Weimar Mania!

The Return of German Inflation and Its Implications

German inflation is back. At the end of September the Federal Statistics Office, the Statistisches Bundesamt, said that they expected inflation to be clocking in at 4.1% in September. The chart below shows just how much of a change that is from the very low inflation regime that Germany typically experiences.

The Germans are not going to like this. There is no people in Europe - and probably on the planet - more inflationphobic than the Germans. The German central bank, the Bundesbank, is infmaour for being staffed with inflation hawks. Indeed, the Bundesbank is one of the few remaining central banks that keeps a close eye on money supply metrics - a sure sign that the zealously anti-inflationary monetarist doctrine still has legs in Frankfurt.

The roots of Germany’s inflationphobia are hard to entangle. But the lore in Germany centers on the Weimar period of hyperinflation which, German economists are eager to tell you, was behind the rise of the National Socialists and the destruction of the country. Needless to say, this signals that the Germans see the threat of inflation in historical terms and cannot disentangle it from thorny issues around national identity.

The German inflationary upsurge looks, like many across the world, to not be a transient phenomenon. Today Bloomberg reports that supply shortages threaten German industries. As early as May, labour shortages were hitting the German service sector; by late August, this shortage had spread to skilled sectors.

Why should non-Germans care? Simply because the Bundesbank plays a huge role in how the European Central Bank (ECB) sees itself and how it formulates policy.

Prior to the European sovereign debt crisis of 2011, the Bundesbank was arguably the most powerful player in the ECB - and this was refelcted in their hawkish monetary policy and their unwillingness to lend to sovereign states with poor finances. But since then, as monetary easing has become the norm and bailouts of European sovereigns has been widely accepted, the Bundesbank have taken a back seat.

Neither the bank nor the German people are happy about this state of affairs. On its face, the Bundesbank defends the ECB, but everyone knows in private there are tensions. These become visible from time to time - such as when a report leaked in 2013 criticising the ECB for its bond purchse programs. In 2019, the head of the Bundesbank had to apologise to the head of the ECB after he criticised an ECB stimulus package.

The German people and their representatives are less cautious. In 2020, after a long legal battle waged by German right-wingers the German Constitutional Court ruled that the ECB’s bond buying program, the Public Sector Purchase Programme (PSPP), launched in 2015, violated the German constitution. The Bundesbank actually had to step in - jaws clenched, one would imagine - and play mediator to iron things out.

The problem, however, is that the German court ruling was probably a correct legal interpretation. The ruling was complex and multifaceted, but the key point of the Court was that the ECB’s monetary policy was tightly defined as being geared toward stabilising inflation and maximising employment. If the tools of monetary policy were used for other ends, especially for political ends - such as to bail out an impoverished sovereign - then the ECB would be wielding these tools illegally. Here is the key passage from the ruling:

A programme for the purchase of government bonds only satisfies the principle of proportionality if it constitutes a suitable and necessary means for achieving the aim pursued; the principle of proportionality requires that the programme’s monetary policy objective and the economic policy effects be identified, weighed and balanced against one another. Where a programme’s monetary policy objective is pursued unconditionally and its economic policy effects are ignored, it manifestly disregards the principle of proportionality enshrined in Article 5(1) second sentence and Article 5(4) of the Treaty on European Union.

Since then, ECB monetary policy has become increasingly - and increasingly obviously - politicised. During the pandemic, under Christine Legarde - a politician, take note - the ECB started setting policy targets based on a variety of ‘social’ criteria, mostly related to environmentalism. Think of this what you will, it seems to go against the letter and spirit of European law.

As inflation takes hold in Germany, expect this to give a much stronger hand to the inflation hawks at the Bundesbank. Rightly or wrongly - in my opinion, wrongly - they will likely blame the inflation on overeasy monetary and fiscal policies. Since the other side will have no real counterargument, this will likely then become the dominant narrative.

In the meantime, the right-wingers are currently pursuing cases against the recent bond-buying by the ECB - attacking it as a “blatant case of government financing”.

German inflation looks set to put the current crop of ECB policymakers in the crosshairs. If inflation starts to rage in Europe, these policymakers will be arguing from a position of extreme weakness. At that point, a Bundesbank takeover of the ECB - at least in spirit - seems likely.

Saying that this will create political tensions seems like a vast understatement. The pandemic and the government responses to it have led to an enormous rise in government borrowing across the world, and Europe is no exception. The EU’s debt-to-GDP ratio rose from 77.5% at the end of 2019 to 90.7% at the end of 2020 - the highest it has been since statistics started.

Expect this to become a political hot potato as attention shifts from the pandemic. Expect it to become a political weapons if the Germans launch a succesful offensive on the ECB.