Photo Gallery: Europe's Top Monetary Policymakers Divided


Euro Crisis Crucible Rift Grows Between Germany's Bundesbank and ECB

There are growing divisions among European Central Bank leadership about how to handle the euro crisis, not to mention between the ECB and the Bundesbank, Germany's central bank. While ECB head Mario Draghi is pleased with his recent decision to flood the markets with cheap money, Bundesbank President Jens Weidmann warns of the dangers.

By the time European Central Bank (ECB) President Mario Draghi made his appearance at the most recent G-20 meeting in Mexico City, most participants were already thinking about the long trip home, but he still had no trouble spreading a bit of good cheer. "Super Mario" casually sat on a dark chair and, with an impish smile on his face, explained in a gentle voice why his loose monetary policy -- which he himself has dubbed "Big Bertha" -- is precisely what's needed. "The euro is now a safer place than it was at the time of the last G-20 summit in Cannes," he said.

Shortly after he returned home, Draghi used his wonder weapon again. Last week, the ECB pumped more than half a trillion euros into the markets  to maintain the money flow in the monetary zone. Europe has experienced a painful lack of liquidity ever since a large number of northern European banks reacted to the euro crisis by severing nearly all lines of credit to financial institutions in the south. Now, with the help of Draghi's second cash injection within just a few weeks, ailing southern European banks were once again able to grant loans and purchase sovereign bonds from their home countries.

Although this has eased the ongoing debt crisis on the Continent, and made Draghi into "Europe's rescuer" in the eyes of many politicians and financial managers, one of his leading partners views this approach with growing concern. Only two days before Draghi made his G-20 presentation, Jens Weidmann, president of Germany's central bank, the Bundesbank, spoke at the Mexico summit, and he had an entirely different message for his listeners. "The crisis cannot be resolved solely by throwing money at it," he said.

There is a rift among top-ranking officials at the ECB , and it also extends between the majority of the ECB's Governing Council and the Bundesbank. First, two leading German ECB officials -- chief economist Jürgen Stark and Bundesbank President Axel Weber -- resigned because the monetary authority was buying up sovereign bonds from Greece and Portugal. Then Weber's successor Weidmann objected to the ECB's purchase of government bonds from heavily indebted Italy.

Now, Weidmann is rebelling against the manner in which Draghi is giving European banks one new cash injection after another. Although Weidmann admits that the measures are basically correct, their conditions are "very generous," he complains -- and expresses his total opposition to this policy in the jargon of the central bankers: "This can particularly become a problem if banks are discouraged from taking action to restructure their balance sheets and strengthen their capital base."

New Escalation

Only a few weeks ago, it looked as though Draghi's arrival in office would usher in an era of harmony at Frankfurt's Eurotower, the ECB headquarters. Germany's monetary policy hardliners had resigned, and even Germany's mass circulation Bild newspaper welcomed the former head of Italy's central bank as "quite German," and even as "very Prussian." But the conflict between Europe's two most important monetary policymakers has become increasingly apparent, and it's compounded almost on a weekly basis by contentious new issues. One day Weidmann votes against special conditions for the ECB with regard to the Greek debt haircut, the next day he objects to the long maturities on Draghi's loans to banks.

Last week, the conflict escalated to a new level. Weidmann complained in a letter to ECB President Draghi that the central bank was accepting increasingly lower-grade collateral in exchange for its cash injections. This poses a danger, he warned, as the central banks in the north of the euro zone are owed ever growing amounts of money by their counterparts in the south. If the euro zone broke apart, the Bundesbank would be left holding a good deal of its bad debt from so-called TARGET2 loans, which currently amount to some €500 billion ($660 billion), he warned.

This may sound somewhat technical to most laypeople, but among leading ECB officials the letter was seen as violating a taboo. TARGET2 refers to the central banks' internal payment system, which has accumulated massive imbalances during the course of the euro crisis . These inequalities aren't problematic as long as the monetary union remains intact. So far, the Bundesbank has always played down this risk. But Weidmann's about-face is a "disastrous signal," say ECB executives because, for the first time ever, the Bundesbank "is no longer ruling out a break-up of the euro zone."

On the surface, the wrangling revolves around loan conditions and interest rates, but in reality it has to do with the basic course of European monetary policy: the question being whether a debt crisis can be combated with even more debt, or whether it will spark the next, possibly even greater crisis.

