22st November 2011: Why The Germans Understandably Hate Inflation

Sweeping up Bank Notes – When Cash Becomes Trash

Quote of the Day:

There is no way it will work, at least not for a longer period — because, of course, following massive buying … as a political solution to this crisis, after a while people would realize that what is on the European Central Bank’s books has to be recapitalized by someone,

Angela Merkel – speaking on ECB participation

Macro Overview

Why the Germans Hate Inflationary Policies

• It’s not hard to see where German hatred of inflationary policies come from. WWII arose out of hyper-inflation in the Weimar Republic which saw Germany at the epicenter of the most expansive war in the history of mankind.
• Remember, Germany is a massive and growing exporter outside of Europe and, as the European consumer hits the skids, this is only likely to increase as a proportion of total exports. ECB money-printing would likely lower the exchange value of the Euro boosting their exports. The fact that Germany campaigns against ECB participation gives you an idea of just how petrified they are of unruly inflation expectations.
• If you look at the chart below it shows how the Paper Deutsche Mark rose against the Gold Mark from 1 to 1 Trillion in the six years from 1918 to 1924 – quite a remarkable feat. Imagine how disruptive this is on a highly productive economy like Germany’s. This is a chart engrained onto the soul of every German – they are not going there again.

German Hyper-Inflation

Why the Germans Hate ECB Monetization

• Well, monetization is inflationary policy, so it stands to reason, why they’d hate it doesn’t it? True, but so many historians and pro-print pundits point to the fact that WWII was caused primarily by the oppressiveness of the Versailles Treaty in the aftermath of the first World War. But this misses the point, the economic reality was that, for whatever reason, there was a sovereign debt problem in Europe (and debt takes many guises). The Germans felt they had no alternative but to inflate their way out of this debt and the rest, as they say, is history.
• Since the painful aftermath of the Second World War, Germany’s Bundesbank has been modeled on a strict mandate of price stability and, under this resolute stewardship of inflation, the German economy has indeed flourished. The ECB is a central bank crafted (correctly in my view) in the same mold of this stoic, uncompromising Bundesbank. With monetary authority over a wide variety of cultures it was even more imperative that the ECB had a simple, pure mandate, unpolluted by political influence, untainted by conflict. Employment distractions and a bias towards monetization and money-printing are highly charged political hot-potatoes for any central bank, never mind a supra-national central bank, to contend with.

Why the Germans Will Not Tolerate Even A Temporary Direct ECB Participation

• This was really well explained in a WSJ Blog yesterday. A typical modern western central bank can print the heck out of its fiat paper currency and can simultaneously cohesively suppress inflation statistics while making the argument that, as soon as inflation “appears”, they’ll be extremely pro-active in reversing the inflationary policies. But, ironically, the ECB is actually more inherently righteous than this as, due to its structure, it finds this argument is much more difficult convey.

• Firstly because, once the bank loses sight or control of inflation, within a culturally broad region of independent fiscal authorities, the dispersion of inflation risk increases greatly. Some cultures within the Eurozone could be in outright deflation (periphery) while other parts are getting cooked by rampant inflation (Germany).
• Secondly, and more importantly, the ECB (arguably the last bastion of supra-national credibility within the EU) immediately loses credibility by overtly stepping over the strict mandate line enforced on it. Additionally, if the ECB makes the decision to monetize peripheral debt, it must do so assertively and with a communicated long term objective (we’ve already seen that the market does not buy half-measures, and the market will test the ECBs resolve on anything like this). By making a heavy and almost indefinite commitment to purchase peripheral debt, the inflationary effects will be felt in Germanyalmost immediately and the Euro will probably tank – exasperating the problem. The ECB and the whole of Europe would then have a gargantuan problem. As German inflation careers out of control, the ECB, having just vaporized most of its credibility, must:

1. Continue with its monetization until peripheral economies are safely out of their debt trap – meanwhile the most productive economy in the Eurozone will have hit the self-destruct button. Good luck managing the fallout from that.
2. If it tries a U-turn and begins a sudden tightening policy, what little credibility it has, will finally desert it – you now have a central bank with no credibility trying to fight runaway inflation in what was the old Weimar Republic. Good luck managing the fallout from that.

Sympathy For The Germans (For a Change)

• I have criticized the way Germany has positioned itself forcefully within the Eurozone and I’ve noted how they have benefited from the weaker Euro and I’ve criticized them for actually being the protagonists who discredited the fiscal framework of the Stability and Growth Pact in the first place (see the excerpt from the Guardian in this piece).
• That said; I do sympathize with their argument with respect to inflationary monetary policies. Not only is there inherent moral hazard to money printing in general, ECB direct involvement with sovereign debt purchases will likely expose more, not less, flaws within the Eurozone framework. I believe treaty change, as I’ve commented on many times (see here for suggestions I made long before it was on the tip of Merkel’s tongue) to be imperative if the Eurozone is to survive. This is because it is fiscal accountability and the very foundations upon which the EU was constructed are the root causes of many of the fractures within the Eurozone.
• Germany is as much to blame as all the other countries for this crisis, as I said in my piece Brokeback Europe:

…there is little fiscal discipline within the EU and therefore little credibility. This is not an opportunity to point nationalistic fingers; this is a fault within the constitutional framework itself. The EU was a collective creation, this gaping policy hole is a collective, European mistake.

• But just because Germany is as much at fault as every other nation, does not mean we should ignore their suggestions for a solution. The southern European states should accept that direct participation by the ECB in the debt markets is out of the question, they should grant Germany this but in return they should demand that German taxpayers put up a significant amount of collateral into the EFSF to draw a line under this once and for all. That is where the negotiation process should be – at the moment Europeans are arguing about which argument they want to have! We’re a long way from finding and implementing a solution, it would seem.

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