The Bundesbank against the World

German Central Bank Opposes Euro Strategy

By Christian Reiermann, Michael Sauga and Anne Seith

The European Central Bank plans to resume buying the bonds of crisis-hit countries on a large scale. Jens Weidmann, head of the German central bank, is firmly opposed to the idea, arguing that it will lead to inflation and lessen pressure on governments to carry out reforms. But he is becoming increasingly isolated within the ECB and in the political world.

Volker Bouffier has always portrayed himself as the last true conservative in Germany's center-right Christian Democratic Union (CDU). Bouffier is the governor of Hesse, the western German state where Germany's financial capital Frankfurt is located, and is known for raging against gay marriage, multiculturalism and school reforms. On questions of monetary policy, he has always been a champion of traditional German virtues. "The European Central Bank cannot become an institution that compensates for the failures of individual government budgets, such as Italy's," he said recently. "That isn't part of its mandate."

But on Monday of last week, Bouffier seemed to be a changed man. He had invited Jens Weidmann, 44, president of the German central bank, the Bundesbank, to a meeting at the Hesse state chancellery. For weeks, Weidmann had sharply opposed the ECB's plans to buy up large quantities of Italian and Spanish sovereign debt. In the meeting with Bouffier and his cabinet, Weidmann had just reiterated his position in the ongoing dispute with ECB President Mario Draghi when Bouffier, to the surprise of everyone in attendance, announced his new priorities. Apparently, the values of Southern European bonds on the balance sheets of Frankfurt banks are now more important than his conservative values.

Of course he still supported stable prices, Bouffier said, but noted that the mood in financial markets had become extremely fragile. And despite his characterization of the ECB's debt-buying plans as sinful, he said that there were no longer any alternatives to massive intervention by the central bank. "The political tools have been exhausted," Bouffier said.

The Bundesbank president is becoming increasingly isolated, and not just in provincial German politics.

'Addictive Like a Drug'

A powerful phalanx of key statesmen, from US President Barack Obama to French President François Hollande and British Prime Minister David Cameron, have long called upon Weidmann to finally abandon his resistance to the increased use of the ECB's "big bazooka." Now even some of Weidmann's former allies are turning their backs on him. Recently, Germany's powerful private banks have come out in support of Draghi, as have Weidmann's fellow ECB Governing Council member Jörg Asmussen and a majority of monetary policy experts in Northern Europe.

The head of the Bundesbank has now decided that the best form of defense is attack. In an interview with SPIEGEL, Weidmann explained why he believes the approach taken by European leaders is wrong. "We shouldn't underestimate the danger that central bank financing can become addictive like a drug," he says.

Of course, Bundesbank opposition is not expected to stand in the way of the Draghi plan. The EU treaties are being violated once again. Two years ago, during the course of the Greek crisis, European governments suspended the principle that no member of the euro zone could guarantee the debts of another member state. Now a similarly fundamental principle is up for renegotiation: the prohibition on national budgets being financed with the help of the ECB.

The risks are considerable. If Draghi's proposal prevails, Europe's central bankers could lose control over the money supply in the medium term, which in turn could lead to substantial inflation. Southern European governments could misinterpret this as a signal that they can obtain cheap money without instituting painful reforms after all. German taxpayers would be saddled with additional billions in risk without having any say in the matter.

Feelings of Desperation

But those European politicians who are determined to rescue the euro have been ignoring democratic principles for a long time. They are feeling desperate because, after 17 monetary summits, they still haven't been able to stop the crisis. And now they are pleased to see Draghi doing the work for them.

The purchase of government bonds sounds technical and harmless, and yet the weapon with which Europe's top monetary policy experts are now going into battle is essentially no different from the euro bonds that German Chancellor Angela Merkel famously said she will oppose as long as she lives. Not surprisingly, Merkel's take on the Draghi proposal is characterized by her typical doublespeak. At home, her advisers insist that it's a good thing that someone is upholding the principles of the Bundesbank. In Brussels, on the other hand, Merkel indicates that the Draghi plan enjoys her full support.

