Economics and politics - comment and analysis
26. July 2023 I Heiner Flassbeck I Economic Policy, Economic Theory, Europe, Forecasts

Overkill – The ECB is driving the European economy up the wall and everyone is watching

The economic situation in Germany is bad, very bad indeed. There are indicators such as the so-called Markit PMI that predict a similarly devastating scenario for German industry as at the time of the great global financial crisis of 2008/2009 or at the time of the Corona shock in 2020. The ifo index also plummeted massively in July. The recently published bank lending survey of the European Central Bank (ECB) shows how strongly the tightening of monetary policy is already having an effect; lending to companies is falling rapidly. But those responsible in government and the central bank look the other way. They do not want to see what is happening because they do not want to admit how fundamentally wrong they have been with their estimates and forecasts.

It starts with the Federal Minister of Economics, who still does not want to take note of reality. In his latest monthly report, he writes that the current data on economic indicators point to a “moderate underlying economic momentum after a noticeable cooling at the end of the first quarter” and “to a gradual recovery of the industrial economy in the coming months”. This is no longer window dressing, these are the tightly closed eyes with which small children believe they can drive away an acute danger.

In other responsible places, there is just as little expertise to come to a realistic assessment of the situation and to take appropriate countermeasures: The ECB, which with its policy decisively shapes the economic situation in the member countries, is, as we have shown many times, blocked by its previous misjudgments.

Because the ECB officials have collectively convinced themselves that they have to fight “inflation”, regardless of the economic situation and regardless of the causes of the price increases, the demand shock caused by the massive price increases for raw materials has turned into a downward spiral for the European economy: Business investment in construction and industry is now replacing the original weakness in consumption as the driving factor.

Even after it has long been clear that there has been no further inflationary pressure since the end of last year, but rather a globally observable deflationary trend, the advocates of uncompromising anti-inflation in the ECB and in the national central banks have not stopped warning of a solidification of consumer price inflation. The leading indicators such as producer prices or wholesale prices, which are already signalling deflation, are deliberately ignored because they do not want to admit to being wrong. The ECB, which in March this year had still said that industrial producer prices as a leading indicator for consumer prices are “a proven and central element of the ECB’s analysis regarding pipeline pressures”, now no longer mentions them.

Although there is and has obviously been no dangerous acceleration of wage increases in Europe despite real wage losses, the ECB is increasingly playing the “risk through wage increases” card. This is perfidious because it was the ECB that rashly declared temporary, external price increases to be “inflation”. Despite this serious misjudgement, however, most European trade unions were never strong enough to avoid significant real wage losses. One-off payments have been an appropriate way to limit real wage losses (especially for the lower wage groups) without adjusting wages to “inflation”. To now play up the wage development as the actual inflationary danger is just another desperate attempt to distract from one’s own failures.

The IMF official responsible for Europe, Alfred Kammer, has set the wrong tone in a particularly pointed way. In a blog post he writes:

“Inflation pressures are likely to persist for some time. Workers will try to recoup losses in purchasing power by pushing for higher wages, while businesses are likely to seek to protect their profits by setting their retail prices to reflect higher labour costs. We do not see inflation coming back to target before mid-2025-and inflation could possibly prove more persistent if, for instance, inflation expectations shift upwards or the share of wage contracts containing backward-indexation clauses increases.”

So in a market economy, companies will try to protect their profits when wages rise? That’s right. They have always done so until now? If competition between suppliers works, firms will, on average, pass on unit labour cost increases in prices, i.e. the part of wage increases that is not offset by productivity gains. The empirics on this are clear for almost all countries in the world (as shown here): Consequently, there has been no arbitrary scope for companies to raise prices over the last forty years and there is nothing to suggest that this has changed since 2021. At least that is what the IMF should know.

But apart from that: the fact that it should be companies in the retail sector, of all sectors, that pass on wage cost increases does not make sense at all. In the wholesale sector and at the producer level, prices are falling, although normal wages are paid there as well. If wage pressures were generally high, you would not have deflation at the non-consumer levels. Also, the ominous inflation expectations, which can never be absent, would exist at all stages of production and sales and not just at the retail level. The whole thing is not a theoretically sound analysis, but a speculation that cannot be justified by anything, and whose only aim is to justify the behaviour of the European central bankers. If the IMF has nothing more to contribute, it had better keep quiet.

The fact that democratically elected politicians throughout Europe stand by without comment and helplessly watch the technocrats in the ECB run in the wrong direction for months and cause enormous damage is no longer comprehensible. But it is (as shown in my last contribution) the direct consequence of the wrong mandate that Germany has imposed on the ECB. Anyone who can retreat to the position that in case of doubt they are only responsible for price stability has the wrong mandate and a cheap excuse to boot. The recession is then declared to be the unfortunately unavoidable price to be paid for price stability. And the fact that price stability is an indispensable social good that the central bank is fighting for is simply thrown in without saying what price stability is actually about in a time of major external price shocks.

So the ECB will continue with its misguided policy and raise interest rates again tomorrow. If, even at the end of this road, no one takes personal responsibility for the wrong decisions, we will see that large parts of the population are lost to democracy. For even if the relationships are not understood in detail, it is correctly assumed that “those up there” are failing, but do not themselves bear the consequences of their failure, but leave the “people on the street” to pick up the bill.