Green Inflation

On 8 February 2022, the video symposium “Green Inflation” took place with Professor Dr. Michael Hüther, Director of the Institute of the German Economy in Cologne (IW), and Professor Dr. Bert Rürup, Chief Economist at Handelsblatt. The video symposium was moderated by the economic policy correspondent of the newspaper DIE ZEIT, Mark Schieritz.

Executive Chairman of Global Bridges, Dr. Beate Lindemann, first welcomed the participants and pointed out that Dr. Josef Joffe, who was originally supposed to moderate the video symposium, was unfortunately unable to attend due to his teaching activities in the United States.

The topic of green inflation was both highly topical and exciting, as the increase in energy prices had already led to social turmoil and economic problems. It was pointed out that the Phillips Curve, which describes the negative relationship between the inflation rate and the unemployment rate, has been flat over the last decade and continuously falling unemployment would not have led to an increase in unit labor costs until the pandemic. The panel recalled that there were many years when we experienced almost no price increases.

However, a strengthening of inflation effects had become visible last year. One of the reasons behind the inflation could be related to the ongoing Corona pandemic as well as the impact of the lockdowns on the overall economy. The IW estimates that there was a loss of value added of around 350 billion euros in the two Corona years so far. However, due to a lack of empirical data on such supply-side shocks (for example, the disruption of supply chains and logistics systems), it is currently impossible to predict how long the rebound effects from the pandemic will last. However, the current price jumps could also be due in equal parts to the ongoing geopolitical tensions, the withdrawal of the temporary VAT cut and the rebound of the global economy.

For about 400 years, inflation has been understood as an increase in prices. However, it has been noted that inflation is the more appropriate term in this case, as it comes from increases in costs. Therefore, green inflation is actually inflation where there is a shortage of consumption or an increase in the price of fossil fuels. Inflation only occurs when the money mantle per se becomes a problem.

In this context, there was a warning of a “price-wage-price spiral”, in which an amalgamation of factors, e.g. the exogenous shock caused by the geopolitical situation but also the current supply chain and semiconductor problems, would result in an inflation that would be amplified by energy prices and driven in the future by the CO2 price. However, in order to achieve the climate neutrality targeted for 2045 in Germany, it is also clear that the use of fossil energy sources and the consumption of CO2 will have to become more expensive. In particular, CO2 pricing has a broad impact, as it affects both production and consumption. In order to accelerate the path to climate neutrality in Germany, the price effect must be strong, especially at the beginning, and the change in relative prices at the expense of fossil energy sources and emission-linked products must be accepted; only then would the necessary significant changes in behavior be initiated. However, one has to consider quantity effects. A comparison with the rising oil prices of the 1970s is appropriate, because oil and CO2 are similar in their broad impact in terms of the relative price level.

Along with the energy transition, an ageing push within the population is currently taking place, which has an impact on productivity and growth. Against the backdrop of a decline in the labor force potential and an increase in the old-age dependency ratio, there have been warnings of a reduction in the volume of disposable resources. However, it is difficult to find an answer to these demographic upheavals, although such a crisis is actually quite predictable. The decline in the labor force could also lead to trade unions being able to push through wage increases for specific groups. In order to keep the labor force constant until 2030, some proposals were made to mobilize it: Increasing weekly working hours, abolishing spousal splitting, introducing all-day schools, etc.

With regard to the question of whether the 2% inflation target would be achievable in the future, there was disagreement in the panel. Against the backdrop of geopolitical turmoil between the United States and China as well as increased climate policy demands, the target was described as rather ambitious. However, it was important to emphasize that 4/5 of the current 5% inflation rate was due to supply-side problems, such as interrupted supply chains; only 1/5 was the result of the energy transition and owed, for example, to the introduction of CO2 pricing or the reduction of emissions trading quotas.

Consequently, the answer to the price increase cannot be a tighter monetary policy, as it would not eliminate the underlying problems. Since the European Central Bank (ECB) would have been expansionary for a long time, the money mantle was already quite large. The question arose whether the ECB should not have stopped its security purchase programs some time ago and ended its unconventional measures (e.g. penalty interest on short-term bank deposits). The decisive factor, however, is that the ECB’s monetary policy is not the driver of inflation and therefore there is no question of interest rate policy action at present. Should there be a price-wage-price spiral in Europe, however, this would have to be reconsidered.

It is also important to note that since 1999 there has been no authority in Germany responsible for monetary policy and consequently for an increase in the price level in the Federal Republic. Conversely, this would not mean that politics does not have to deal with the rise in the price level. It has been warned that the ambitious phase-out of fossil fuels and the energy transition could lead to massive distributional and thus social policy distortions. Therefore, financial policy in particular would have to answer important social questions and the state would have to ensure that the lower income groups do not end up in need of basic security. Against this background, the demand was made to compensate the inevitable losers of the price effects by targeted compensatory measures: Since an increase in energy prices will be unavoidable, people with low incomes would have to be compensated; irrespective of the generally existing promotion of the consumption of climate-friendly energies.

The adjustment of the basic income support on 1 January 2022 shows the relatively small amount of funds required to compensate for the trend. To mitigate hardship cases, one-off payments such as a heating allowance for housing benefit recipients could also be well suited. In summary, it was emphasized that social compensation was indispensable to create the necessary social acceptance for the energy transition.

Besides the clear social policy mandate, however, there would also be a tax policy one. Since high inflation rates are noticeable in income tax, the call for a dynamization/smoothing of income tax rates and their indexation with inflation came up. Whether this would be feasible in view of the current decline in potential growth, however, remained questionable.

However, the mentioned compensation for the increase in the price level would have to go beyond social imbalances. From the audience came the demand to relieve industry, especially those energy-intensive sectors that have had negative net investments in recent years, by lowering the industrial electricity price. Against the backdrop of the ecological transformation, planning and approval procedures would also have to be accelerated.

By 2026, the CO2 tax will double, which will also have an impact on current inflation. Climate protection programs such as the Fit for 55 package and the switch to more expensive renewable energies will be visible in rising production costs and thus also consumer prices. At the same time, however, it became clear during the video symposium that a certain degree of green inflation will be both correct and necessary in order to achieve the ambitious climate goals and to bring about the necessary behavioral changes by adjusting relative prices at the expense of fossil energy sources.