But the two positions will in reality be incompatible if the euro crisis continues to escalate. Weidmann wants the monetary union to be able to force crisis-ridden countries to withdraw from the euro zone if there is no other way to ensure monetary stability. Merkel, on the other hand, wants to preserve the monetary union at all costs, even if this means inflation and financial crashes.

Now Weidmann is even losing the chancellor as an ally, even though he served as Merkel's economic adviser for five years.

The Talking Paperclip

When Merkel appeared before the press at financial summits or to discuss monetary issues, Weidmann, as her adviser, always stood in the background, a thin, youthful-looking man with his brown briefcase wedged under his arm. As an adviser, he was exactly what she wanted: quick-witted, discreet and loyal to the point of self-denial.

Weidmann, who holds a doctorate in economics, spoke only when he was asked. And when he did state his position at length in off-the-record conversations, he had no trouble coming up with even more tedious wording than his boss. Journalists nicknamed him the "talking paperclip."

Given his nature and reputation, observers were convinced that Weidmann would prove to be even more flexible in his new position than his predecessors. Previous Bundesbank chief Axel Weber, for example, had resigned over his opposition to bond purchases, and ECB chief economist Jürgen Stark followed suit shortly after Weidmann came into office.

It was all the more surprising that the new Bundesbank president was soon openly championing Germany's positions even more staunchly than his predecessors. Whereas Weber and Stark tended to keep their criticism to themselves, Weidmann, in speeches, op-ed pieces and interviews, warned of the dangers of a misguided euro crisis policy. He was regularly outvoted in the ECB's Governing Council. Nevertheless, ECB President Draghi soon realized that it would be foolish to ignore Weidmann's most powerful weapon: the deep-seated and well-founded mistrust that always takes hold in the population when politicians push for banks to start printing money.

When Draghi talked of a possible new bond buying program a few weeks ago, Weidmann's resistance was to be predicted. In light of rising interest rates for Spanish and Italian bonds, Draghi felt the need to send a strong signal to the markets. Without consulting with his colleagues on the ECB Governing Council first, he announced, during a speech in London at the end of July, that the ECB would do everything in its power to save the euro. "And believe me, it will be enough," he added cheerfully.

Buying Time

Draghi explained his plans in more detail soon afterwards. Unlike earlier cases, he said, the bond purchases would be tied to conditions. Only those countries that had applied for assistance from the European bailout fund and were prepared to commit to reforms could expect assistance.

This was Draghi's way of accommodating his critics, to the delight of the government in Berlin. According to government insiders in Berlin, Merkel and German Finance Minister Wolfgang Schäuble characterized the Italian economist's plan as "important and valuable" and felt that Draghi's announcement alone had already had an effect. Indeed, since Draghi's London speech the risk premiums on Spanish and Italian government bonds have declined considerably.

With his strategy, the ECB chief is mainly buying time. Members of Merkel's and Schäuble's staffs appear to accept Weidmann's notorious opposition to Draghi with a shrug. At the Chancellery, where the young Bundesbank president used to work, there has even been malicious talk of "fundamentalists." In the Finance Ministry, too, Weidmann is increasingly regarded as a troublemaker. "Some people interpret the ECB's mandate more narrowly. Others interpret it a bit more broadly," says a senior Finance Ministry official, with a trace of fatalism in his voice.

Privately, Chancellor Merkel also has little sympathy for the intransigence of her former adviser. Merkel apparently feels that Weidmann and his staff shouldn't be making such a fuss.

It's a classic conflict over a cheap money policy. The government wants to use the medicine as quickly as possible, because it's easy to get. The Bundesbank, on the other hand, sees the risks and side effects and warns against writing the prescription in the first place. From the Bundesbank's perspective, the most important objective of a central bank is to maintain price stability. By buying up government bonds to force down their yields, they are intervening in fiscal policy, a classic role of government.

Fatal Consequences

The consequences can be fatal. With its bond purchases, the ECB is flooding the markets with money. If it doesn't claw back the money elsewhere, it continues to inflate the money supply. Experience and theory have shown that the injection of funds into the markets could eventually lead to rising prices -- in other words, inflation, which central bankers are required by law to prevent.

