Inflation is the trauma of the Germans. Twice in the 20th century, financial assets were devalued and hyperinflation ruined the economic life. The founding myth of the Federal Republic of Germany was therefore not the creation in 1949 of the constitution, or Basic Law, but the currency reform a year earlier. Before that reform, the public mood had hit rock bottom while suicide rates peaked. From 1948, economic development resumed, price stability returned, and social life and the political system got back to normal.
This historical dimension continued to cast its shadow over the early stages of European monetary integration in the late 1980s. The Maastricht Treaty that outlined the independence of the European Central Bank and its mandate primarily to ensure price stability was born out of the German experience and the model of the Bundesbank. Only these guarantees made letting go of the Deutsche-Mark politically feasible.
Many Germans fundamentally misconceive European monetary policy. They believe the ECB to be a new Bundesbank, which delivers reliable monetary policy tailored to German needs. The fact that monetary policy in a monetary union with structurally different economies cannot satisfy everyone has been ignored or suppressed by many Germans. This misunderstanding was not an issue as long as the ECB was able to reliably secure a stable price level without unconventional measures.
The Bundesbank has never experienced the need for unconventional monetary policy measures. Compared to the Fed, the German central bank was a haven of conservatism in monetary policy. Even the admission of Money Market Funds in Germany in 1994 was accompanied by criticism because of possible incentives for short-term actions. Unlike the ECB, the Bundesbank was never required to support economic policy by pursuing a high level of employment and sustainable growth without endangering price stability.
This explains why many Germans condemn the ECB’s unconventional monetary policy. This criticism has quite good reasons, but it goes far beyond the factual framework. The reputational risk for the European Central Bank is widely considered irrelevant. And yet this risk increases the longer the ECB keeps on missing its self-defined goal of price stability.
In 2003, the ECB reviewed its strategy and target: The pursuit of price stability should aim to maintain inflation rates close to 2 percent over the medium term. The idea was to underline the ECB’s commitment to providing a sufficient safety margin to guard against the risks of deflation, with the 2 percent target rate allowing for different rates of inflation within the euro area. German politics, the public and the media tend to dismiss as a mere macroeconomic issue the risk of nominal short-term interest rates at or near zero causing a liquidity trap and limiting the central bank’s capacity to stimulate economic growth. The historical trauma of inflation obscures this problem.
In addition, the ECB is criticized for expropriating savers with its low interest rate policy. In fact, negative real interest rates are not new: They occurred after the oil crisis in the mid-1970s and after German reunification in the early ’90s. The German polemic against the ECB obscures more legitimate concerns. ECB monetary policy has started to resemble the Bank of Japan’s. As a result of ruptured credit bubbles and subsequent banking crises, both central banks are facing stagnating economic growth and price development close to deflation. Large purchasing programs of government bonds, zero interest rates and now even negative nominal interest rates have not brought about normalization so far.
In Japan, the result is a structurally weak economy, in which the transmission of monetary policy to the real economy — in a country where bank lending is the dominant route — has stalled despite massive intervention. The lack of reforms is a serious issue. Europe’s financial system is also bank-based and as such a functioning banking system is similarly essential to the effectiveness of the Continent’s monetary policy. The right response to the banking crisis would have been re-capitalization of the banks and balance sheet adjustments.
In recent years, nearly 80 percent of the systemically important banks of the euro area have had to shrink their lending. This has led to a disintegration of the ECB bank lending channel into 18 national channels — and these channels only work in a few countries, such as Germany. However, for countries with a sound banking system, ECB monetary policy is now too expansionary. It will diminish banks’ interest income and have negative effects on bank lending. Persistent low interest rates are also the result of a strategic game between the ECB and the governments of the debtor countries. If these countries were to enhance their reform efforts, then the ECB could (and would) raise interest rates. In the case of successful reforms, the low interest rate policy would indeed be inflationary. But higher interest rates would complicate government financing, and lower the incentive for reform. The result now is an overall economically inefficient situation of reform deadlock and low interest rates.
While interest costs for France, Italy and Spain have fallen since the beginning of the ECB’s quantitative easing program, their total government deficits and especially their structural budget deficits have increased. Reforms in the banking sector have so far largely failed to materialize. Non-performing loans in the euro area have increased steadily since the crisis began. They still amount to more than €800 billion. Italy’s announcement to set up a “bad bank” is certainly a necessary step forward, but it is far too late.
The governments of euro countries overburden monetary policy with their failure to reform. All this harms the ECB’s reputation and destabilizes the euro. Postponed reforms threaten to forge economic structures in the euro area as stale as Japan’s, while leading to even greater disintegration. EU countries should not be passing the buck to the ECB — responsibility rests with the governments. The ECB, meanwhile, should phase out unconventional policy in a slow, controlled way that includes proper communication to avoid a capital market shock.
The article on politico.eu