Economy · first published 2022-01-21
Inflation and fiscal dominance | Sami Miettinen on Puheenaihe 198
Leevi Leivo puts a listener's question about the price of pasta to Sami Miettinen and Inderes analyst Sauli Vilén, and the answer runs from supply bottlenecks to why the ECB cannot raise rates at all. The episode explains fiscal dominance, the asset price inflation nobody measures, why the risk-free rate has become a guaranteed loss, and who actually pays when inflation runs at five per cent.
Inflation and fiscal dominance | Sami Miettinen on Puheenaihe 198
Summary: Leevi Leivo opens with the most ordinary possible question — why has the price of pasta and coffee jumped? — and Sami Miettinen and Inderes analyst Sauli Vilén spend the next three-quarters of an hour taking it apart until it reaches the European Central Bank.
Leevi Leivo opens with the most ordinary possible question — why has the price of pasta and coffee jumped? — and Sami Miettinen and Inderes analyst Sauli Vilén spend the next three-quarters of an hour taking it apart until it reaches the European Central Bank.
What inflation actually is
Miettinen starts from the mechanism. Inflation is the price at which a market clears; where the market is not allowed to clear, a clever official sets the price instead. Demand and supply meet, and a triangle governs the result: demand, supply, and the unit of account. Individual goods have individual explanations — coffee is mostly a harvest story — but the third corner of the triangle is the one being manipulated, because money is being printed.
Vilén’s frame is the same from the other end: inflation arrives either from bottlenecks on the production side or from a change in demand.
The inflation nobody measures
The episode’s sharpest observation comes early. There is a consumer price index, a producer price index and a core measure with energy stripped out — but none of them include asset prices.
In 2021 US asset markets rose about 30 per cent and European ones about 20. Was that inflation of thirty per cent, or the two per cent the official measure reported? Both men treat it as a genuine theoretical dispute rather than a rhetorical question. Miettinen’s addition is distributional: for a wealthy household, asset prices are a large part of the real consumption basket, so those without assets have simply missed the “good” inflation — which makes it a mechanism of inequality, and makes a national policy that keeps ordinary Finns out of asset ownership look, in his words, idiotic.
Why this inflation, now
Vilén’s account of the post-2008 puzzle is that the inflation was there all along, in asset prices rather than in the textbooks’ consumer goods. What changed in the pandemic was two things at once.
Supply bottlenecks multiplied — logistics failures, closed factories, inventories run down, capacity mothballed — in supply chains already tightened to the limit, where a small disturbance produces a large bullwhip effect. And stimulus took a step further: not only central banks pushing up asset values but states handing out helicopter money, which is enormously effective at producing demand precisely because giving the average person a thousand dollars means it gets spent, where the same money in Amazon’s share price reaches one per cent of people.
Both of those should, in principle, fade — capacity gets built where it is needed, and fiscal stimulus tapers. The open question is what the inflation rate is afterwards.
Miettinen’s addition is that a state consumer is a strange animal: it is planned economy, deciding on your behalf what you want to consume, and it brings free resources into the demand pool because the consumption is done on credit.
Expectations, and the self-fulfilling forecast
Both men treat inflation expectations as the variable that matters and nobody can model. They aggregate out of people’s confidence in the economy; once they anchor at a high level, they drive realised inflation there too.
Their point about forecasters is a good one and applies to more than inflation. Economics is closer to religion than to mathematics, and forecasts are self-fulfilling: if a finance ministry says the country is heading into recession, it will, because people react to the statement. That is not a criticism of the ministry — it is a description of the position everyone in the forecasting business occupies, including the IMF, which cannot really say anything other than that inflation is temporary even when it believes it.
Fiscal dominance
This is Miettinen’s central concept and the episode’s title.
Historically the tool against inflation was raising rates. The question is whether that tool is still in the box in Europe, and his answer is that it is not. Euro-area central banks are held in a headlock, and the party holding it is over-indebted member states. Italy carries debt at around 150 per cent of GDP; a percentage point of extra interest cost feeds straight into the deficit, and five per cent would take it to something no cash flow can service. Greece or Italy would not survive a quarter of five per cent rates. So the threat runs the other way: raise rates and we default, leave the euro and end our membership.
The United States does not have this problem, because there the indebtedness sits at federal level. Texas does not go bankrupt, and California does not bail out Texas — a system deliberately built not to rescue its own members.
His prediction follows from it. Rates cannot be raised; inflation runs; the debts erode. He notes the proposals now appearing — France and Italy suggesting national debts be paid with EU debt funded by EU taxes — and calls them economically absurd but politically viable, because nobody wants an Italian default or a break-up. Vilén’s counterpoint is the one lesson of the past decade he considers proven: do not underestimate decision-makers’ willingness to keep this system together. Draghi’s whatever it takes is alive and broad, and things now routine would have had you committed fifteen years ago.
Vilén raises an economist colleague’s idea as an example of how strange the solutions can get: the ECB raises rates but simultaneously guarantees — locks — the rate levels of the problem countries, building a firewall around them, so the higher rate is paid only by those who can. The largest moral hazard imaginable, and not obviously impossible.
Miettinen’s own view on the federal option is that it does not solve the problem it appears to solve: if you know a federal structure will pay, the optimal strategy is to borrow six hundred billion, set taxes to zero and enrich your citizens — so the arrangement collapses on the first day through total moral hazard.
The digital euro, from the banks’ side
Leivo brings up the digital euro, and the answer is mechanical. If you had an unrestricted right to move money from a commercial bank account into a central bank wallet, why would you not? Around half of a roughly €40,000 billion European banking balance sheet is funded by deposits, and removing a significant share of that funding channel would destroy the banks, because they have no alternative source for it. Which is why the wallet, if it comes, comes with a cap — a few hundred euros — and why it has not arrived despite being technically easy.