Weidmann also suspects that the ECB indirectly contributes to funding the national budgets of crisis-ridden countries, which it is prohibited from doing under the European Union treaties. Although the ECB is not lending money directly to governments, its policy "is too close to state financing via the money press for me," says Weidmann. With his comment, he is articulating the fear that the crisis-hit countries will exploit the bond-buying program to constantly issue new debt.

In addition, the bond buying reduces pressure on governments to institute reforms. That's something that the ECB's bankers learned a year ago, when they bought large numbers of Italian government bonds, only to look on as the government of then Prime Minister Silvio Berlusconi promptly put its reform efforts on ice.

To prevent this, Draghi now wants to ensure that future bond purchases are subject to strict conditions. But this makes the ECB even more dependent on the political world, because it prevents it from intervening in the future when it sees fit. Instead, it will have to wait until politicians have created the necessary preconditions.

This raises new questions. For instance, will the ECB even have the option of refusing assistance? And how will it justify buying one country's bonds at an interest rate of 7 percent while it buys those of another at just 5 percent?

Euro Bonds Through the Back Door

Schäuble's experts have recognized the threat to the central bank's independence, and are searching for solutions. They believe that it's perfectly conceivable that Italy or Spain will not have to commit themselves to reforms under the auspices of the euro-zone bailout fund in the future, but will merely make a voluntary commitment to the European Commission. The advantage of this approach is that the ECB's actions would not be dependent on decisions by the euro-zone finance ministers. The drawback is that a voluntary commitment would not be as binding as a program that formed part of a bailout agreement.

Whatever form the ECB actions take, the bond purchases are nothing but a back-door way of sharing risk. While Merkel refuses to enter into a liability union through jointly guaranteed euro bonds, she has nothing against the ECB handling this task. All members of the monetary union are liable, in proportion to their shares of ECB capital, for the risks the central bank accumulates by buying the bonds of ailing countries. Not surprisingly, Sigmar Gabriel, chairman of Germany's opposition center-left Social Democratic Party (SPD), accuses European politicians of using alternative means to introduce euro bonds.

Sobering Track Record

Economists and investors also doubt that Draghi's new program will produce the anticipated relief in the long term. The track record to date is sobering. Between May 2010 and early 2012, the ECB intervened in the so-called secondary markets, where bonds are traded after being issued, buying a total of €211 billion in Greek, Italian and Spanish sovereign debt. Its actions brought a brief respite for the ailing countries at the time, but risk premiums soon shot up again.

The new program could be similarly ineffective, warns Clemens Fuest, an Oxford-based economist who advises the Merkel administration. "If investors are convinced that a country is bankrupt, not even an intervention by the central bank would change this," he says.

Andrew Bosomworth, managing director of the German office of Pimco, the world's largest investor in government bonds, fears that the new program will mainly attract speculators rather than long-term lenders. "If interest rates for a particular country go up, they (the speculators) will bet on an ECB intervention," he says. "Investors oriented toward sustainability will not return until their confidence in the euro-zone project has been renewed." In other words, a measure designed to hinder speculators could in fact be a boon to them.

Experts warn that, in the end, the debt-ridden countries' creditors would simply offload large portions of their bond holdings to the ECB, without the affected countries being helped in the long term.

In a worst case scenario, the debtor countries could see their economies continue to shrink while poor-quality bonds, whose value is no longer linked to the real economy, pile up on the ECB's balance sheet. The possible consequences are well known from monetary history: inflation, currency reform and assets losing value.

Some Good News

According to some critics, the new ECB program is not even necessary, because key economic indicators are already improving in the crisis-ridden countries.

There is something to this. Economic imbalances in the euro zone have been reduced considerably. The current account deficits of all crisis-ridden countries are shrinking, although this news should still be viewed with caution. Ireland is already showing a surplus, which could approach the level of the German surplus in the next few years. Italy and Spain are about to balance their current accounts. Greece has cut its current account deficit by almost two-thirds.

Unit labor costs, an important barometer of a country's competitiveness, are declining in all countries except Italy, and exports are growing as a result. All of the crisis-hit countries have managed to increase exports in the last two years.

