Surprising news last week. The Dutch government suffered an unexpectedly large budgetary setback. A pay hike for government workers turns out to have a bigger impact on the budget than previously thought. But why? In the news we read: “the pay hike for government employees is a bigger burden than previously estimated, because inflation is near zero. The government budget is linked to that inflation and, as a result, barely grows. This has resulted in a €2.5-billion-euro windfall.


For me, this was very important news, and I’m not talking about that enormous amount of €2.5 billion euro! I considered it important, because it clearly proves something I have been arguing for quite some time. That is, that governments have nothing to gain from low inflation, but do from high inflation. With higher inflation, the government budget grows. Always a nice thing, as government at least. Of course, expenditures also increase, but revenues increase too. For instance, employees’ wages will fall in higher tax brackets, because their wages rise with inflation. Essentially, real wages do not increase, but they do pay more in taxes (I’m aware of the fact that tax brackets are corrected for inflation, but the past few years the Dutch Capitol Hill decided to put off any inflation adjustments, and now you know why!).

The above means that whoever thinks that the government will protect him/her against inflation, is very naïve. The government is actually keen on inflation!

Yet, even then you could think: The European Central Bank (ECB) will act responsibly and, when inflation is at the verge of exceeding 2 percent, intervene. Some remarks, though.

In the first place, the chairman of that bank implicitly promised last December not to intervene when inflation reaches or even exceeds 2 percent, as I wrote earlier.

In the second place, even if the ECB would choose to intervene, would they have any reasonable chance of succeeding? The reason I ask this question and why the answer could simply be a “no”, is the state of affairs with regard to the public finances of three large euro countries: Italy, Spain and France.


Take Italy for example. That country paid on average 4.4 percent over its public debt, which amounted to €1,606 billion euro at the end of 2007. Thus the amount of interest paid would equal €70.6 billion euro. Yet, in February this year, its average interest rate amounted to only 1.56 percent. Even with a public debt that is almost 65% higher, at €2,143 billion euro, assuming a 1.56 percent interest rate, interest payments were slashed by half for Rome.

What figure would Italy have to pay in case it would be charged a normal interest rate on its new debt? Let’s assume the average 4.4 percent we’ve mentioned above, over €2,143 billion euro, which would equal €94 billion euro. That is €25 billion more than before the crisis, or 1.2% of Italian GDP.


We’ll now cross the Mediterranean Sea and look at Spain. Before the crisis, Madrid paid a somewhat lower interest rate on average than Rome, equaling 4.18 percent. Public debt amounted to €384 billion euro, which would translate into annual interest payments of €16 billion euro. Whereas Germany and Italy saw their interest expenses decline substantially, Spain actually paid more interest! More? Indeed, more. The reason: while interest rates on Spain’s public debt are substantially lower, 1.56 percent in February this year, public debt has increased to €1,048 billion euro, a mind-blowing increase of 173 percent compared to the end of 2007! No one will be surprised to hear that a normalization of interest rates would be nothing short of a disaster for Spain. At that normal (average) rate of 4.18 percent, Madrid’s annual interest expense would increase to €44 billion euro, which is almost three times as much as before the crisis. Those additional interest payments would equal 2 percent of Spanish GDP. Quite a large bill to pay.


To conclude, we’ll make a quick calculation for the country north of Spain: France. Using the average interest rate that Paris paid at the beginning of 2008, interest expenses would amount to €52 billion euro a year. Public debt has, since then, increased by over a third, but with help of significantly lower interest rates, interest expenses amount to slightly more than €12 billion euro. At normal interest rates, interest expenses would increase to €85 billion euro, almost €35 billion a year more than before the crisis (which is akin to an additional bill of 1.3 percent of French GDP). Note that in all our calculations we assume that interest rates only “normalize” and will not exceed pre-crisis rates, and that public debt remains constant (in absolute terms) and doesn’t increase. While the first assumption might be within the realm of possibilities, the probability that the second assumption will prove to be right is as high as the current deposit rate at the ECB: lower than 0 percent.


Why is this all relevant and what does it have to do with the future ECB monetary policy? In one word: everything.

The question is, after all, whether the ECB is able to end QE and raise interest rates without causing a financial disaster in Madrid, Rome and Paris, which could trigger a collapse of the currency union.

In case the ECB quits QE and hikes rates, yields on government debt with maturities of up to (more or less) 7 years could rise abruptly. These are the bonds that are heavily influenced by QE and the zero percent interest policy (ZIRP). But in that case, Spain, France and Italy could go bankrupt in a matter of days. Why?

Because half of total public debt in both Spain and France matures in less than five years. Italy is even worse off: three quarters (75%) of their total debt have a maturity of less than five years.

The consequences will be, I fear, a prolonged period of zero percent interest rates and QE by the ECB to avoid the reckoning of irresponsible fiscal behavior of large euro countries. This in turn implies that the coming years (think long term, the end of this decennium and the beginning of the next), high inflation is increasingly more likely. The often heard phrase “QE forever” might appear to be overly exaggerating, but I am getting increasingly convinced that this is what we’re heading toward. Quitting QE jeopardizes the euro.

If the ECB has to choose between allowing a run up in inflation and leaving it there, or risking a disintegration of the monetary union, what would the bank decide to do? Especially when we take into account that high inflation would benefit governments of euro countries to, for instance, reduce their sky-high and growing debt burden.


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