Christine Lagarde is taking a big economic risk by doubling down on stimulus when the eurozone money supply is already exploding at rates unseen since the launch of the euro. She is taking an even bigger political risk in doing so after Germany’s top court ruled that the European Central Bank abused its power in earlier bond purchases, straying from monetary management into broad economic policymaking without a treaty mandate.
Radical monetary policies are disturbing long-established relationships within German society, whatever the theoretical justification – less scientific than Frankfurt pretends.
“The ECB has no legal or democratic mandate for what it is doing, and it is giving the false impression that there is a free lunch,” said Thomas Mayer, Deutsche Bank’s ex-chief economist. “We are heading for a constitutional crisis in the European Union and there are no means for diffusing it. The euro is simply not viable and the next couple of years are going to determine whether it all breaks apart. The markets don’t understand what is happening,” he said.
“We could be heading for 1970s inflation. The ECB is creating all this money but at the same time the supply side of the economy is being constrained (by deglobalisation). If the German people wake up to 5pc inflation when this is over, they’ll conclude that the euro is out of control.”
Prof Mayer is author of Europe’s Unfinished Currency and a fellow at the Centre for Financial Studies in Frankfurt. His critique has hardened since his days as “Mr Euro” at Goldman Sachs in London. The ECB’s founding father, Otmar Issing, has reached similar conclusions, warning that the project has been fatally subverted by malpractice.
Prof Mayer says there is no consensus for treaty changes to permit debt pooling or fiscal transfers, so EU bodies are instead “bending the law” in order to hold the euro together. This has run smack into the Verfassungsgericht in Karlsruhe.
“The pro-euro economists are now trying to discredit the court because they have nothing else left. They say the judges don’t understand economics. It is shocking,” he said.
Prof Volker Wieland, a member of the five-man Council of Economic Experts, said it was a mistake for the ECB to expand pandemic quantitative easing when economies are bottoming out. “In a currency union of fiscally sovereign states, it cannot be the job of central bankers to rescue individual states and redistribute money,” he said.
The ECB may be right that a deflation spiral is the greater risk – and implicitly that inflation is part of the cure for Club Med debt dynamics – but it is in uncharted waters and economic opinion differs widely. Mrs Lagarde has no political margin for error.
The Verfassungsgericht ruled that the ECB had “manifestly” breached the principle of proportionality with mass bond purchases. The Bundesbank will be prohibited from taking part in QE operations from August onwards unless the ECB can meet the court’s objections. Markets are bravely assuming that politicians will not allow this to happen.
Every feature that the court disliked about the original QE scheme is pushed further in the €1.35 trillion (£1.2 trillion) pandemic scheme. It is open-ended and therefore increases fiscal risk, eroding the budgetary powers of the German parliament and violating the Grundgesetz.
The liabilities are real. The Bundesbank has extended almost €1 trillion of “credits” to Club Med peers – above all the Bank of Italy – through the ECB’s Target 2 payments network. Large losses will be crystallised whether the euro holds together or fails.
Hans Werner Sinn, ex-head of the IFO Institute, says Italy is insolvent. Covid-19 will push the debt ratio to 160pc of GDP this year. He proposes an international forum in 2022 to forgive part of Italy’s debt – akin to the London conference in 1954 resolving Europe’s post-War debts. Such a settlement could cost German taxpayers €150bn. “The Bundesbank would have to be recapitalised by the German state,” he told Die Zeit.
Under pandemic QE, bonds purchases deviate from the capital key (GDP share) and are therefore skewed towards Club Med. “There is no exit strategy. The ECB is not paying the slightest regard to court ruling,” said Prof Gunnar Beck, a lawyer for the plaintiffs and a Euro-MP for the anti-euro AfD party.
Prof Beck said the immediate crisis will be defused by an EU fudge. The German court will go along with it. “These judges don’t want to be seen as gravediggers of the eurozone project,” he said.
Yet the long fuse is lit. Plaintiffs may push for an injunction to tie the hands of the Bundesbank. There will be a fresh case against the new PEPP scheme. The next ruling may pull the plug altogether.
Mrs Lagarde said the ECB is accountable to the European Court – not the German court – and that EU law has primacy. This evades the issue. The Verfassungsgericht ruled that Euro-judges are themselves exceeding their powers – ultra vires, no less – and are making up the law as they go along in an “incomprehensible” fashion.
It declared that member countries are the “Masters of the Treaties” and that the EU is not a unitary state. Karlsruhe has never accepted the European Court’s claim to primacy and it cannot be found in the Treaties.
The backlash against the ECB’s latest move has so far been muted in Germany because key figures in the Left-Right coalition are content to let central bankers save EMU. But this quiescence is misleading. German taxpayers suspect that they are being taken for a ride. Resentment is festering.
Prof Thorsten Polleit from Bayreuth University said the combined fiscal deficits of the eurozone this year will be around €1.4 trillion, roughly the sum that the ECB plans to buy. “The ECB is simply financing budgets with the electronic printing press. This is a massive monetary expansion,” he said.
The Institute of International Monetary Research says “broad” M3 money has been growing at a 19pc rate over the last three months (annualised) and will rise further “The Germans wanted to be good Europeans and bequeathed the Bundesbank to monetary union. But now they are being outvoted by countries abusing the system. It is a Frankenstein monster,” he said.
Pandemic QE is different from post-Lehman QE. Banks were crippled after 2008 and drastic central bank stimulus was needed to offset monetary contraction. This time M3 is turbocharged. Monetarists say it will catch fire as Covid-19 recedes and “velocity” returns to normal.
Prof Polleit said the ECB is walking in the steps of the German Reichsbank in the early Twenties. “We’re not heading for hyperinflation of course but in some ways it is similar. The Reichsbank started buying a little, and then a bit more, until they realised that it was out of control,” he said.
Weimar inflation was a diabolic disturbance of the settled social order. Speculators made fortunes overnight. Diligent law-abiding citizens were pauperised, losing their bank savings and paper securities. The sense of injustice drained the Weimar Republic of its legitimacy.
While Weimar inflation stemmed from the upheavals of the First World War, Germany did succeed in stabilising the mark and controlling prices for a while. The rot set in when the Reichsbank stepped up money creation to cover falling tax revenues.
Inflation spiralled higher in early 1923 after French troops occupied the Ruhr to extract war reparations. Germans stayed at home under a policy of passive resistance, a form of lockdown. Printed money covered the shortfall.
A jump in inflation to 5pc today would be less dramatic but it would nevertheless be corrosive. Home ownership rates in Germany are the lowest of the big OECD states. Half live in rented property – the working class – and few have much financial wealth beyond bank savings. An inflationary bubble would impoverish them, while enriching others. It is a formula for a Trumpian turn in German politics.
Oxford professor Richard Werner said the euro has become a doomsday machine. “In the end it destabilises every country in one way or another. It will be Germany’s turn next,” he said.
One thing is beyond doubt, the monetary union cannot last for long without the political consent of the great Deutsche Volk.