Prices in Europe have been rising since 2021. It was quickly defined as inflation. Some economists did not want to use this term hastily. But what is inflation? What, on the other hand, does deflation mean? And what is meant by the term stagflation?
What does inflation mean?
Inflation refers to a permanent increase in the overall price level of an economy. Not only the prices for individual goods or services are affected, but all prices and thus the price level (the average of goods prices) as a whole. This is a process of rising prices. People can buy less and less for the same amount of money.
How is inflation measured?
A price index is used as a basis. There are different ones. The price index for the gross domestic product (GDP) reflects the price development of all goods and services that are included in the GDP of a country. The price index for the standard of living or the consumer price index reflects the goods and services of daily use. A so-called basket of goods was determined. It consists of approx. 650 goods and services (in Germany). The Harmonised Index of Consumer Prices (HICP) applies to the European Union. This reflects the data of the national statistical offices of the Euro zone and the entire EU. The data are comparable due to the “harmonised methodology”.
An overview of inflation developments in Europe by HICP for individual countries is provided by EUROSTAT (2013-2021). The statistical office of the European Union also published up-to-date figures on inflation by economic sector (2022).
What are the reasons of inflation?
They are usually complex and controversial; there are various opinions on the subject.
Some economists argue that an expansion of the money supply in relation to the supply of goods must inevitably lead to inflation. This view is rejected, among other things, by stating that there should then already have been a big inflation in the last 20 years. After all, the volume of money in the world is many times larger than the value of the world’s gross social product.
There is widespread agreement that inflation can be demand- and/or supply-driven.
Inflation triggered by the demand side of an economy can occur, for example, when many citizens stop saving and spend money on consumer goods at the same time. Or when companies invest in large numbers and demand machines in return. Or when a country’s products are bought abroad in particular quantities and production cannot keep up.
Similarly, a strong price increase affecting all prices can be triggered by the supply side of an economy. An example is the so-called wage-price spiral: due to the market power of companies, profit expectations dominate price formation (profit push inflation). Conversely, trade unions can push through wage increases due to their power (if any). If companies do not accept to make lower profits or if they can not compensate for the increased wages through higher productivity, they will pass these higher costs on to prices. They rise. Workers’ representatives, for their part, try to compensate by raising wages. And so on.
Inflation – price increase
A price increase should not be confused with an inflation. It affects only individual goods or occurs only in some segments of an economy. A price increase can also lead to an increase of the general price level, since individual products are components of many other products, such as oil or gas.
The situation in 2022
At present, the prices for energy (especially gas and oil) and food are rising. Since energy is needed for the entire production and since without the (fossil) energy sources an economy is not possible under capitalism, many other prices are rising as a result.
What are the reasons? With the start of the Russia-Ukraine war in February 2022, gas prices jumped. This is due to a gas shortage as a result of the sanctions against Russia and the reduced supply of oil and gas by Russian operators. The reduced supply meets a liberalised market for example in Germany, so it seems that even long-term supply contracts of gas are linked to the stock exchange price of gas. In this situation, the German government commissioned a private company, Trading Hub Europe (THE), to buy gas on the stock exchanges in large quantities. This strong demand from a large customer on behalf of a government drove prices up artificially. They are distorted. Critics argue that this could have been avoided if THE had regulated the buying and selling of gas through future contracts as usual.
In addition, there is the so-called merit order principle on the electricity stock exchange: all suppliers charge according to the price of the most expensive producer. At present, this is the gas-fired power plants. As a result, much cheaper suppliers, for example of green electricity, nevertheless sell their electricity at high prices. By calculating the electricity prices, they make high profits, which can be equated with non-performing income (rents). They are paid by the consumers through their bills.
Inflation is therefore not something that suddenly befalls a society. It can be caused by different developments and activities of different players. It can also be caused by wrong political decisions.
Consequences of inflation for an economy
Inflation affects people differently. If their income does not rise at least as much as prices, they can buy less for the same money. This hits people with „small wallets“ particularly hard. They include the unemployed, families affected by child poverty or people in old-age poverty. Inflation damages their livelihoods.
Inflation leads to losses for creditors and gains for debtors. Those who have invested money or assets lose them. This is because it is worth less when prices rise, but not when interest rates rise. In a mirror image, debtors gain who have taken out a loan. If the inflation rate is higher than the interest rate at which a loan was taken out, they pay back less debt. This can also affect the state, which can thus reduce its public debt.
What does deflation mean?
This refers to a reverse development. Prices fall over a longer period of time and in different sectors of the economy, so that the overall price level falls. Companies stop investing because they expect prices to fall even further and they do not make a profit. Likewise, consumers hold back because they expect products and services to become even cheaper. A recession threatens. But the value of money is rising.
What does stagflation mean?
This word is a compound of “stagnation” and “inflation”. It indicates that in the real economy (the production and consumption of goods and services) there is only low growth and often also unemployment. Economic development is stagnating. At the same time, on the monetary level of the economy, there is a permanent increase in prices in almost all areas of the economy.
Stagflation is often triggered by so-called supply shocks. Examples are the energy crisis in Europe at the latest since 2022 or disrupted supply chains as a result of the Corona crisis in 2020-2021 and others. As a result, production comes to a standstill, and at the same time products become more expensive.
How to cope with inflation?
Tackling the causes
The first step is to address the causes of the constantly rising prices. In the context of the current situation (2022), this means a) gaining access to cheap oil and gas and b) changing the pricing mechanisms in the oil and gas markets.
Central bank policy
The central bank of an economic area shall ensure a stable price level. (The US Federal Reserve also has to consider effects of monetary policy on the labour market). In “normal” times, the European Central Bank aims for an inflation rate of close to 2%. This is seen as necessary to enable growth. If inflation occurs, it can raise interest rates. As a result, less credit is taken out, less is invested, less is produced, sold and demanded. This can have a dampening effect. But it can also usher in deflation. This danger exists if the causes cannot be remedied with such an interest rate policy.
Tips for each individual
The recommendations depend on the wealth situation of each individual.
– Try to understand the situation, recognise the causes and assess possible developments.
– If inflation is forecast to continue over the long term: purchase long-term consumer goods now (e.g. printer, PC, duvets, bicycle).
– If medium-term or temporary inflation is expected: refrain from buying durable consumer goods.
(However, both strategies are rational from the point of view of an individual. If many act in this way, this can have a crisis-reinforcing effect.)
– Acquire real estate or/and territory, preferably such that can also be used for agricultural purposes.
– Join others to form cooperatives or active circles of friends who support each other and grow their own food.
– Acquire silver and/or gold as a means of exchange in the extreme case of currency failure.
– Keep cash on hand, as there may be a bank run due to several crises going on at the same time.
– If necessary, purchase shares or bonds after consultation with various providers and e.g. consumer protection organisations; take into account ethical aspects (no shares for war and armaments industry) as well as economic developments (future of medium-sized companies).
– Stockpiling for crises: Information should be provided by the Ministry of the Interior of each country. Other advice can be found in numerous internet sources.
– Don’t buy brand-name products, others are just as good but cheaper.
– Buy longlasting, energy-saving household appliances.
– Take out only necessary insurances and contracts and cancel them if necessary, for example mobile phone contracts, newspaper subscriptions, repair insurance, insurances for glass, glasses, mobile phones, etc.
– Get politically involved for an economic policy in which inflation and deflation are unnecessary. Democracy needs participation! The power of citizens is bigger than they often think.
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