Although debt and cheap money triggered the global financial crisis, the central banks of the US, Japan and the UK continue to reduce interest rates, flood the markets with liquidity and make it easier for companies, banks and countries to acquire new debts (see graphic).

First Signs of Inflation

But what boosts the economy and stock markets over the short term also entails significant risks over the long term, at least according to the Bank for International Settlements (BIS), which acts as an umbrella organization for the central banks. The Basel-based institution, which already predicted the big crisis back in 2003, is now warning nearly as urgently against the dangers of the lax monetary policies that prevail today. The Swiss bank says that such policies remove the incentive for political reforms, increase the risk of price bubbles on stock exchanges and real estate markets, and make it increasingly difficult to return to normal conditions. BIS Deputy General Manager Hervé Hannoun recently spoke of the "illusion of unlimited intervention." He said that this solution could have the ugly result of a "surprising inflation" rate.

Bundesbank President Weidmann takes a similar view as he notes with concern how ECB President Draghi has emulated the lax monetary policy of the US Federal Reserve since he took office last November. One of Draghi's first official acts was to lower the base lending rate -- and when it came to drafting his bank program, he ignored all requests by the Bundesbank to limit the duration and scope of the measures. Sources at the Bundesbank say that although Draghi admittedly takes pleasure in repeatedly praising Germany's culture of stability, they contend that there's a marked discrepancy between his words and actions.

These concerns are understandable now that statisticians are registering the first signs of inflation. In February, the inflation rate in the euro zone didn't decline, as expected, but instead rose by 2.7 percent, primarily due to the rising price of gasoline. Furthermore, on other markets where investors like to speculate with cheap money from the central bank, prices are currently rising -- in the German real estate sector, for example.

The impact of this development is felt on a daily basis by Florian Koch, owner of the Berlin branch of the real estate firm Dahler & Company. On a gray March afternoon, Koch is standing in front of the Bertolt Brecht monument, near the Berliner Ensemble, home of the theater company established by the leftist playwright in East Berlin shortly after World War II. Behind the Brecht statue, an investor is building a decadent capitalist manifesto made of concrete, steel and glass, which will include a concierge service, a health spa and a private café.

The basement floor hasn't even been completed, but half of the luxury apartments have already been sold -- at premium prices of nearly €15,000 per square meter ($1,840 per square foot). "Two years ago, such prices in Berlin were unimaginable," says Koch. "But today they're not unusual for the high-end sector." During the first six months of 2011 alone, investors purchased €4.5 billion in real estate and land in Berlin for -- an increase of 60 percent over the previous year.

Too Much Money

It's a similar story in major cities across Germany. Once one of the most sluggish real estate markets in the world, where prices in many areas have tended to fall rather than rise, Germany has suddenly become a hot tip for international property speculators. Andrew Bosomworth, an investment analyst for Allianz subsidiary PIMCO, is concerned about this development. "The housing market is being swept clean. Germany is now in the same situation as Spain and Ireland at the beginning of the monetary union: Real interest rates are too low and the (ECB's) monetary policy is too lax for Germany. This could be the beginning of the next bubble."

A credit analyst at a large German bank says that cheap loans are primarily driving this unhealthy development. "If we continue like this, we'll have a subprime problem in Germany in five years." Subprime loans are the mortgages that were widely granted in the US until 2007, in many cases to impoverished debtors who later defaulted in droves.

Fear breeds fear -- as is the case with the fear of inflation. Since so many people are afraid of the euro losing its value, they're investing their money in material assets, causing prices to rise -- not only for buildings and land, but also for artwork, vintage cars and timepieces. Only three years ago, for instance, Berlin merchant Falko Modla was selling watches made in the former East Germany for €85 apiece. "Now, the price range starts at €300," he says. Certain rare models go for €500 and more. "Today's market is prepared to pay the price," he says.

There's simply too much money around. Indeed, all concerns are pushed aside on the stock and commodity markets and investors are buying like mad. Ever since the announcement of Draghi's cash injections, the German stock index, the DAX, has risen by 20 percent -- and prices for copper, aluminum and zinc have also increased sharply. The price of oil has jumped by 15 percent and a fine ounce of gold costs roughly 10 percent more than it did two months ago.

If additional cheap loans of this type are granted to banks, "there's a big danger that new bubbles will form on the commodity markets," says Eugen Weinberg, a commodity analyst at Commerzbank. He says the recent stock market rally is already "alarming."

