after Corona: Will states and central banks keep the interest rate low through financial repression as a result of the increased national debt ratios and thus generate inflation? This would keep the debt sustainable. However, inflation does not necessarily have to be reflected in the prices of goods, but can be reflected in the prices of assets. To what extent does the companies' room for maneuver to set prices increase as a result of monopoly and de-globalization? Inflation has been so low in recent years because the global - especially Chinese - supply of goods has been very elastic. This could change with increasing self-sufficiency and protectionist measures.

The second scenario assumes that aggregate demand will recover much more slowly because unemployment rises and the propensity to consume and invest falls, as was the case in the Great Depression of 1929 in the USA. At that time, the US unemployment rate remained very high well into the 1930s. Inflation dynamics are essentially determined by the development of nominal wages. An overall economic deleveraging effect has a deflationary effect: companies and states repay their loans, which reduces the previously expanded money supply and the liquidity that has been created is siphoned off again. This effect could be exacerbated by debt deflation. Here it would be important to avoid the contractive effects of tax or interest rate increases. The debt should be reduced in the long term, because the real costs of the crisis are already being borne today by foregoing production and consumption. Future generations would only be burdened by a lack of investment today due to the crisis, as their production and consumption possibilities are reduced. The intergenerational redistribution effects of today's national debt are therefore rather small, the macroeconomic intertemporal funding restriction largely unchanged.

Overall, it must be assumed today that the supply side can recover much more quickly. In contrast, demand is likely to pick up only slowly and with a delay. Even if there is no immediate threat of deflation, inflation should remain very low. On the other hand, the already existing combination of debt overhang and effective lower limit of interest rates is likely to harden, and technical leeway for a more expansive monetary and fiscal policy will become even smaller. Neither demand-pull inflation (via government spending or the supply of money) nor cost-push inflation (via wages or oil prices) are very likely. There is more to suggest that the recovery of the global economy will take longer with predominantly recessive and deflationary phenomena. Deflation is therefore more likely and, at the same time, the greater danger.

The decisive factor for the further course of the economy is how severely the global economy will be affected by self-reinforcing demand shocks, which underlines the importance of internationally coordinated and synchronized stimulus packages. The German economy has fallen into a deep recession due to the restriction of global economic relations and the protective measures taken here. With the approved economic stimulus package, politicians have set demand impulses and incentives for investment. A rapid recovery of the economy after the end of the epidemic would be conceivable. Probably, however, there will only be a gradual loosening depending on the further infection process. Even if there are no setbacks, the process of catching up and adapting to the changed framework conditions will take some time. In view of the uncertainty, companies are reducing their investments and willingness to hire. And private households are also postponing the purchase of durable goods, especially since increasing unemployment is dampening the propensity to buy. Overall economic activity will therefore not return to the pre-Corona level anytime soon.

Even if macroeconomic activity increases again after the slump in March / April 2020, real gross domestic product (GDP) will once again fall much more sharply in the second quarter than in the first quarter. In the third and fourth quarters - provided there is no second wave of the epidemic - it will increase noticeably again, but this will not be able to compensate for the declines. All in all, real GDP is expected to decline by 5% in 2020. In 2021, if the virus epidemic is contained, an increased economic recovery due to catch-up effects and funding programs can be expected. Foreign trade, travel and production relations will normalize more and more. The pre-corona level could be reached again in the second half of 2021. In the full year 2021, real GDP could then grow by 4.5%, the economic picture would thus correspond to an asymmetrical V (see Figure 1).

illustration 1
Price-adjusted gross domestic product in Germany
Adjusted for seasonal and working days

1 Change compared to the previous quarter in%, extrapolated to the annual rate.

2 Figures: Change compared to the previous year in%.

Sources: Federal Statistical Office; from 1st quarter 2020 forecast of the HWWI.

The risks of a longer and deeper recession are nonetheless present with an L-shaped course of the global recovery. Further economic policy measures such as the European recovery program (EU Recovery Fund) and the accommodating pandemic emergency purchase program of the ECB therefore seem justified against the background of warning historical deflationary experiences, without losing sight of the undesirable side effects and after-effects.

Henning Vöpel, Jörg Hinze
[email protected], [email protected]