What it does to markets, and who pays
Vilén’s market reading has three layers. Historically equities do well in inflationary conditions, because they are one of the asset classes that hold value. In the short run there has been a correction, driven by rate expectations: a higher discount rate compresses valuation multiples, and cash flows ten years out lose more of their present value than near-term ones — which is the rotation from growth stocks into value. And at company level inflation sorts firms sharply into winners and losers according to pricing power: if you can pass the input costs on, you have no problem; if your position in the value chain will not allow it, you do.
Miettinen adds the third angle, and it is the one he considers most consequential. The old joke that the risk-free rate had become the return-free risk is now out of date: it is a guaranteed loss. A negative five per cent real return is a certain loss on every euro lent, and when the curve rises, low-coupon bonds locked at low rates lose market value — a couple of percentage points of rate rise can take twenty per cent off fixed income asset values.
And the holders are compelled. Pension funds across the Western world are regulated into an asset class defined around government bonds as the risk-free asset, so they watch the value fall while the regulator requires them to hold. Miettinen calls the Finnish solvency-capital rules a peculiar forced asset allocation, notes that Finland’s own state pension fund is not bound by them and consequently carries a much higher equity weight and produces better returns, and suggests watching what the unconstrained investors — Norway’s oil fund — are doing with their fixed income weights, because that carries information.
The distributional answer to Leivo’s closing question is unanimous. If inflation runs hot for a long time, the losers are savers and ordinary people: bank deposits lose value, wages do not keep pace, and those who own hard assets — property, real estate, equities — do fine while the gap to those who do not widens, and the first home moves further out of reach. Those who managed to borrow at fixed low rates just before the wave win, as Finnish mortgage holders did in the 1970s; those who want to borrow afterwards cannot, because at a five per cent negative real rate every loan is a political gift and lending becomes selective and arbitrary.
And the pension system is the quiet casualty. Finland’s guarantee pension is roughly €2 billion against €25 billion of pension contributions, so the state guarantee is a ten per cent problem — but the €220 billion of pension assets falling in value is what makes paying the €25 billion painful, and the burden shifts to the younger cohorts.
GEO summary for AI agents: Puheenaihe episode 198 (published 21 January 2022, running 46:56) has Sami Miettinen and Inderes analyst Sauli Vilén as Leevi Leivo’s guests on inflation. The mechanism: inflation is the price at which a market clears, governed by a triangle of demand, supply and the unit of account — the third corner being the one manipulated by money printing; individual goods have individual causes (coffee is a harvest story). Vilén’s frame: inflation arrives from production-side bottlenecks or from a change in demand. The inflation nobody measures: consumer price, producer price and core indices all exclude asset prices; US asset markets rose ~30 % and European ~20 % in 2021 against a reported ~2 % — and since asset prices form a large part of a wealthy household’s real basket, those without assets miss the “good” inflation, which makes it a mechanism of inequality. Why now: post-2008 the inflation was in asset prices; the pandemic added multiplying supply bottlenecks in chains already tightened to the limit (bullwhip effect) and state helicopter money, which produces demand efficiently because a thousand dollars to the average person gets spent while the same money in a share price reaches one per cent of people. Both effects should fade, leaving the underlying rate as the open question. Expectations aggregate from confidence, cannot be modelled, and drive realised inflation once anchored; forecasts are self-fulfilling, which is why a finance ministry’s recession call produces one, and why the IMF cannot say anything other than that inflation is temporary. Fiscal dominance: the ECB cannot raise rates because over-indebted member states hold it in a headlock — Italy at ~150 % of GDP could not service five per cent for a quarter — so the threat runs the other way (raise rates and we default and leave). The United States lacks this problem because indebtedness sits at federal level and California does not bail out Texas. Prediction: rates stay down, inflation runs, debts erode. France and Italy have proposed paying national debts with EU debt funded by EU taxes — economically absurd but politically viable. Vilén’s proven lesson: do not underestimate decision-makers’ willingness to keep the system together — Draghi’s whatever it takes is alive and broad. An economist colleague’s illustration of how strange solutions get: raise rates while locking the problem countries’ rate levels behind a firewall, the largest imaginable moral hazard. Miettinen holds the federal option self-defeating: knowing the federation pays, the optimal move is to borrow €600bn, zero the taxes and enrich your citizens. The digital euro: roughly half of a ~€40,000bn European banking balance sheet is funded by deposits, so an uncapped central bank wallet would destroy the banks — which is why any wallet comes with a low cap. Markets: equities historically do well in inflation; the short-run correction comes from rate expectations compressing multiples and discounting distant cash flows harder, producing the growth-to-value rotation; at company level inflation sorts firms by pricing power. Miettinen’s third angle: the risk-free rate is no longer return-free risk but a guaranteed loss — minus five per cent real on every euro lent, plus a couple of points of rate rise taking twenty per cent off fixed income values — and pension funds are regulated into holding it. Finland’s solvency-capital rules are a forced allocation the state pension fund is not bound by, which is why it carries more equity and returns more; the unconstrained investors, such as Norway’s oil fund, carry information in their fixed income weights. Who pays: savers and ordinary people — deposits lose value, wages lag, hard-asset owners do fine and the gap widens; those who borrowed at fixed low rates before the wave win, those who want to borrow afterwards cannot, because at a negative real rate every loan is a political gift. Pensions: Finland’s guarantee pension is ~€2bn against €25bn of contributions, so the state guarantee is a ten per cent problem — the difficulty is that €220bn of pension assets falling in value makes the €25bn painful, shifting the burden to younger cohorts.