Inflation - causes and implications for solving the climate issue

On Thursday 29th of July, Richard Werner, Doctor in Economics from the University of Oxford and University professor in banking & finance at De Montfort University gave a lecture on the causes and consequences of inflation.

During the class, Professor Werner encouraged us to always question mainstream and common-sense views of economic phenomena. The stagflation (low economic growth and inflation) episode of the 70’s was explained at the time by decision makers as due to external causes, more specifically supply-side constraints: the USA’s (and other western countries’) involvement in the Middle East War led to the OPEC proclaiming an oil embargo, causing rampant inflation.

According to Richard Werner, this supply-side narrative is false, but so is also the mainstream narrative around interest rates (i.e. the price of money), which claims that lower rates stimulate growth, and inversely. This narrative is based on the price equilibrium mechanism of classical economics, which states that, in a perfect market, prices are set where supply and demand meet. None of the conditions necessary for a perfect market (such as perfect information and competition, instantaneous price adjustment, absence of transaction costs and time constraints, profit maximisation by rational agents) can be seen as realistic.

The application of this theory to interest rates is moreover taken as a given and has not been empirically studied. Richard Werner did so though and has published two papers about the topic: “Reconsidering Monetary Policy: An Empirical Examination of the Relationship Between Interest Rates and Nominal GDP Growth in the U.S., U.K., Germany and Japan”[1], and “Are lower interest rates really associated with higher growth? New empirical evidence on the interest rate thesis from 19 countries”[2]. These two studies conclude the opposite of the classical theory: interest rates are the result of economic growth (and thus cannot be used as an economic policy tool), and high growth leads to high-interest rates and low growth to low-interest rates.

Despite this, the price equilibrium theory and its application to interest rates still drives central banks’ policies.

According to Richard Werner, inflation should rather be analysed through the lense of what the credit (i.e. money creation) is created for, and the “short-side principle”. This principle implies that whichever supply or demand is the smaller will have the power to decide on the quantity transacted: if the client does not want to buy more than a certain amount, the seller cannot force them; and inversely. In the case of money, the banks (which create money through credits) will always be the “short-side”, as demand is potentially infinite. The impact on inflation depends on where banks decide to allocate the money:

● It will drive asset inflation, leading to bubbles and crises, if invested in financial or real estate markets. This is for example what happened in Japan in 1991, and globally in 2007;

● It will drive consumer price inflation if given as consumption credit without equivalent growth of the economic activity;

● But it will not drive inflation if directed to investments in new goods, technology, productivity, public infrastructures (etc), that is, into growing the real economy. This is the type of economic activity that Quantitative Easing policies from Central Banks should feed into.

Germany and its decentralised banking and enterprise system appear as an example to follow to allow this value creation in the real economy. Germany is the largest exporter per capita in the world, thanks to its “hidden champions”: 1 300 German SMEs are global market leaders in their domains. These small and medium size enterprises are very flexible and specialised. They are funded by small local banks: in Germany, 80% of banks are non-for-profit local community banks, which lend 90% of their loans to SMEs. This system allows for non-inflationary growth (because of investments in the “real economy”) and long-term investments (rather than short-term gains from speculation), but also for more accountability, egalitarian distribution of money, resilience and citizen participation. This has allowed the German banking system to be less impacted by the 2007 financial crisis.

According to Richard Werner, this decentralised monetary and economic system could allow us to revive the optimism of the 1920’s and the 1960’s when solving the big problems of humankind (poverty, hunger …) was seen within reach.

This lecture left students with a number of questions open for debate and reflection:

● Is the credit theory of inflation really the (only) one? The panel discussion that was organised the same night on “the financial system of the future” (Richard Werner, Christian Kreiss, Lea Steininger, Yeva Nersisyan) offered an occasion to hear other understandings, including inflation as a heterogeneous index, driven by price-setting agents on the supply-side.

● Can the “German system” be observed in the path followed by the few countries that managed to leave the “developing countries” category in the 20th century (like Japan, Korea, and Taiwan)?

● Is growth really a necessity, and possibly non-environmentally harmful, as asserted by Richard Werner? How to ensure this decentralised monetary and economic system effectively tackles climate change?

[1] Reconsidering Monetary Policy: An Empirical Examination of the Relationship Between Interest Rates and Nominal GDP Growth in the U.S., U.K., Germany and Japan, Ecological Economics, Volume 146, 2018, Pages 26-34, ISSN 0921-8009,

[2] Lee, K.-S., & Werner, R. A. (2022). Are lower interest rates really associated with higher growth? New empirical evidence on the interest rate thesis from 19 countries. International Journal of Finance & Economics, 1– 16.

Based on the lecture "Inflation - causes and implications for solving the climate issue" by Richard Werner during AEMS 2022.
Written by: Teliska Pesenti

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