What to do About Inflation?

by Anni Marttinen  |  23rd Dezember, 2022

In autumn 2021, the euro-area economy was recovering and the Covid-19 pandemic was about to subside. Russia's brutal attack on Ukraine in February 2022, however, forced a new order of priorities in international politics. The war and the resulting energy crisis darken the outlook for the economy. The energy crisis and economic fluctuations now affect everyday life for all. Russia is using gas as a weapon of energy warfare. The European Union must get its Member States back onside in order to solve the energy crisis.

The deleterious effects of the energy crisis on growth still largely lie ahead. World trade will not shore up the euro-area economy. Economic growth has slowed down in the United States and China, which weakens the euro area's export prospects. The possibility of a recession in the euro area has increased.

Inflationary pressures have intensified during the summer of 2022, as the energy crisis has worsened in Europe. Natural gas and electricity in particular have become expensive and there is a shortage of energy. In August, inflation was 9.1 per cent in the euro area and 7.9 per cent in Finland, increasing to 8.4 per cent in September. Before the war in Ukraine inflation had already started to accelerate due to the demand-side shock created by Covid-19. It was forecast to be a temporary rise, however, that would cool down after the world economy opened up again, but the advent of the war added supply side effects to the inflation problems.  

Inflation has been accelerated in particular by the rising cost of energy and food, but in the course of 2022 the prices of many other products and services have also risen. According to preliminary data for Finland, wage earnings in July-September 2022 are 1.8 per cent higher than the previous year. There is the risk of an inflationary spiral in terms of wage increases if inflation continues into next year (2023) or further. This year (2022), most collective agreements have already been settled.  

Although monetary policy can influence energy prices only to a limited extent, it must react to the acceleration of the general price level increase. The ECB's key interest rates were raised by 0.5 percentage points in July and 0.75 percentage points in September as well as in October. The situation for households will be challenging this year and next year as well in Finland, when high inflation and rising mortgage interest rates will increase costs more than income. This year, consumer prices will rise about 5 per cent faster than earnings. The weakening of purchasing power and the contraction of domestic demand are buffered by household savings accumulated during the Covid-19 period, the employment situation, which has remained good so far, and government support measures. Accelerated inflation has so far been reflected only moderately in wage developments in the euro area.  

Inflation affects household inequality

In consumers’ everyday lives, inflation can be seen not only in gasoline, but also in food prices, for example, which were 12.5 per cent higher in August 2022 than a year previously. The acceleration of inflation calmed in August when the rise in gasoline prices stopped, but prices in general still rose exceptionally sharply. Consumers became poorer as inflation hit food and energy, consumption of which can be difficult to change quickly. Housing costs rose in August by 9 per cent compared with the previous year and by 1 per cent compared with the previous month.  

The level of wage increases was decided in many sectors at the end of 2021, when nothing was yet known about inflation. Broadly speaking, wages will rise by a couple of percent, but inflation will be more than 5 per cent. Even the social partners have warned of the risk of an inflationary spiral and demanded collective patience in wage negotiations. There is a risk for inflation spiral if collective patience is not practised. All in all, spiralling inflation will not increase workers’ purchasing power but dampen it.  

There are contradictory views on what should be done with wages. Some say that in the current economic and social climate, there need to be wage increases. The contradiction lies in economists’ views on economic prospects. Some think that the economy will pick up next year, which calls for patience. Some think that there is a risk of economic recession if purchasing power is not increased. Furthermore, negotiations may be hindered by employers’ desire to agree collectively on wages. Some consider that collective agreements can in fact dampen the effects of wage competition.  

Many formerly unemployed people and people outside the labour force have got jobs only this year, when the demand for labour and the number of open jobs has broken all-time records. The incomes of people who got jobs have probably increased, and in many cases more than this year's inflation rate.  

Recipients of benefits and pensions may, in principle, be even better protected from inflation than wage earners. This is because income transfers are tied to the consumer price index. When inflation is faster than the increase in earnings, those who receive pension and benefit income within the framework of index protection benefit more than wage earners.  

However, inflation has remained high for several months now and it has reduced real household income. The real earnings of full-time wage earners from regular working hours decreased by 4.6 per cent compared with the second quarter of the previous year.  

The rise in prices increased the poverty rate by a total of 2.5 percentage points. The increase corresponds to approximately 62,000 more households in poverty. The increase in the poverty rate particularly affected one-parent families with children (an increase of 5.8 percentage points). After the price increase, 22 per cent of these households are below the poverty line. At a conservative estimate, price increases pushed about 16,000 families with children into poverty. There is a high risk that over 13,000 children will fall into poverty.

The Finnish government has found ways of supporting people in response to high inflation – but macroeconomically it may not have been the smartest approach

The government decided on a temporary social benefit increase in July 2022, when we didn’t know how long the rise in inflation would continue. In August 2022 the government decided on new measures in the budget resolution. In this situation the smartest thing to do is to help the people who need it most. The government wanted to give a little something to everyone, however, and cut taxes that benefit mostly middle-income people who are not really struggling with inflation.  

