Volker Wieland: Inflation, stagnation and the need for change

Germany has been hit hard by the surge of inflation, the energy crisis and the challenges resulting from the Russian war on Ukraine.  While the German economy has recovered from the COVID-19 recession of 2020, economic activity has stagnated in real terms for four years.  Real GDP has been stuck at or around the pre-COVID level of 2019.  Most recently, the governing “traffic light” coalition consisting of the Social Democrats, Greens and Free Democrats has fallen apart. How did all this come about, what role did inflation play, and what policies are needed to get us out of this predicament?

As a member of the euro area, Germany has delegated monetary policy to the European Central Bank. The ECB’s task—as laid down in the Maastricht treaty—is to maintain price stability. 2020 marked the end of a long period of low inflation. Inflation rose quickly throughout 2021, reaching 6% by year end. The Russian attack on Ukraine in 2022 and the ensuing energy crisis acted as an accelerant. In Germany, inflation peaked at 11.6 percent in October 2022 (measured by the annual increase of the harmonized consumer price index). Since then, HICP inflation has declined to 2.4% as of October 2024. The total loss of purchasing power comes close to 20% in just three years.

Monetary and fiscal authorities responded aggressively to the pandemic. The ECB supplied huge amounts of long-term liquidity at negative interest rates. National governments and the EU provided debt-financed fiscal support on a scale never seen before. And the ECB bought up more government debt than was newly issued. 

Monetary and fiscal support were much needed in 2020. Yet, by the end of the year the economy had recovered most of the pandemic decline.  The expansionary policies, however, lasted well into 2022. Fiscal support policies were even renewed in that year due to the energy crisis. The ECB maintained negative policy rates till summer 2022. Thus, monetary and fiscal policy supported aggregate demand long after the COVID recession.  

Aggregate supply remained constrained, first due to temporary shortages, pre-existing structural problems and post-Covid structural changes, and then also due to the rapid increase in energy costs. As a consequence, inflation rose quickly, first in 2021 and then after the Russian attack in 2022. The speed and duration of the inflation surge were not anticipated. The ECB responded much too late, partly because it considered the inflation short-lived and partly because it had promised to continue net asset purchases and negative interest rates for a long time afterwards. Eventually, it tightened policy quickly from the second half of 2022 onwards. This helped rein in inflation. Headline measures have declined quickly, as energy prices have fallen. But core inflation has also come down. It remains to be seen whether the return towards the target of 2% will be sustained.

Understandably, inflation and stagnation cause much dissatisfaction and frustration. Households want to regain purchasing power. Germany has seen harsh conflict between unions and employer organizations and there have been long drawn out strikes.  In a stagnating economy, increasing real incomes for some involves distributing real losses to others. At the same time, all households and businesses have to bear higher real costs for imported energy.  

Monetary and fiscal support played a role in the surge of inflation. By contrast, the deeper causes of the German economic stagnation are largely on the supply side. They include excessive regulation and bureaucracy, low productivity growth and labor scarcity, lack of competitiveness and comparatively high taxation. 

The German government has been slow to normalize fiscal policy but quick to increase the regulatory burden. The “traffic light” coalition was built on debt. As long as crises justified activating the exception clauses of national and European fiscal rules, diverging priorities of coalition partners could be seemingly reconciled. They wanted more generous social transfers, large subsidies to firms to achieve climate and industrial policy goals, more generous public pensions and higher defense spending without higher taxes and social security contributions.  Debt made it possible. And the share of government spending and transfers in GDP rose by 4 to 5 percent relative to 2019.

The 2023 constitutional court ruling on the debt brake and the revised EU fiscal rules rendered the debt-based, demand-side oriented approach to policy infeasible.  Yet, the ruling coalition proved unable to change course and develop an effective strategy for boosting aggregate supply. Such a strategy requires a significant shift of priorities towards structural reforms and deregulation.

The detailed, control-oriented, subsidy-heavy approach to economic and climate policies needs to be abandoned. Inefficient regulation that leads to burdensome bureaucracy has to be rolled back. Policy should establish framework conditions that allow markets to work and competition to serve as the discovery process that drives innovation and growth. Cost-effective policies that increase the supply of labor, capital and energy would help move the German economy out of stagnation and deliver sustainable growth. Growth is needed to maintain prosperity, protect the climate and build the strength to defend the peoples of Europe and their values.