The cornered tiger of eurozone monetary policy

Mario Draghi delivered a positive surprise to the markets with a 25 basis points interest rate cut in his first significant decision at the helm of the European Central Bank (ECB), displaying he will be much more market-friendly in his approach than his predecessor, Jean-Claude Trichet.

During a press conference held after the Nov. 3 decision, he was strikingly pragmatic - something that reflected his American investment bank background for many analysts.

However, as Dario Perkins from Lombard Street Research points out in a recent analysis, such an easy-going tone is expected to create more strains between the mighty Bundesbank and the ECB. The historic relation between the two increasingly resembles Mary Shelley’s Frankenstein. The ECB was mainly designed by Germany’s Otmar Issing and its rigid anti-inflationary stance has been a key component of the eurozone central bank since its inception. This stance remained in place even during the first phase of the global financial crisis: as the Federal Reserve, the Bank of Japan and many others pulled down interest rates to near-zero, the ECB stubbornly kept its refinancing rate at 1.5 percent.

However, the eurozone debt crisis has changed everything and the new period characterized by lower interest rates and more importantly, government bond purchases (which have reached a cumulative 180 billion euros) seems to have found its governor in Draghi.

However, the ECB practically backstopping government debt has already created enormous strain, as seen in the resignations of Jurgen Stark and Axel Weber. And history shows that efforts to undermine the Bundesbank’s control over monetary policy have resulted in significant damage to international and inter-European financial order. Here are some reminders:

- In May 1971, the inflation-wary West Germany was the first country to leave the Bretton Woods system, as it was unwilling to continue supporting the U.S. dollar by deflating the Deutsche Mark. The shock move laid the ground for the United States terminating convertibility of the greenback to gold on Aug. 15 the same year, killing the Bretton Woods system.

- In October 1987, the Bundesbank increased short-term interest rates from 3.60 to 3.85 percent due to inflation fears, effectively destroying the Louvre Accord of February 1987 between West Germany, France, U.S., Britain, Canada and Japan. The accord aimed to stop the depreciation of the dollar and achieve currency price stability among industrialized economies. The Bundesbank move triggered other rate hikes in the U.S., Japan and Britain. The shock waves pushed the 30-year U.S. Treasury bond yield to 10.25 percent while stock markets plummeted.

- In 1992, the Bundesbank drove interest rates to record high levels, publicly announcing it had to act against inflationary pressures stemming from reunification. This policy forced Britain to leave the Exchange Rate Mechanism (ERM). According to Jeremy Leaman, author of “The Bundesbank Myth,” what the Germans really wanted was to “stall or even to hinder the realization of European monetary union and the loss of its policy dominance.” (The Guardian, Feb. 11, 2005)

All three episodes vividly display the highly political nature of monetary policies, while also underlining the national interest currents that lie beneath the smiling face of “European integration.”

The lesson here is clear: Do not underestimate the Bundesbank’s creativity!