What Europes central bankers are currently contemplating is reminiscent of George W. Bush and Iraq: preemptively combating a danger which is difficult to verify. This can be a dangerous adventure.
In 2003, Bush had the Iraqi government overthrown and its ragtag army routed with hundreds of thousands of troops and high tech weapons because Iraq possessed weapons of mass destruction which were an acute threat to the United States. It became apparent that this was an expensive misdiagnosis. The Iraqi dictator did lose his power but only after umpteen thousands of people lost their lives and the country slid into chaos.
One could now say that this really has nothing in the least to do with the European Central Bank. Clearly, no one, as a rule, has to die from decisions on interest rates. Yet, it should be remembered what the inflation fighters are exactly planning to do to stabilize prices, analogous to Bush and his hawks in Iraq. Inflation is developing a momentum of its own and we believe it could be as difficult to deal with as were the nonexistent Iraqi nuclear weapons. The attempt to fight the presumed threat preemptively with higher interest rates could result in extensive collateral damage, but it would not be as deadly as Iraq.
Embedded European Central Bank Watchers
Just like Donald Rumsfeld, hawks in the European Central Bank, such as the Germans Jürgen Stark and Axel Weber, are now talking up this danger to tell us and the world about inflation related implosions. The talk is of eroding purchasing power, global inflation, and the measures necessary to prevent these problems. There are already observers of the European Central Bank who praise this as stability in the great battle against evil. Just like the "embedded correspondents" in the Iraq invasion.
Of course, inflation has risen to almost four percent, which is undesirable in the long term. Only the extremists themselves, such as Stark, admit that they are not able to prevent oil price increases. It would be dangerous, though, if speculation about inflation took on a life of its own and slid over to secondary effects on wages, prices, and costs. The doubts begin right here.
Although inflation has been over three percent for months, there is still no serious indication that it is taking on a life of its own. Core inflation without energy and food is just over two percent despite a doubling in the price of oil, and near a historic low of 1.7 percent in Germany. Other than oil and food, nothing is becoming more expensive up to now.
It can be similarly difficult to establish that inflationary expectations are increasing. What is somewhat helpful is the attempt to derive these expectations from the influence of interest rates on inflation-indexed bonds. Gloomy economists from the Société Générale say that the most recent burst of inflation could not even have been deduced from these interest rates. The same applies to the inflation forecasts by economists in European Central Bank surveys. Furthermore, these forecasts also reveal little about the secondary effects of inflation which would affect working people. Yet, instead of being cynical, consumer surveys are pointing to the all clear signal. If this is related to the anticipated annual inflation rate, then there are currently fewer pessimists and optimists than there were in 2000/01, when another period of inflation did not follow.
Even if inflationary expectations could be determined, it would still be debatable as to whether they would also automatically set off price/wage spirals, as the inflation fighters in the European Central Bank predict. It could also be that people react with resignation more easily today. An example of this is that people no longer obtain more income so easily from liberalized job markets and decreasing union influence. It could also arise from resignation over climate protection. The increase in oil prices since 2005 may have led to this, because Germans have curtailed their oil consumption by 7.4 percent this year, according to David Milleker, chief economist from Union Investment.
The fear of living large works in strange ways because Germans have still increased their savings despite declining purchasing power. Also, most people in the Euro Zone are once again expecting higher unemployment, which quickly tempers their boldness in making wage demands.
What currently characterizes the Euro Zone are sharply declining real wages, not increasing wages, says Gilles Moec of the Bank of America. The spirals are just going downhill. As opposed to the situation in the 1970s, wages are really following inflation only in Spain.
If it is correct that the danger identified by the hawks in the European Central Bank is similarly lacking in substance just like with Rumsfeld, the Bank is probably threatening a disaster like the ruffled Iraq warriors, who wanted to achieve their goal by similarly oversized but misdirected means. If the European Central Bank raises its interest rates next week as expected, this will increase investment costs all over the Euro Zone and will also threaten to drive the Euro higher. This is why the business climate has so stunningly slumped as a result of oil price increases, the fall of the dollar, past de facto interest rate increases, and bank failures, just like what happens in recessions.
Lower Wage Pressure by the Creation of Unemployment
Even Bank representatives like Lorenzo Bini Smaghi acknowledge that decisions on interest rates do not have indiscriminate effects on all sectors, as they lower the macroeconomic demand" and spread conversion costs over the entire economy. Thomas Mayer, chief European economist at Deutsche Bank, says it somewhat more directly that the guardians of the Euro are in fact trying to break the wage pressure by the creation of unemployment." For this reason, they hazard the risk of a recession, according to experts at Société Générale. Whoever has a reserve bank like this does not need any enemies.
The question is whether this could not be more sensitive. Perhaps, in the meantime, reserve bankers and wage negotiators will make a deal in which they will renounce higher interest rates and other excessively large wage increases. Or else, governments of countries with truly high inflationary pressure will take countermeasures on the national level. In Germany, taxes could not be decreased to support real income. This would minimize the pressure to absorb the loss in purchasing power resulting from higher wages.
All of this would be better and simpler. Europes reserve bankers risk enormous collateral damage to abolish a danger they cannot correctly prove. Just like Mr. Bush.