What is worse, recession or stagflation

Monetary policyDeflation or inflation - what are the consequences of the corona crisis?

In our seriesCapital explainswe give a condensed overview of current economic topics. This time: Deutsche Bahn and local public transport - with an editor Stefan Schaafwho writes about monetary policy and finance at Capital.

Many experts disagree on the assessment of the long-term economic consequences of the corona pandemic. Some anticipate inflation, others anticipate deflation. What makes it so difficult?

The corona crisis leads to a severe slump in economic output, i.e. a recession. The German economy shrank by 2.2 percent in the first quarter, although almost only March was affected by the pandemic. The second quarter is likely to be even worse, while many economists expect the economy to recover in the second half of the year. However, as long as the economy is shrinking, many factories or service providers are underutilized and less is earned. That speaks in favor of falling prices and thus more of a deflationary tendency. In May the inflation rate in Germany was only 0.6 percent, in February it was 1.7 percent. However, this trend is offset by a peculiarity of the corona crisis, which distinguishes it from the global financial crisis of 2008 and 2009, for example.

source: tradingeconomics.com

Because of the pandemic, borders were closed, factories ceased production, employees could not get to their workplaces or even fell ill. So there is a shortage of upstream products and services. That speaks for rising prices. Which trend will ultimately prevail cannot yet be foreseen, also because the price war on the crude oil market, instigated by Saudi Arabia and Russia, has a strong influence on inflation developments.

Deflation weighs on debtors

After all, consumers benefit from falling prices. What is actually so bad about deflation, i.e. a general fall in prices?

At first glance, that makes sense, after all, everyone is happy about a bargain when shopping. But it makes a difference whether a car is cheaper for one person or an individual, or whether prices are falling across the economy. If consumers expect everything to get cheaper and cheaper, then they wait to buy non-essential items because they think they can get them cheaper. Economists call this wait-and-see attitude attentism. It can trigger a downward spiral of falling prices, less production and income, further falling prices and so on.

Deflation also puts a strain on anyone in debt. If the price level falls, the debt increases in real terms and is more and more difficult to service. That likely leads to more bankruptcies. In the end there is mass unemployment, as in Germany in the years after 1930. Because the state also increased taxes and reduced spending during the crisis, the economy in the German Reich collapsed completely. We know from history lessons what this led to.

After the support of many companies by the government and the ECB, wouldn't rising inflation suggest itself?

Central banks essentially pursue the goal of monetary stability, but they are not aiming for an inflation rate of zero. The reason for this is that they want to keep a little distance from deflation because of the risks mentioned. The European Central Bank defines its mandate for price stability as “below but close to 2 percent in the medium term”. Other central bankers like the US Federal Reserve are clearer in their goal and simply speak of two percent. When the eurozone economy slipped in the direction of deflation a few years ago, the ECB countered this with bond purchases, thus preventing the downward spiral. Ever since the ECB started buying bonds during the global financial crisis, warnings have been issued about impending inflation, but this has not yet happened.

It is true, however, that a loosening of monetary policy and an expansion of the money supply - also known colloquially as money printing - will drive the inflation rate. The reason for this is that if the amount of products and services is unchanged but there is more money available, then prices go up. It's like in the game of "horse trading": Because more and more "money" comes into play, dogs, cows or geese are simply becoming more and more expensive.

These products have become cheaper in the Corona crisis

# 1 gas, heating oil, petrol, diesel

The global drop in oil prices is primarily responsible for the falling inflation rate. In April 2020, energy in the euro area was almost a tenth (minus 9.7 percent) cheaper than in the same month of the previous year. In April 2019, however, statisticians had registered an increase of 5.3 percent. The biggest slump in consumer prices in Germany was for liquid gas. In April it was 18.6 percent cheaper than in the same month last year, as the Federal Statistical Office announced. In second place was heating oil with a minus of 17.3 percent. Refueling also became significantly cheaper. Gasoline and diesel fuel recorded a decline of 16.5 and 13.3 percent, respectively.

# 2 new cars

Anyone who currently needs a new car despite the uncertain economic situation has good cards. The media reported discounts of up to a third. "The dealers' yards are full: after six weeks of lockdown there are endless new cars - now the factories are producing again, which is also putting pressure on prices," reported "Auto Bild".

# 3 butter

Long-life food from domestic production, which is less affected by Corona measures, has often become cheaper during the pandemic. This also applies to butter. According to the Federal Statistical Office, it cost an average of 7.8 percent less in April than in the same month last year.