As a result of the government's budget tussle, many Finns will find relief in their everyday lives: value added tax (VAT) on electricity will be reduced, families with children will receive an additional child benefit, and efforts will be made to help low-income people in various ways. Next year's budget proposal is 8.1 billion euros in deficit, which means new debt will be taken on. The national debt will rise to 146 billion euros at the end of the year.

The budget resolution also includes a decision on new investment support for households and companies for more affordable energy solutions. The government is also planning two different electricity subsidies for citizens. One would be a tax deduction based on the electricity bill; the other would be a subsidy paid directly.

A direct electricity subsidy is a good idea, but the amount to be paid should be fixed. In this way, households would keep the incentive to save electricity, as the amount of the subsidy would not increase in accordance with the electricity bill. The details of the subsidies have not yet been specified. The total cost of both to the state is estimated at 600 million euros. It is positive that, because there are many uncertainties associated with the development of electricity prices, a solution has been sought in an energy package involving a number of different means.  

The maximum electricity deduction is 2,400 euros, while the direct electricity subsidy is 2,640 euros. The deductible for the electricity subsidy for low-income people would be 400 euros per month. In this situation, the VAT reduction therefore fails as an income transfer because it also benefits those with good incomes and those not suffering from high electricity prices. The taxable amount paid for electrical energy and the related basic fee are eligible for the deduction. The electricity transmission fee does not entail an entitlement to a household deduction. The tax deduction is applied on a personal basis.  

The government estimates that the reduction would affect approximately 252,000 households. About 265 million euros in tax revenue would be lost. EU countries’ efforts to find ways to limit household energy bills are understandable, but a rough increase in spending is not, and would not help to fight inflation. Instead, it is right to smooth out the effects of price increases with customised and temporary measures for those in the most vulnerable positions.

The price tag for the state for the VAT reduction is estimated at 209 million euros. It is good that no budgetary decisions were made that would have shifted the focus from moving away from the use of fossil fuels. The government will continue its expansionary fiscal policy in the budget agreement now being made. This is not a sensible fiscal policy in a situation of high inflation.

At Christmas, families receive additional child benefits: Kela, the social security agency, pays an additional child allowance to each family with children at the end of December, i.e. the child allowance for December is paid twice. From the beginning of next year, child allowances will be paid normally again, and there will be no additions, but families with children will be supported in many other ways. The day care fee will be permanently reduced from the beginning of August next year, and the care supplement for children in private care will be increased by 100 euros per month. Support for private care is paid to families where the child is cared for by a paid nanny or the child is in a private kindergarten.

The unemployment insurance child benefit has been increased by 24-45 euros per month, depending on the number of children. On top of the unemployment benefit paid by Kela, a child benefit increase is paid if the unemployed person has dependent children under the age of 18. The amount of child support increases if there are more children.

Students’ parents get 10 euros more per month when a guardians’ increase is made to the student allowance. Single parents will receive 5 euros more per month for the next year, when the single parent increase in child allowance is increased. Children of families who rely on income support receive a 10 per cent increase in basic child support, i.e. part of the child income support reserved for the next year.

The government has also appealed to electricity companies to pass on the VAT discount to consumers’ bills and to allow longer payment periods if necessary.

No additional subsidies are currently being prepared for companies or agriculture due to the high price of electricity. However, the situation is being monitored and energy minister Lintilä considers the situation particularly difficult for primary agricultural producers. Lintilä says that only a few tools are available, given that the energy tax refund has already been decided and the industry energy tax is already at the EU minimum. In the EU, the decision to tax windfall revenues is a good addition to the palette, but also the decision on a price cap should be made quickly.  

The government decided in September to add a possibility in the budget to support the collateral services of the electricity companies with 10 million euros. The possibility has not been used, however, because the companies are doing better than had been assumed in early autumn. But the option is still available, making the public deficit seem larger than it actually is.  

Parliamentary elections in April 2023 are now building a narrative for public finance

Finland, like many other EU countries, has taken on a lot of debt for the purpose of buffering the economic and social effects of Covid-19 and the war in Ukraine. Finland is among the medium to low debt countries in the EU with debt to gross domestic product (GDP) ratio of 65 per cent and a relatively low deficit. Finland has also managed to keep its fiscal stance less expansionary than many other countries. Still, the political discussion and narrative revolves around public debt and how to cut it.  

There has been an ongoing public debate on how to rearrange the framework for public finances, building one in which we can tackle the climate crisis and social injustice simultaneously, while also tackling demographic aging. The Finnish tradition is always to find answers in cutting expenditure and therefore the debate has also started with this. We see a lot of initiatives to broaden the tax base and introduce new taxes from the Social Democrats and the Left Coalition Party. Party programmes have not yet been published, but there are suggestions related to increasing the corporation tax of unlisted companies, a windfall tax is now going through parliament, and a capital gains tax is publicly debated, but not taken up yet. We also see a lot of momentum for bringing back the wealth tax that was removed in 2006.