Wake Up At the ECB

Trichet Can Relax; As Growth Slows, So Will Inflation

News | Melvyn Krauss | February 2008

Federal Reserve Chairman Ben Bernanke has allowed global stock markets to railroad him into a whopping 75-basis-point cut in interest rates just one week before the regularly scheduled meeting of the Fed’s decision-making Open Market Committee. European Central Bank President Jean-Claude Trichet would never allow this to happen to the ECB – he manipulates markets; markets don’t manipulate him.

Indeed, with America’s economy in apparent freefall, Trichet is threatening euro-zone trade unions with pre-emptive interest-rate hikes unless they behave as he sees fit.

But these threats may be proving counter-productive to the achievement of price stability in the euro-zone economy, the central bank’s primary objective. For example, to make his threats of an interest-rate hike in the midst of a global slowdown credible, the ECB president is using his press conferences to tell the world how strong European growth is. Besides being at odds with reality, the claim of strong growth actually encourages the trade unions to ask for even higher wages. And why shouldn’t they if things are as good as Trichet claims?

Trichet also makes his job more difficult for himself by talking up Europe’s inflationary threat. His colleague on the ECB Governing Council, Bundesbank president Axel Weber, seems to have gotten the message that the more ECB officials talk up inflationary fears, the more the trade unions will ask. So he recently toned down his rhetoric by warning that euro-zone inflationary pressures should not be "over-dramatized."

How true! The essential economic reality confronting the ECB today is that the American economy is falling headlong into a serious slump – Bernanke’s surprise cut speaks volumes to this. It defies economic logic to think that the global economy – including Europe – will escape its consequences.

As European growth slows, so will inflationary pressures. So Trichet should relax, stop threatening others, and let the economic slowdown do the work for him.

Even with sticky wages and prices in Europe, the global slowdown will reduce energy, commodity, and food prices on world markets, all of which are important factors behind currently elevated European inflation levels. The crude oil price already has dropped substantially from its highs at the beginning of the year.

But the evolving slowdown is not the only reason the threat of a wage-price spiral in Europe is overblown. Germany is facing a key wage negotiation with public-sector unions. Even if the unions win large wage increases – which is very likely and entirely justifiable given their past restraint – this will have only a negligible effect on Europe’s price stability.

Increased public-sector wage costs mean increased government spending on wages. If this is financed by cutbacks elsewhere in the budget, the main consequence will be only a re-distribution of government spending, which is not necessarily inflationary.

Nor is it inflationary if the wage increases are financed by higher taxes. Only if the budget surplus diminishes would there be an inflationary impact, and that would not be due to a wage-price spiral, but to an increase in net government demand, which actually might not be a bad thing for an economy facing a potentially severe economic slowdown.

In the United States, it should be remembered, the need for a fiscal stimulus developed, so it seems, out of the blue. The same may happen in Europe, especially given the ECB’s refusal to cut interest rates.

A decent settlement with public-sector workers could give Germany a "backdoor" fiscal stimulus just at the right moment, i.e., when aggregate demand is flagging.

The real problem with a generous wage settlement with public-sector unions is that private-sector unions could use it to get more than their productivity gains warrant. Contracts with the metal and chemical workers also are coming up for negotiation this year in Germany, and union leaders are talking tough. Berthold Huber, the head of Germany’s huge IG Metall engineering union, recently promised his rank and file "a mega year" for pay increases.

But the global slowdown, which takes the fangs out of the strike threat, will keep private-sector workers in line no matter how much their leaders may rant and rave. Everyone, including bellicose trade unionists, tends to become more reasonable when the economy turns south.

Rather than encourage the unions with exaggerated talk of strong European growth and inflationary excess – and disrespect them with threats and interventions – ECB Chairman Trichet should speak softly and let nature take its course.


Melvyn Krauss is a senior fellow at the Hoover Institution, Stanford University. 

Copyright: Project Syndicate, 2008.


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