The Hollow Euro Specter of Inflation Haunts Europe

If Europe's single currency is really to be saved, fundamental reforms have to follow the emergency bailout by euro-zone members. The biggest danger comes, however, from the European Central Bank, which has given up its role as the protector of price stability. The risk of inflation is increasing. By SPIEGEL staff.
A Hungarian money changer corrects the sale price of foreign currencies in Budapest: The euro zone is running the risk of inflation.

A Hungarian money changer corrects the sale price of foreign currencies in Budapest: The euro zone is running the risk of inflation.

Foto: Bela Szandelszky/ AP

It's Friday morning, the day after Ascension Day, which is a public holiday in Germany, and most people in the country are taking the day off to enjoy a long weekend. On top of that, it's raining in Munich, making this an ideal morning to sleep in late. But the premises are already jam-packed at Pro Aurum, a private trading house for gold and other precious metals. Business has been booming for a week now.

Clients receive coffee and newspapers to make their wait more pleasant. They all want to buy gold bars or coins, Canadian Maple Leafs, Australian Kangaroo Nuggets and Austrian Vienna Philharmonic coins -- anything, as long as it's made of gold and will retain its value.

Pro Aurum boss Robert Hartmann and his 45 employees at the Munich headquarters have barely been able to handle the rush. Hartmann even had to temporarily shut down Pro Aurum's online shop. "We are all working to the hilt," he says.

Hartmann has experienced a similar run in the past -- in September 2008, when the investment bank Lehman Brothers went bankrupt. This time, however, as a result of the euro crisis , even people who previously paid no attention to precious metals are taking an interest in gold, he notes. Many feel very unsettled, some are even "slightly panicky," he says.

Gold Endures

Pro Aurum's clients are taking refuge in a form of currency that people have trusted through the ages. The Reich mark, the East German mark, the German mark, the euro: Paper currencies may come and go, but gold endures. Or so they tell themselves, studiously ignoring the fact that the value of gold can also fluctuate enormously.

The precious metal has never been so coveted. Within a year, the price has soared by one-third, and over the past few weeks it has climbed from one record to the next. The price of gold hit a new high in euros on Monday, trading at over €1,000 a troy ounce. Meanwhile the euro also fell to a new four-year low against the dollar, slumping to around $1.23.

The price of gold is an indicator of people's lack of trust in their currency. And these doubts about the stability of the euro increases virtually every day -- despite, or perhaps precisely because of, the recent spectacular bailout  of the European common currency system.

The €750 billion ($950 billion) rescue package has calmed financial markets, at least for the time being. Stock markets have recovered and risk premiums on government bonds from the southern euro states have declined.

Birth of a New EU

Still, the price for this bailout is high -- possibly too high. The events on that dramatic weekend in Brussels marked the birth of a gigantic European transfer union, where previously unthinkable sums of money are made available to rescue southern euro-zone members. But over and above that, a number of determined politicians under the leadership of French President Nicolas Sarkozy have managed to undermine the independence of the European Central Bank (ECB).

Ever since the launch of the euro over 11 years ago, the French have been annoyed that the common currency generally adheres to German principles. While the French central bank is traditionally viewed as an executive organ of government growth and employment policies, the European Central Bank is politically independent and exclusively committed to the goal of achieving price stability, just like the Bundesbank in postwar West Germany.

Over the past few years, Paris has repeatedly tried to bring the European monetary authority to heel. French government representatives complained at times about interest rates that they felt were too high. At other times, they called for a devaluation of the euro to boost their own exports. Their requests were never granted. Until recently, the ECB enjoyed a reputation for combating inflation even more resolutely than the legendary guardians of the German mark.

All of that has changed since last week. Under the mounting pressure of waves of speculation against the euro, German Chancellor Angela Merkel has allowed herself to be talked into a bailout package that is nothing less than a general overhaul of the monetary union according to the agenda set by the French. In addition to letting the European Commission use the central bank to achieve its own aims, the Germans have accepted the fact that several monetary policy principles are being cast by the wayside. The central bankers are making their printing presses available to finance government loans. They have accepted that European countries are liable for the debts of individual states. They are putting more money in circulation, even though there is already so much liquidity on the markets that a number of experts anticipate that this will soon trigger a rise in inflation.

Now the guardians of the euro are purchasing government bonds from troubled countries like Greece, Spain and Ireland -- thereby breaking a taboo that the ECB has always tried to respect. The central bank, which has always prided itself on its independence, has capitulated to the wishes of the politicians.

Gigantic Wave of Debt

There is a growing fear that a gigantic wave of debt will soon roll over Europe and the euro-zone countries will deal with it as elegantly and unscrupulously as they have so often done in the past -- by allowing inflation to reduce their debts. These concerns are shared by more than just the notorious paper money skeptics who predict the return of hyperinflation.

Even serious experts like Joachim Fels, a top economist at Morgan Stanley, have no qualms about addressing the likelihood of such a development. Although it is an extreme scenario, says Fels, it certainly cannot be dismissed out of hand. At the very least, the central bank can apparently "no longer resist the temptation to use inflation to reduce the mounting public debt."

Max Otte, a professor from the German city of Worms who foresaw the crash of the financial markets before others, sees the supposed stability union as already being well on the road towards becoming an inflation union. According to Otte's calculations, annual price increases of roughly 7 percent would be enough to reduce assets by one-half in just under 10 years. "We are eroding the euro from within," says the economist, "all the signs point towards inflation."