Although many experts are critical of the recent trend, the financial industry is delighted. It's a golden opportunity for banks and funds when they can use cheap loans from the ECB to go hunting for lucrative returns. This increases profits, but it also solidifies unhealthy business practices.

Cash as Camouflage

That is also happening under Draghi's monetary program, which has done nothing to change the fundamental problem plaguing the European financial sector: The banks no longer trust each other. For their part, German banks are hoarding huge sums that they park in so-called overnight deposits at the ECB. Meanwhile, financial institutions in Italy and, of course, Greece are left high and dry. Even banks in France are repeatedly having problems acquiring fresh capital.

The ECB's supportive measures will "win time" at best, says Michael Kemmer, general manager of the Association of German Banks. But they can by no means replace the private bank market, he argues.

If there's anyone who knows precisely what Kemmer means, it's Commerzbank CEO Martin Blessing. The Frankfurt banker has watched helplessly while his bank's ailing subsidiary Eurohypo has ruined his annual results, year after year. Eurohypo is a relic from bygone days. Initially, it set out to make a fortune by bankrolling, of all things, sovereign states and real estate deals -- a business model that has probably been relegated to the dustbin of history since the outbreak of the financial crisis. What remains is a bloated, toxic balance sheet amounting to €200 billion, brimming with sovereign bonds and real estate loans from troubled states like Spain, Italy and Greece.

Eurohypo should actually be liquidated. Nevertheless, Draghi has given the bank some breathing room, once again. The real estate bank borrowed €10 billion from the ECB to pay off internal loans from Commerzbank. Likewise, the Düsseldorf-based IKB Deutsche Industriebank, which hasn't really gotten back on its feet since it nearly collapsed in 2007, has also reportedly taken a handout from the ECB. Analysts say that the French-Belgian Dexia bank, which recently produced losses of €11.6 billion and is now finally about to be broken up, has only been kept alive thanks to regular ECB contributions.

That's the nice thing about Draghi's money. It covers up problems -- camouflaging those faced not just by bankers, but also by politicians. Many governments in the Mediterranean region ran into troubled during the euro crisis when investors no longer wanted to purchase sovereign bonds from heavily indebted southern European countries, causing their interest rates to go through the roof. The bailout operation launched by the ECB, consisting of purchasing large quantities of government bonds from these crisis-ridden states, was met with decisive resistance from the Germans, though.

Big Price Tag

Draghi's monetary program also produced a gentle solution to this problem. The banks used a portion of the funds that flowed to them from the ECB to make lucrative extra deals. They purchased billions of euros worth of sovereign bonds from ailing countries. The banks pay the low interest rate of 1.0 percent on the central bank loans, while Italian and Spanish government bonds produce yields of five percent. The difference is pocketed as profit.

Apparently, everyone is given a helping hand -- ailing banks as well as debt-ridden countries. But this approach is only effective if the governments use the time gained to put their budgets in order. If they go bankrupt, however, taxpayers will also have to bear the losses for banks that have gotten into trouble.

"The program may have a calming effect in the short term, but it is a calm which could be deceptive," Weidmann said recently.

The calm also comes with a hefty price tag. In addition to pumping increasing amounts of money into the financial system for progressively longer maturity periods, the ECB has in exchange accepted more and more dubious collateral, dangerously escalating the conflict between Weidmann and Draghi.

Now, the ECB balance sheets contain large quantities of the notorious junk bonds that dragged down many banks during the financial crisis. Many financial institutions have even cobbled together their own new credit derivatives from dubious real estate loans in order to trade them for new loans from the central bank.

The bankers have really put their imagination to work in coming up with a growing range of creative, new forms of collateral. For instance, with the friendly support of their home governments, financial institutions are making increasingly excessive use of a legal loophole that has long been largely ignored: They issue their own bonds and have them stamped with state guarantees in exchange for a minor fee, all for the purpose of submitting them to the ECB as collateral.

Draghi Aware of Risks

Putting this formula to use, in December alone Italian banks printed their own new bonds worth €40 billion, which they exchanged for cash. The central bankers have also turned a blind eye to the value of many sovereign bonds. When the rating agencies awarded Greek, Portuguese and Irish bonds with junk status, the ECB promptly decided to entirely ignore this information so it could continue to count them as collateral.

