Most policymakers have unwavering faith in the economic models they follow to try and predict the likely trajectory of growth, inflation and other vital economic indicators.

Many also believe that past experiences of booms and busts are invariably reliable guides to forecast the future, even if the usual caveat so briefly enshrined in the phrase “all things being equal” is never ignored.

Understandably, many are now asking why the ECB, the European Commission and the IMF, among other international institutions, have failed to predict the risk of stagflation. Sluggish growth and galloping inflation now seem to be the most significant economic risks.

Otmar Issing was the ECB’s first chief economist when it was created in 1998. In an interview with the Financial Times, he blames the ECB for a “mis­diagnosis” of the factors behind the surge in inflation. He argues that the ECB “lived in a fantasy” that downplayed the danger of inflation spiralling out of control.

Of course, with the benefit of hindsight, many can convincingly point the finger at the ECB and other institutions for not being prepared to avoid the trap of stagflation.

Germany’s top-selling tabloid paper, Bild Zeitung, now refers to ECB president Christine Lagarde as “Madame Inflation”. Germans have an ingrained fear of inflation, which goes back to the hyperinflation their country experienced in the 1920s.

Issing makes a very valid argument that all policymakers should endorse. He told the Financial Times: “The ECB relied on its forecasting models. This model cannot give the right signals because it is based on the past and cyclical experiences – and the pandemic did not cause a cyclical downturn. You need a much broader approach to explaining inflation in a time of structural changes. If you have a misdiagnosis, of course, you have a misguided policy.”

Other critics of the ECB argue that it has become too focused on how political leaders might react if monetary policy is perceived to be hindering economic growth.

Current Italian Prime Minister Mario Draghi always shrugged off this type of criticism when he was the head of the ECB. He consistently defended the independence of the ECB from political influence to the hilt.

Some policymakers may subconsciously feel that they must act as cheerleaders to boost the morale of the public in difficult economic times

Current president Lagarde, in a press conference in 2020, replied to a question about Italy’s staggering debt by noting that the central bank’s bond-buying programme wasn’t “here to close spreads” (the difference between the yield on Italian bonds and those on the eurozone’s safest government security, the German 10-year bond). Lagarde’s unfortunate wording reflected her lack of diplomatic experience, and not a change in ECB policy, and within the hour, she hurried to correct herself in a television interview.

Issing is not trying to cause political turmoil, even if his straight-talking should be eye-opening for policymakers.

Issing agrees with mainstream monetary policy experts by arguing that now is not the time to raise interest rates to elevated levels. Still, he adds that the ECB had already kept its (monetary) stimulus in place for too long, which “was very hard to defend” given the rebound in growth and inflation while unemployment has fallen to a record low.

Some policymakers may subconsciously feel that they must act as cheerleaders to boost the morale of the public in difficult economic times. Still, they would do well to acknowledge the limitations of the economic models they rely so much on.

Issing claims that “inflation was a sleeping dragon: this dragon has now awoken. The ECB lived in the fantasy of continuing this (loose monetary) policy without any negative consequences. They would be in a better, or at least less bad situation if they had started to normalise policy before – this war should not distract from this fact”.

While it is to be expected that many want their lives to return to normality as early as possible, it would be unrealistic not to acknowledge that the pandemic and the Ukraine war might keep inflation high for a long time. These two factors are likely to reverse 30 years of globalisation as trade tensions rise, businesses make supply chains more resilient and Europe accelerates its switch from fossil fuels.

These once-in-a-lifetime seismic economic changes usually inflict increased hardships on households and businesses. Political leaders need to take the public in their confidence and discuss their plans on how they will promote sustainable long-term growth even if, in the short term, some may see their living standards deteriorate.

Europe may indeed be experiencing such seismic economic changes.

 

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