New Positions

If the German government has its way, Bundesbank President Axel Weber will be tasked with preventing the worst, as the successor to the current ECB president, Jean-Claude Trichet , who is due to retire next year. For the past few months, Merkel has been lobbying heads of state and government in Europe to pave the way for the German's career jump. A week ago Sunday, Weber sided with the ECB's chief economist, Jürgen Stark, and the president of the Dutch Central Bank, Nout Wellink, by voting against the purchase of government bonds from heavily indebted euro countries -- but then had to defer to the majority.

Merkel appears confident that her plans will go through. After all, she has already arranged for Stark to become Weber's successor as the new president of the Bundesbank. She recently asked Stark about the position and he agreed.

Should Merkel actually manage to push through her candidates next year, the ECB and the largest and most important of its member banks will be led by two staunch monetary hawks who see it as their primary goal to rein in inflation.

But can this actually succeed? And is it even possible to save the euro?

Buying Time

The actual work of rehabilitating the monetary union has just begun for Europe's governments. They have merely bought themselves a little extra time with the bailout package, which is limited to three years.

First and foremost, Greece will have to repair its tattered public finances -- a difficult, if not impossible task. During an appearance on a German television talk show last week, Josef Ackermann, the head of Deutsche Bank, voiced skepticism over whether the Greeks will actually manage to service their debts.

The other troubled euro-zone members are in much better shape, but even they will have to adopt harsh measures. Portugal and Spain announced additional austerity measures last week.

According to the German government, that won't be enough. The Chancellery and the Finance Ministry say that each individual member state should redouble its cost-cutting measures to build trust in the euro.

Putting the Brakes On

German Finance Minister Wolfgang Schäuble will soon meet with the finance ministers of the monetary zone, the so-called Eurogroup, and introduce an initiative aimed at launching a Europe-wide consolidation program.

The German government plans to set a good example. It will of course respect the country's new "debt brake," a recent amendment to the German constitution which obliges the government to gradually balance the budget. As of 2011, Berlin will cut spending by some €10 billion annually -- year after year.

In order to demonstrate just how serious it is about reducing government debt, by early July the German government intends to do more than just outline where it will trim the budget in 2011 -- it also plans to name savings and cutbacks for the following years until 2014, which marks the end of medium-term financial planning.

In addition, the German government wants to convince the individual German states to support a collectively approved strategy to restructure the budget. It intends to use the so-called Stability Council, a newly created forum of the federal government and the states, as a means to that end.

There is no point in the federal government and German states drawing up their budgets largely independently of each other, as has been the case up to now, says one member of the government. Cost-cutting measures that require amendments to existing legislation can often only be set in motion with the approval of the states, so it makes sense to reach an agreement with them beforehand, says the government source.

Social Services in the Crosshairs

Finance Minister Schäuble will soon need this support. If nothing else, he intends to trim the missing billions from the 2011 budget by scaling back state social services. This could include cuts to family allowances and welfare payments for the long-term unemployed. "Whether it's social services or state subsidies, nothing is taboo," says a high-ranking aide to Schäuble.

Restructuring state finances won't be enough, however, to stabilize the euro over the long term. What is most urgently needed is to remove the congenital defects that plague the common currency. In this respect, the key thing will be a better coordination of member states' economic and financial policies.

On top of that, the Stability and Growth Pact, which sets rules for budgetary behavior within the euro zone, needs to be given new teeth. Any violations of sound financial policies must automatically trigger sanctions or fines, instead of the current system, where majority decisions are needed before such measures are taken.

Looking at the Books

Proposals made by EU Economic and Monetary Affairs Commissioner Olli Rehn foresee exactly those kinds of tougher regulations. Rehn intends to bolster the euro by having member states surrender additional sovereign rights. He proposes that all states be subject to central budget coordination in Brussels. Before national parliaments approve their budgets, Rehn and his team want to have a look at the books and raise objections if necessary. Euro zone finance ministers would also get the chance to review draft budgets before they are presented to national parliaments, under Rehn's plan.

Rehn's initiative puts politicians in the individual member states as well as the entire monetary union in a dilemma. On the one hand, in order to support the euro, it is absolutely necessary to have centralized supervision and control. On the other hand, the commissioner's proposals could be attacked as being undemocratic. They call for an impersonal bureaucracy with no democratic legitimacy to have a greater say in member states' budgets than national parliaments, with their freely elected representatives.

Not every member of parliament will take such a loss of power lying down. The responsibility for the state budget, which parliaments managed to wrest from monarchs in earlier centuries, is often rightly referred to as parliament's prerogative. In Germany there is yet another stumbling block. In its June 2009 decision on the Lisbon Treaty, the German Constitutional Court put the brakes on Germany's further integration within Europe, by giving the German parliament a bigger say in EU matters. But increased integration is exactly what Rehn's plans would entail.

Can the Euro Survive?

It is by no means certain whether and how the euro can survive in its current form. Whether it will be a strong or a weak currency, and whether or not it will win back the confidence of citizens and investors, depends primarily on the ability of the ECB to actually collect back the money that it has spent on purchasing government bonds. "We will withdraw all the additional liquidity that we supply," promises ECB President Jean-Claude Trichet in an interview with SPIEGEL. 

Technically the withdrawal of liquidity does not present a major problem -- the central bank merely has to roll back its emergency programs. The ECB gives commercial banks, for example, so-called tenders on a weekly basis. If the central bank were to suspend these operations for a while, it would allow it to withdraw liquidity from the market.

It could also sell bonds to withdraw money from the market. Or it could resort to the time-honored tool used to reduce the amount of money in circulation: It could raise interest rates.

The difficult part about all of these actions is finding the right timing. If the central bankers act too soon, they risk smothering the current economic recovery. If they wait too long because they cannot resist the pressure from politicians, prices could spiral out of control.

Then it would be nearly impossible to keep the currency from plummeting.

Translated from the German by Paul Cohen
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