Draghi feels that the risks on his balance sheet are "well managed." Experts at the Bundesbank, though, have serious doubts about this, particularly since in a number of ailing countries cash-strapped banks are even allowed to submit mortgages, consumer loans and inferior quality corporate loans in exchange for fresh, cheap money. To make matters worse, there are no proper rating procedures for such collateral. "The central banks of the euro system are taking substantial risks in their balance sheets that are at the limit of their mandates," says Weidmann.

The head of the Bundesbank also favors helping the banks with extra money to avoid the threat of a credit crunch. But to limit the harmful side effects of the program, Weidmann is urging higher interest rates, shorter maturities and new rules for bank financing. He says that the most recent concessions to cash-strapped banks, allowing them to pawn off corporate and consumer loans, should be withdrawn immediately.

Draghi knows the risks of his policies. But he's not entirely wrong when he points out that his initiatives have turned around the mood in the euro zone. This makes the criticism from the neighboring institution in Frankfurt all the more difficult to understand. How can it be, he often asks, that he is celebrated around the world, and yet only the Germans are taking a critical stance?

In any case, he knows that he enjoys the support of the majority of the ECB Governing Council. French central bank head Christian Noyer, for example, opposes a hasty change in the conditions for loans. "I wouldn't opt to tighten the standards for collateral at the moment -- we can do this once the crisis is over," he says.

Rifts Widen

Not surprisingly, the mood is tense between the two Frankfurt monetary authorities. At the Bundesbank, they like to call Draghi the "investment banker" because, following his tenure at US investment bank Goldman Sachs, he pays too much attention to the needs of the financial industry, they allege.

At the same time, the bankers in the other euro countries are growing tired of regularly receiving statements by the Bundesbank in which Weidmann's team of legal experts express their concerns about the ECB's crisis management. "The Bundesbank shoots down every proposal in a completely destructive manner," is the message even from central banks that are well-disposed toward the Germans. Other institutions more politely refer to a "massive overemphasis" on the part of the legal team.

The rifts between Europe's monetary watchdogs are getting wider. In the Eurotower, the Germans are seen as stubbornly sticking to their principles. On the other hand, the officials of the Bundesbank are concerned that their traditional monetary policy line -- which was originally supposed to serve as the model for the ECB -- is being gradually pushed aside during the crisis. When former ECB chief economist Jürgen Stark resigned, he admitted in frustration: "I'm not satisfied with the way this monetary union has developed." The mandate of the ECB has been "extended to the extreme," he said.

Weidmann sees it as his duty to change that. But the balance of power is against him. At the head of the ECB, there are no less than two representatives of financially weak, crisis-ridden countries: Mario Draghi and his deputy Vítor Constâncio of Portugal. That alone would have been unthinkable just a few years ago. In the top decision-making circle, the ECB Executive Board, three of the six members are from southern Europe -- and two more come from the heavily indebted countries of Belgium and France.

Next in Line

The superior strength of the southern Europeans is also disquieting for other northerners. The Finns, Austrians and Germans intend to at least partly roll back this revolution. On March 12, the council of finance ministers is scheduled to vote on a successor to outgoing ECB Executive Board member José Manuel González-Páramo -- and Luxembourg's Yves Mersch is widely tipped to take the Spaniard's place.

Nevertheless, many central bankers are no longer willing to be pressed into the trite old categories of hawks and doves. The ECB Governing Council is now primarily occupied by pragmatists who switch from one coalition to the other. Even the new German on the Governing Council, Jörg Asmussen, matches this description. Back in the days when Weidmann and Asmussen were still top government officials in Berlin -- one in the Chancellery, the other at the Finance Ministry -- they both had the reputation for being an unbeatable duo. German newspapers called them "the men in the shadows."

But today Asmussen acts as a kind of foreign minister for the ECB, and thus owes his loyalty not to his old friend Weidmann, but rather to a new ally: his boss Draghi.

If Weidmann intends to push through his positions, he'll have to count on other allies such as the head of the Finnish central bank, Erkki Liikanen, and his Dutch colleague, Klaas Knot.

Weidmann is counting on another long-term outcome anyway. In seven years, a successor will have to be found for the 64-year-old Draghi. When that happens, there will be no way to circumvent Germany, which has waived opportunities on two occasions to take the position. Weidmann, 43, would not only be the right age, he'd also have the right profile -- as a stalwart representative of the Bundesbank tradition.

Translated from the German by Paul Cohen
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