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The Eurozone debt crisis has opened space for breaching the established rules, signing new treaties and implementing unorthodox measures.
The European Central Bank (ECB) has contributed to trying to resolve the crisis by purchasing government bonds in the distressed peripheral economies, injecting liquidity into the Eurozone banking system, and announcing ‘to do whatever it takes to save the euro’ in the summer of 2012. Critics of the policy, however, have cited inflation as a major risk; Germany in particular is concerned.
The sources of inflationary fear can be traced to the Weimar Republic, saddled with war reparations, which experienced rising inflation in 1921/22. It culminated in hyperinflation between February and November 1923. The German currency went into freefall and the dollar was worth 4.2 trillion marks, compared to 4.2 marks in 1914. Prices shot up at 1.6% daily between February and April and at 12% daily from July 1923 until the introduction of the Rentenmark.
The middle class mainly suffered from wiped out savings, as the poor had much less to lose and speculators found new ways of making money. Only those holding foreign denominated currency accounts and tangible assets survived.
The Germans believe that targeting low inflation may deliver social and political stability. The Bundesbank, the independent German central bank with a goal to ensure price stability, managed to stabilise increasing inflation, while aiming to prevent a wage price spiral. Maintaining low inflation was an important political means to create trust in the German economy.
By the same token, keeping inflation low was an important tool for the export oriented economy, as it defended the stable exchange rate, which in return boosted export demand. Revaluation of the hard currency, the Deutsche mark, was out of question because it would have increased prices. The central bank recognised the economic benefits brought by low inflation, in a form of a competitive advantage; therefore, the Bundesbank was anxious to do everything possible to keep inflation low. As long as inflation was low, the Bundesbank supported the ideology of mercantilism systematically and consistently until Germany joined the euro.
In 1975, the Bundesbank announced targeting inflation by a numerical target, partially, to inform the public about inflationary trends easier. Following the oil shock of 1979, a target inflation range of ± 1% or 1.5% was defined, and a 2% price assumption over the medium-term was included in the central bank’s calculations in 1984.
Years of pursuing the same policy and informing the German society about inflation have ensured that targeting low inflation, coupled with a stable currency, was the best option suitable for the German economy, which has resulted in developing a culture of low inflation. Moreover, the arguments against high inflation and bringing the Weimar Republic experience into the debate have created a cultural fear of inflation. The rhetoric of disadvantages of increasing inflation was used consciously, with great success.
At the time of signing the Maastricht Treaty in 1992, Germany insisted on building the future independent Eurozone Central Bank (ECB) on the Bundesbank’s model, the model of low inflation. The ECB’s role would be targeting inflation bellow, or close to, 2% over the medium term. Establishing fiscal rules, and targeting inflation, meant giving away sovereignty and tying countries’ hands. Ultimately, it would allow Germany to take advantage brought by low inflation for its exports.
On the one hand, the Eurozone member states would converge and enjoy benefits of low government yields. On the other hand, the objective, for the countries not following inflationary policies, was to change their stance on inflation, particularly once the high inflation countries would see benefits generated by low inflation. In other words, it would transform such countries’ perception and develop a new culture of low inflation at the Eurozone level.
As the debt crisis has evolved, fundamental divergences among the economies within the single currency bloc have been striking. The peripheral economies and the banking system have been supported by the ECB in spite of Germany’s refusal. Berlin has argued that it would infringe the Bank’s independence and could potentially generate inflation in future. However, the countries in need of the Bank’s liquidity do not worry about such arguments but only their own situation. Demands by France, such as investing in European programme designed to stimulate growth, have been rejected on the grounds of generating inflationary pressure, a non-negotiable position for Germany.
Other Eurozone members’ economies, for example Austria’s, are closely tied to the German economy. The new members, Slovakia and Estonia, are another example. Not only have they met the criteria to join the euro, but they also set up their economies and financial services alongside Germany’s in order to facilitate trade.
The fact is Germany needs exports, therefore, it argues that low inflation is the most suitable choice for the Eurozone economy as it delivers stability. The rhetoric of anti-inflationary pressure continues to serve the German national interest, but this time outside its borders, at the Euro area level, whilst the riddled with austerity peripheral economies might benefit from higher inflation. The emphasis on low inflation has taken the lead over the debate of the dissatisfaction caused by austerity in the struggling economies, thus created tension among the Eurozone member states.
The trauma and legacy of the fateful year of 1923 continue to be with the Germans today. Ironically, the country providing leadership in the Eurozone during the debt crisis is at odds with others, but its historic experience is too strong to be ignored and the lessons have made a fundamental impact on the German society, which is difficult to change. Low inflation is an eternal rule. The word ‘inflation’ has become a taboo in Germany and people no longer ask questions about the logic behind it. It could also be argued that fear of increasing inflation has superseded fear of hyperinflation, as no OECD country has experienced it in the recent decades. Nonetheless, the developments in the Eurozone crisis might determine whether the culture of fear of inflation will remain so profound in future.
Germany is a prime example demonstrating that it is possible to learn from its past and discuss its experience 90 later if necessary. However, Germany may have forgotten what role the social instability had played in the change of political regime in its country 80 years ago, as the German authorities have concentrated on the rhetoric of anti-inflationary pressure.
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