Fiscal policy indicators are also improving, now that austerity measures are taking effect. Italian Prime Minister Mario Monti plans to balance his budget next year, which would put the country on a similar level as Germany. Portugal has cut its budget deficit in half, and Spanish Prime Minister Mariano Rajoy is also making headway. The situation is easing noticeably in Ireland, so much so that the government was recently able to borrow money again on international financial markets.

Optimists say that the good news from the other countries will also have an effect on the market sooner or later. Confidence in the euro zone will then return, and countries, with the possible exception of Greece, will be able to obtain funding without being dependent on the help of the bailout funds. The condition, however, is that reform efforts continue and are not prematurely terminated -- for example because of bond buying that is theoretically supposed to ease the burden on those countries.

Shopping Without Limits

The debates on the details of the program that Europe's monetary watchdogs are currently engaged in show how great the risks are. Representatives from the south would prefer it if the ECB went shopping for bonds on the secondary markets without any limits. One idea is to establish general upper limits for interest rates on government bonds, or to artificially limit the spread between the bonds of crisis-hit countries and, say, Germany.

Central bankers from the north, however, only want to buy bonds on the markets in extreme situations, in short but energetic campaigns, such as when interest rates suddenly shoot up as they did in the week before Draghi's London announcement. Another idea that has recently been circulated is to pre-announce certain intervals for interventions by the ECB, such as for days when countries issue new bonds.

Which camp will ultimately prevail is still unclear. The proposals by the relevant task forces will be discussed in the ECB Governing Council for the first time in early September, at which point other council members will try to persuade Weidmann once again.

His fellow council members are reacting sharply to Weidmann's fundamental opposition. There is talk of a power struggle within the ECB that ignores the effects on the central bank's reputation. "We must speak to the outside world with one voice," one official says emphatically. The central bankers are faced with a dilemma: They need the confidence of investors to make their crisis management work. But ongoing criticism from within their ranks is partly responsible for the miserable results of the first bond-buying program, say central bankers.

But Germany's chief monetary watchdog refuses to defer to this logic. Weidmann believes that any purchase program is wrong, and he will not let anyone persuade him otherwise -- neither his fellow board members nor the chancellor.

Temporary Truce

Merkel and Weidmann have talked a lot in recent weeks, sometimes by telephone and sometimes in private at the Chancellery in Berlin. As a result, they have reached a sort of temporary truce.

Weidmann, who doesn't see himself as being isolated, will continue to openly voice his criticism of the Draghi program, but he will not torpedo the effort for the time being. He will implement the ECB decisions and will not file a complaint with the European Court of Justice. In return, Merkel will show an understanding for Weidmann's positions, but she will not support them.

It's a stalemate that benefits both Weidmann and Merkel. Weidmann doesn't want to overdo the conflict, given his ambitions to eventually head the ECB himself. Merkel, on the other hand, has no interest in having a fundamental dispute with the Bundesbank. As a minister in the cabinet of former Chancellor Helmut Kohl, she realized that it didn't pay off for members of the government to tangle with the central bank. When then Finance Minister Theo Waigel wanted to have the Bundesbank's gold revalued in 1997, he faced a storm of protest in the media and was forced to drop the idea.

Merkel knows that many members of the ruling coalition parties are more likely to support Weidmann than her today. "It isn't helpful to add to the problems by printing new money in Frankfurt," warns Rainer Brüderle, the floor leader of the pro-business Free Democratic Party (FDP), the junior partner in Merkel's coalition government. Bavarian Governor Horst Seehofer, leader of the CDU's Bavarian sister party, the Christian Social Union (CSU), believes that it is "fatal to keep buying up new bonds from indebted countries." CDU economic expert Michael Fuchs supports Weidmann "wholeheartedly," saying the ECB cannot become a money press.

Draghi's plan doesn't just upset the traditional division of tasks between fiscal and monetary policy; it also puts a strain on the relationship between the head of the Bundesbank and the chancellor. The conflict is manageable, as long as the euro crisis doesn't escalate and no ECB interventions are necessary. But if the central bank were to buy Southern European sovereign debt for hundreds of billions of euros once again, the truce would quickly end.

To retain his credibility, Weidmann would eventually have to oppose the program. Then Merkel would drop him -- just as she drops everyone who gets in her way.