Dhe countries of the euro area have tried to absorb the consequences of the extreme inflation for the people with a wide variety of aid programs in the past few months. This actually did have a short-term mitigating effect on people’s burden of higher prices. In the longer term, however, higher government spending is likely to actually drive inflation. Conversely, the inflation caused to a large extent by so-called supply effects is likely to have a negative impact on the budgetary situation of the states.
These are some of the findings of a “Fiscal policy and high inflation” analysis of the European Central Bank’s (ECB) economic report, published ahead of Monday. Based on model calculations, the ECB economists come to the conclusion that the inflation support provided by the states is likely to have a positive effect on inflationary pressure in 2022 and 2023. However, these effects are likely to largely reverse in 2024 and 2025.
Inflation down 0.9 percentage points
“On average, government policies mitigated about a quarter of inflation-related household income losses in 2022,” the analysis reads. For the past year, the economists estimate an inflation rate of around 9 percent for the large euro countries plus Portugal and Greece, which have been examined more closely as examples. They estimate that this rate would have been 1.7 percentage points higher if there had been no government intervention in heating, gas and electricity prices.
In addition, there would be energy price support and inflation compensation for state employees. The increase in disposable income by an average of 5.8 percent compensated for around 60 percent of the burden of higher inflation in 2022 – 0.9 percentage points of which were due to government energy price support.
For the next two years, the economists are now expecting an inflation-driving effect from the government interventions: in the case of price limits, above all through their lifting – in the case of energy price support through higher demand.
Image: FAZ
ECB President Christine Lagarde and Executive Board member Isabel Schnabel have repeatedly pointed out the risk that government aid programs could have an inflationary effect. The central bank had demanded that fiscal aid should therefore be “temporary”, “targeted” and “tailored”. Lagarde complained last year that only 10 to 20 percent of the aid met this.
Schnabel recently criticized that a large part of the aid was subsidies for fossil fuels – only a small amount was for investments: “That will have an inflationary effect in the medium term.”
Negative effects of inflation on national budgets
The ECB has also dealt extensively with the opposite question, how inflation affects national budgets. When it comes to inflation, it is often the case that there are short-term positive effects on budgetary positions when spending is already budgeted for and revenue increases as demand-driven inflation increases. With the current inflation, which was initially strongly supply-side and was driven by prices for imported goods such as oil and gas, a negative effect on the budgetary situation can be expected.
Inflation is hurting growth and revenue, while spending has been boosted by the bailout programs. The rate hikes by the central banks also made it more expensive for states to pay their debts. Model simulations showed that this would have negative effects on households and the debt situation in the short term.
This overshadows any positive effects on revenue and will lead to a deterioration in the budget balance by almost 0.5 percent of gross domestic product in 2024.