While it is becoming increasingly clear that Europe is falling into a Japanese style deflationary trap European central bankers continue to refuse to talk about the need for monetary easing to curb deflationary pressures. Instead they seem to be focused on everything else. We have been through it all – the ECB has concerned itself with who was Prime Minister in Greece and Italy about Spanish fiscal policy, rising oil prices in 2011 and about “financial stability”. And believe it or not it has become fashionable for European central bankers to call for higher wages in Germany!

This is from Reuters (on Sunday):

The European Central Bank supports Germany‘s Bundesbank in its appeals for higher wage deals in Germany, Der Spiegel magazine quoted ECB Chief Economist Peter Praet as saying on Sunday.

Low wage agreements were needed in some crisis-hit countries in the euro zone to bolster competitiveness, the magazine quoted Praet as saying.

By contrast, in countries like Germany where “inflation is low and the labour market is in good shape”, higher earnings increases were appropriate, Der Spiegel reported him to have said.

This would help bring average wage developments in the euro zone in line with the ECB’s inflation target of close to 2 percent, his argument continued, said Der Spiegel.

The Bundesbank historically has been a strong advocate of wage restraint, but with euro zone inflation stuck below 1 percent and consumer prices rising just 1.0 percent in June in Germany, Europe’s biggest economy, some fear deflation.

Bundesbank Chief Economist Jens Ulbrich has been widely reported by German media to have encouraged German trade unions to take a more aggressive stance in wage negotiations given low levels of inflation.

First of all one should ask the question why European central bankers in this way would interfere in the determination of prices (wages). The job of the central bank is to provide a nominal anchor – not to have a view on relative prices.

Second you got to wonder what textbook European central bank economists have been reading. It seems like they have completely missed the difference between the supply side and the demand side of the economy.

We know from earlier that ECB Chief Economist Praet seems to have a bit of a problem differentiating between supply and demand shocks. Apparently this is a general problem for Eureopan central bankers – or at least Bundesbank’ Jens Ulbrich suffers from the same problem.

What Ulbrich seems to be arguing is that we should solve Europe’s deflationary problem by basically engineering a negative supply shock to the German economy. The same kind of logic has been used as an argument for the recent misguided increase in German minimum wages.

Hence, it seems like both Praet and Ulbrich actually acknowledge that there is a deflationary problem in Europe, but at the same time they very clearly fail to understand that this is a monetary phenomenon. As a consequence they come up with very odd “solutions” for the problem.

This can be easily demonstrated in a simple Cowen-Tabarak style AS/AD framework – see the graph below.

ECB’s overly tight monetary policy has caused aggregate demand to drop shifting the AD curve from AD to AD’, which has caused a drop in inflation to below 2% (likely also soon below 0%).

The Bundesbank now wants to deal with this problem not by doing the obvious – easing monetary policy aggressive – but instead by causing a negative supply shock. Obviously if German labour unions are given further monopoly powers and/or the German minimum wage is increased then that is a negative supply shock – wages increase without an increase in productivity or demand for labour. This causes the AS curve to shift left from AS to AS’.

The result of course would be higher inflation, but real GDP growth would drop further (to y” in the graph). Or said in another way it seems like the Bundebank are advocating “solving” Europe deflationary problem by increasing the structural problems on the German labour market.

Obviously Jens Ulbrich likely would argue that this is not what he means (his reasoning seems to follow a typical 1970s style “Keynesian” macroeconometric model where there is no money and no supply side – higher wage growth cause demand to increase), but that doesn’t matter as the outcome of an exogenous negative supply shock to the German economy would be bad news for Europe rather than good news.

Stop micromanaging the European economy – and do monetary easing

It is about time that European central bankers stop obsessing about matters that have nothing to do with monetary policy – whether it is fiscal policy, financial stability or labour market conditions. They can and not should try to influence these matters. The ECB should just take these matters as given when they conduct monetary policy, but it not for them to influence these matters.

The Bundesbank or the ECB should not have a view on what the level of the public deficit in Spain is or the how much German wages should increase. The first is for the Spanish government to decide on and the second is for German employers and labour unions to negotiate. It is becoming very hard to argue for central bank independence when central bankers (mis)use this independence to interfere in non-monetary matters.

The ECB is failing badly on this at the moment has the risk of falling into a deflationary trap is increase day by day. So why do the Bundesbank and the ECB just not focus on solving that issue? Depressingly the problem is very easy to solve – also without worsening German labour market conditions.

PS The argument for higher wage growth and tight money is very similar to what caused the so-called Recession in the Depression in the US in 1937. The Roosevelt administration got increasingly concerned in 1936-37 that inflation was picking up while wage growth remained weak. The Roosevelt administration feared this would cause real wage to drop, which would cause private consumption to drop and unemployment to increase. This obviously is a very primitive form of Keynesianism (but something Keynes did in fact advocate) and today it should be clear to everybody that political attempts to cause real wages to outpace productivity will lead to higher rather than lower unemployment. And this is what happened in 1937 – the FDR administration troed push up real wages by increasing nominal wage growth and tightening monetary policy caused the recession in 1937.

PPS Unfortunately the Abe government in Japan seems to suffering from the same illusion that “engineering” a rise in real wage – without a similar rise in productivity – can help the Japanese economy.