The ECB’s increasingly shrill mantra that it makes policy for the monetary union as a whole and not for its largest member (Germany) could well cause a black swan to appear — in the form of a German political shock this autumn. The Frankfurt-based officials have been ignoring the historical observation of Nobel Prize-winning economist Robert Mundell that central banks of federal unions are intuitively alert to symptoms of monetary instability in their dominant economic member — for example: Ontario in Canada and New South Wales in Australia. (California, at around 13% of the US economy does not qualify as “dominant.”)
The German economy is now emitting signals of serious euro-monetary disorder even though these become muffled in the various statistical averages across the euro-area as a whole which register on the dashboards of the Frankfurt monetary bureaucracies. Chancellor Merkel, the modern-day Metternich, fighting desperately to sustain the European status quo, apparently does not hear or see any of the alarm signals. These include a climbing inflation rate (already at 1.7% year-on-year in December — equivalent to 2.5% if as in the US imputed rents of owner-occupied dwellings were included — and widely forecast to be substantially higher in coming quarters). Also of note is a red hot market in residential real estate and a massive trade surplus (at around of 8% of GDP) fuelled by an ultra-cheap currency.
Sacrificing the German Consumer To Save the European Project
The German chancellor seeming insensitivity stems from her need for Mario Draghi to “do whatever it takes” to salvage the European project. And Draghi needs Merkel in his attempt to salvage Italian financial stability. German voters have the chance in the Bundestag elections this September or October to reject this unloving couple. Economic sources of discontent include savers experiencing deeply negative real rates (together with zero or negative nominal rates), would-be homeowners or renters anxious about affordability, and individuals struggling to provide for their old age. And who knows, a US-European trade war could erupt with the catalyst being the huge German trade surplus and the cheap manipulated euro. There would be a host of potential victims.
Even so, it will not be easy for these disaffected voters to topple the status quo immediately given the 7-party confrontation opening up this autumn. The best they can hope for is a stalemate. That could occur if there is sufficient backlash against the “elites” in Berlin and Frankfurt who promised their fellow citizens that they had fully protected them against economic danger in Europe after the Deutsche Mark’s decommission. Indeed it was the leading Bundesbanker (Professor Otmar Issing) that Berlin put into the ECB at the start who formulated a policy framework of permanent inflation (the 2% inflation target) and did not oppose a culture of political correctness where there would be no explicit focus by policymakers on monetary symptoms in the dominant member.
Many German citizens, especially the avid readers of Bild, impugn the worst motives to the ECB, suspecting that Mario Draghi has been mobilizing German savings at severely negative real interest rates toward salvaging Italy’s government and banks. Prominent professors from leading research institutes concur with the view that the ECB is pursuing a radical and ultimately inflationary policy so as to alleviate the debt crisis in Southern Europe
This is the nightmare that the German pioneers of the European Monetary Union, supported ultimately by a non-enthusiastic Bundesbank, said could never happen. And indeed the present Bundesbank chief came to the ECB ’s defense last year against attacks from German politicians (including Finance Minister Schaeuble) and the press regarding the vast transfer of German savings via the ECB into Southern Europe.
Both the ECB and Bundesbank chiefs seem to agree it is an essential condition of monetary union that sometimes Germany must accept inflation-like conditions for the greater good of union-wide stability. (They would deny that rising prices there are symptomatic of euro monetary inflation given their fixation on euro-area averages.) In particular, the argument is that German prices and wages should rise above trend for some time so as to reduce the extent of declines elsewhere as necessary for “re-balancing.”
Signs of Economic Danger — and a Possible Political Backlash
It does not take great vision to see that the signs of euro monetary inflation lie both in the European core (Germany) and more broadly. The latter includes the fantastically low sovereign credit spreads and the giant carry trades which have formed in currencies (out of negative rate euros into foreign currencies), credit (out of low risk credit into high risk), and term premiums (out of short-maturity government bonds into long-maturity).
Any general carry trade unwind amidst global asset market falls would make the German elite including the Christian Democratic Union, Social Democratic Party, and the Bundesbank vulnerable to intensified popular anger in the run-up to the elections. Without such an unwind there would be the alternative hazard of climbing inflation, also anathema to so many German voters, especially in the context of zero or negative nominal interest rates. The strongest vote against the elite is a vote for the anti-euro anti-immigration Alternative for Germany (AfD), or the Left Party. No doubt the mainstream parties will all try to trim their sails to the anti-ECB mood. But who would trust any such trimming given their long contrary record to date?
In considering the outcome of an anti-elite vote in Germany’s markets will probably take seriously the scenario of the Grand Coalition (CDU/Christian Social Union/SDP) losing its overall parliamentary majority; the SDP and AfD could well be in a dead heat for second place (15–20% each of the popular vote) and the Left in a 10–15% range. Then no workable government coalition might be possible, triggering early new elections.
The CDU/CSU, to winning back support from the AfD, could dump Angela Merkel and unite behind a new chancellor candidate who addressed Germans’ grievances regarding monetary union (and of course immigration). Big gains for the CDU/CSU in this second election could mean that it could form a government with partners (perhaps the FDP and the Greens) who would strike a coalition deal which would include seeking a review and clarification of the monetary clauses of the Maastricht Treaty. The aim would be to reverse the “constitutional erosion” of the EMU’s first two decades which have left Germany highly vulnerable to inflation and indirect fiscal transfers.