Often we come across the argument that one of the ways for Greece in particular and the eurozone's periphery in general to overcome the crisis is for Germany to tolerate high inflation. The idea is that if there is more (inflationary) money in circulation in Germany, the German consumers and producers will "spend more" and will thus import whatever goods Greece and the periphery have to sell, or they will have "more money" to go holidays in these countries and thus help them overcome the crisis with less pain. This account enjoys widespread approval, despite the fact that it hasn't really been clearly thought out. I uphold that there is a series of errors in this simplistic mode of thinking which I shall document in this article.
At first it casts to the wind the single most important lesson of economics: there is no such thing as a fixed pie. Indeed if there is anything we have learned from the study of economics all these centuries, in fact at least ever since Aristotle, is that through cooperation, trade and division of labor, we increase the scope of goods and services that we all can have. The more we work together, the more we economize and thus the more we increase the total amount of things we can enjoy. It is non-economics, trade barriers, closed borders, barbed wire, stringent migration controls, warfare etc. that can pit humanity in what game theorists call a zero sum game, or in other words a situation where the size of the pie is fixed and one can only gain at the expense of everybody else. Therefore the argument that Germany must practically lose for Greece and the periphery to gain, is incorrect from the outset because it assumes that the pie is fixed and that Greece may only gain if Germany loses. As a corrective to such thinking it must be noted that we do not have a zero sum game in Europe since we fortunately do not have economic nationalism between these states - we had in the first half of the 20th century and we all know what happened.
Secondly this argument is way too simplistic, to the extent that it is not an economic argument at all, even though it uses macroeconomic magnitudes like inflation. Such thinking is tantamount to the laboratory experiments that chemists conducted to observe the behavior of liquids in communicating vessels. What the chemists noticed, is that if there is more liquid in one vessel, there will necessarily be less liquid in all the others. In chemistry this is indeed correct, but in the real, complex world of economics such thinking is dubious at best, because it excludes the infinite possibilities that open up in the inflationary process. Why will an increase in inflation in Germany lead to such a proportional and equilibrated expansion in Greece and the rest of the periphery? What makes them so certain that an increase in the money supply in Germany will necessary feed in to the imports sector and that the importers will necessarily buy more Greek and other peripheral goods? Why not buy more Japanese goods? Or more iPads and other American high-tech products? Why not go holidays to Turkey instead of Greece? etc etc. My point is that this argument takes many things for granted and misinterprets reality, as it reduces the complex system of the economy, with all the acting human individuals in it, into a chimerical "communicating vessels" experiment.
Moreover this account completely neglects two other economic principles: (1) incentives, (2) expectations. To understand this better we need to make it clear and above board that an expansion in the money supply will first and foremost feed into financial institutions, because this is how the current fiat monetary system works. For those of you who follow events in Europe, I may only remind you that the LTRO, that massive infusion of one trillion euro by the ECB, did not reach out the real economy but instead flowed into state coffers, overnight bank deposits at the ECB and in general other areas that have nothing to do with consumers and producers. The inflationary money always goes first to the financiers. So the question is what kind of incentives and expectations do financiers have to pass that extra liquidity into the real economy in the form of credit, so that we may witness all these supposed benign effects of higher inflation in Germany?
As the situation currently stands financiers have little incentive to supply credit to the real economy, since they can use that extra money to buy more government bonds instead, ideally from Germany, which can then be used as top quality collateral to raise the bank's capital adequacy, or for even more cheap liquidity from the ECB or it can even be put together in some nice financial derivative and be traded at Wall Street. Same applies for their expectations: A political system that can only find a solution to the eurocrisis through inflation is in fact implying that there is no solution at all, which means that financiers will expect things to get worse and this can only make them even more averse in supplying credit to the real economy. Again the possibilities are practically infinite, and therefore the simplistic "communicating vessels" approach which draws out human behavior among all others, cannot withstand scrutiny.
Lastly I must stress that the very reason we have all this deterioration in Greece and the periphery in general is because of the inflationary, erratic capital inflows that started together with the introduction of the single currency. I have restated this in my article on money illusion as a solution to the eurocrisis, but I will say it again: In Greece, in Spain, in Ireland etc we experienced roughly six-seven years of unsustainable growth, of massive misallocation of scarce resources and of inflation, also known as bubbles. The reason we had that in the first place is because German and French banks, which with the establishment of the euro had the opportunity to go international, suddenly gained access to a tsunami of new capital they had to invest. Some of it went to Wall Street's wildly speculative toxic derivatives, some to the property bubble in Spain, some to the consumption bubble in Greece and so on. Do we want this to happen again or will we finally realize that we need a massive reallocation of resources in the production of real goods and services and in the tradable sector? What we need is real growth not another series of bubbles. If we agree on that basic principle, then we must comprehend that inflation does not create real growth, it only creates artificial growth which eventually will have to collapse, as bubbles burst, leaving behind tons of devalued capital, failed projects and masses of unemployed.
The nostrums of the inflationists, those mechanistic over-simplified ideas which have no application in the economic sphere, may only lead us to more trouble. The belief that inflation in Germany will help Greece is flatly incorrect. Real investments will help Greece; reallocation of resources to increase productivity and exports will help Greece; a simplification of formalities and a dismantling of the sclerotic bureaucracy will help Greece; a stable political system that gives confidence to investors will help Greece; a modernization of public services and a rationalization of the public sector will help Greece; a simpler and much more efficient tax regime and tax collection mechanism will help Greece; a more effective judicial system will help Greece; a decrease in military spending through open minded compromises with neighboring countries will help Greece.
In a nutshell real reforms will help Greece, not the inflationist bungling. Inflation can do nothing of all this, except from satisfying the delusions of some macroeconomists and econometricians who know nothing about Greece.
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