The accelerating inflation in the trans-Atlantic community is an unusually delayed reaction to long years of an extraordinarily excessive credit creation.

But here we are. At the center of the unfolding economic crisis is a terminal unraveling of an unsustainable 78-years old global financial “arrangement.”

The “arrangement” in question was an outgrowth of the Bretton Woods Conference in July 1944. The agreement reached in the lush New Hampshire hills gave the world an unworkable international monetary system based on fixed exchange rates and a symmetric obligation for deficit and surplus countries to balance their external trade accounts with an appropriate adjustment of monetary and fiscal policies.

In that system, the dollar was to serve as the principal reserve and transactions currency, and the U.S. would unconditionally redeem into gold all foreign dollar holdings at the price of $35 for an ounce of fine gold.

Predictably, it did not take long for the trans-Atlantic squabbling to start. The surplus running Europeans refused to adjust their trade accounts while loudly complaining about dollar shortages. The system was doomed because its fundamental principles of disciplined and symmetric adjustment policies were rejected.

Inflation is central to dollar’s key currency position

In response to that, the U.S. began to gradually close its gold window in late 1960s -- and slammed it shut in August 1972. With the dollar convertibility gone, the U.S. Federal Reserve was free of any external policy constraints.

That’s how the Bretton Woods international monetary system morphed into a pragmatic “arrangement” based on the U.S. dollar: A currency serving American economic objectives of “maximum employment and price stability” would also be a principal global reserve asset and a worldwide medium of exchange.

The early years of the dollar standard in the 1970s marked the beginning of a U.S. inflationary wave peaking at 14.8% in March 1980. That inflation was brought down to below 3% in 1983 by pushing up the key policy interest rate (federal funds rate) to 20%.

A return to price stability in the U.S. was won at a very high cost: A 16-month recession of 3.6% and an unemployment rate of 10.8%.

A similar inflationary flareup is happening now. Driven by soaring energy and food costs, the U.S. consumer price inflation doubled in the year to April to an annual rate of 8.3%.

Over the same period, and for the same reasons, the consumer price inflation in the European Union (E.U.) also shot up from 2% to 8.1%.

A deep and long recession lies ahead

The question is: How likely is it that the surging energy and food costs will slow down, or even decline, in the months ahead?

On current evidence, the probability of such an event occurring is zero. Energy and food prices are continuing to rise as a result of supply shortages caused by sweeping sanctions and minefields blocking the shipping of food through Black Sea waterways. None of those problems will be lifted in the months ahead. In fact, both sanctions and the dire conditions in the European war theater will continue to worsen.

Meanwhile, the increasing inflation is raising labor compensation claims, which will inevitably lead to further price hikes in goods and service markets.

In the U.S., for example, unit labor costs – the floor below the future inflation trends – in the first quarter of this year surged to an annual rate of 7.3% -- more than a three-fold increase observed during the same period of 2021.

And all that is happening at a time when credit conditions in the U.S. and in the E.U. remain excessively loose, with negative real short-term interest rates of minus 7.3% and minus 8.7%, respectively.

The way to stopping inflation will be long and hard. To begin with, real short-term interest rates would have to be quickly brought to their neutral position of +2%. From that point on, the pace of the credit tightening process would depend on the rate of inflation decline.

If that sounds like a far-fetched dream – it is. But technically, that’s what it would take to restore price stability – inflation rates of 0%-2% -- in the U.S. and the E.U.

That, of course, is not going to happen in the months ahead because the ensuing recession would cause massive unemployment, widespread bankruptcies and crashing asset prices.

Such an outcome is unthinkable for the White House staring at a possibility of Democrats losing the control of legislative authority next November and of the presidency in 2024.

For the E.U. a recession would be a political defeat, a loss of any influence over the war in Ukraine and the unraveling of a union desperately seeking relevance in world affairs.

Ultimately, however, the more the U.S. and the E.U. postpone coming to grips with rising inflation, the longer and the deeper will be the recessions they will have to face.