The battle lines are hardening. More and more eurozone governments are calling for the ECB to loosen monetary policy, for example by directly purchasing government debt in an attempt to bring down borrowing costs and arrest their slide into slump. For its part, the German government and the Bundesbank are calling for the ECB to exit the currently loose strategy, fearing a surge of inflation in Germany. But higher German inflation is the inevitable flipside of a strategy that places the full cost of adjustment on the struggling economies. It is also indispensable if the crisis-hit economies are to rebalance and avoid insolvency. Higher inflation presents formidable political challenges for Germany, but the alternative is a wave of national defaults, culminating in either a fully-fledged transfer union or a collapse of the currency union.
Germany's strategy for dealing with the eurozone - fiscal austerity and internal devaluations across the south of the currency union - can only work if economic activity strengthens (and prices rise) elsewhere in the currency union. The struggling members of the eurozone (a group that is steadily increasing in size) are trying to regain price competitiveness by reducing their costs relative to the rest of the eurozone, and attempting to reduce public indebtedness by pursuing aggressively pro-cyclical fiscal policies. The result has been a collapse of inflation in Greece, Ireland and Portugal and rapidly weakening inflation pressures in Spain and Italy, as they slide into depression.
The ECB targets inflation of ‘close to but under 2 per cent' for the eurozone as a whole. Assuming inflation falls to zero in Spain, Italy and the peripheral trio, and averages around 2 per cent in France and the Benelux trio (it is unlikely to be any stronger given the headwinds facing these economies), it follows that inflation in Germany (plus Austria and Finland) will need to rise to around 4 per cent. The German economy's growth prospects are not as strong as many believe, with the OECD, the European Commission and the IMF forecasting only modest growth over the next few years. However, the IMF estimates that the German economy is running at close to (or even above) capacity. The country's so-called output gap (the difference between the actual output of an economy and the output it could achieve at full capacity) is zero and its trend rate of growth (the rate of expansion consistent with stable inflation) is low.
The current monetary stance is certainly too lose for Germany given these capacity constraints. Assuming that the German economy is not derailed by the slump across much of Europe (an admittedly large assumption), German inflation will start to rise relative to the rest of the eurozone. If the ECB treats Germany like any other eurozone economy, it will hold eurozone interest rates at their current levels (or even cut them) irrespective of the level of German inflation, as long as eurozone inflation as a whole remains on target. After all, the ECB was sanguine about above average Irish or Spanish inflation in the run up to the crisis.
In reality, it is a moot point whether the ECB would allow German inflation to run to 4 per cent. Germany is considered the anchor of the monetary union. Many at the ECB (and not just those from Germany and core countries closely aligned with it) believe that higher inflation in Germany would constitute a loss of price stability, threatening the credibility of the euro. ECB members will also be aware of the threat that higher German inflation could pose to the legitimacy of the euro in Germany. The German government won over sceptical Germans to the euro by promising that the ECB would deliver the same degree of ‘price stability' as the Bundesbank. The Bundesbank and the German government would resent much higher German inflation. A sharp rise in German prices would almost certainly harden German opposition to other reforms of eurozone governance, not least any form of debt mutualisation.
But assuming the ECB does treat Germany like any other eurozone economy, what would happen? Germany could try to tighten fiscal policy further in an attempt to offset the very weak monetary stance. But it is unlikely to be any more successful than the Spanish or the Irish were in nullifying the impact of inappropriately loose monetary policy. Negative real interest rates in Germany would stimulate economic activity in Germany, increase the demand for labour and push-up wages. Higher German prices and wages would help facilitate the necessary adjustments in price competitiveness between the eurozone economies: the peripheral countries would be able to reduce their wage costs relative to German ones without having to cut nominal wages. German costs would rise relative to the rest of the currency union, removing one of the obstacles to a return to economic growth (and debt sustainability) across the south of the eurozone. This is how adjustment takes place within a currency union, and was how Germany managed to engineer such a large real depreciation (or ‘internal' devaluation) in the first place - against a backdrop of robust inflation elsewhere in the currency union. Any attempt to permanently lock-in the competitiveness gains will simply perpetuate the crisis.
In a welcome intervention, the German finance minister, Wolfgang Schaüble, recently argued that German wages should rise more quickly than in the other eurozone economies as this would help the needed rebalancing within the eurozone. But such a recognition has yet to permeate official thinking as a whole, and has not really reached the Bundesbank. There are signs that the Bundesbank accepts that German inflation will need to exceed the eurozone average, but certainly no acknowlegement that the differential needs to be very substantial. The Germans are proud of the ‘competitiveness' eked out within the eurozone. Indeed, they continue to argue that every other member-state can pursue the same strategy as them.
Germany faces a difficult choice: either it accepts higher inflation and risks the German electorate's confidence in the euro, or it paves the way for a wave of defaults culminating in either a fully-fledged transfer union or the collapse of the euro.