Photo Gallery: The ECB'S Dangerous Firepower

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Breaking Taboos Concerns Mount in Germany Over ECB Bond Buys

The euro drama is escalating in Berlin. In order to save the common currency, the European Central Bank is now purchasing large volumes of Italian government bonds. German central bankers and politicians in Chancellor Merkel's government oppose the move, which they see as a dangerous threat to the ECB's independence.

The timing was very cunning. It was 7:50 p.m. on Sunday, Aug. 7, when Germany's Federal Press Office released a joint statement by Chancellor Angela Merkel and French President Nicolas Sarkozy. Though hedged in diplomatic terms, the Continent's two most powerful political leaders were demanding that the Frankfurt-based European Central Bank (ECB) take an active role in helping Spain and Italy weather the euro crisis. Either the bank supplied money, they said, or the euro was finished.

It wasn't long before the wire agencies transmitted the first news alerts. It was a carefully planned chain of events -- and an insidious one, too.


Photo Gallery: From Currency Guardian to Crisis Manager


Indeed, Merkel and Sarkozy knew only too well that, at that very moment, the ECB's governing council was holding a conference call to discuss the next steps. The council's 23 members had been arguing for almost two hours over whether the ECB should buy up Spanish and Italian sovereign bonds to prop up their value.

It took the central bankers almost two more hours to cobble together a majority to support the plan. The toughest resistance came from Jens Weidmann, the president of the Bundesbank, Germany's central bank. He stubbornly opposed the decision till the bitter end -- but all was in vain. The next day, the ECB launched the greatest purchasing of government debt in its history.

The move shakes the already fragile foundations of the monetary union. But it's not just the stability of the euro that's at stake; it's also the credibility of the very institution charged with preserving its value.

When the ECB was founded 13 years ago, it was meant to be a European version of Germany's Bundesbank and the heir to its steadfast principles: The sole duty of central bankers is to maintain price stability while remaining politically independent. And their supreme task is to deny the government access to the money printers. Indeed, things at Europe's central bank were supposed to go just like they did under Karl Otto Pöhl and Helmut Schlesinger, the legendary pair of Bundesbank presidents who served between 1980 and 1993 and primarily solidified their reputations by being able to say "no" at the crucial moment.

'Europe's Biggest Bad Bank'

But, under the pressure of the euro crisis, Europe's central bankers have assumed duties listed nowhere in their statutes. For example, the ECB is drafting austerity programs for heavily indebted countries, including Greece, Ireland and Italy, bailing out major banks and propping up the value of the sovereign bonds of five euro-zone countries.

Critics have come to ridicule the ECB as "Europe's biggest bad bank," and the reputation of ECB President Jean-Claude Trichet has also suffered. Indeed, even some of Trichet's close companions believe he has become all too eager to bend to political will. For example, in a guest contribution published in London's Financial Times on Aug. 8, former ECB chief economist Otmar Issing criticized the bank for considering an amendment to its "no bail-out" clause. Doing so, he wrote, would be "a move on a slippery road to a regime of fiscal indiscipline drowning hitherto solid countries in the morass of over-indebtedness."

Indeed, the common currency that was supposed to unite the Continent is now threatening to split it apart. And one of the deepest fissures runs straight through the ECB itself.

Trichet and his colleagues from heavily indebted countries in southern Europe favor a massive effort to purchase sovereign state bonds. But the head of the Bundesbank and his colleagues from the EU's "net payer" countries, such as Luxembourg and the Netherlands, believe that would be a major mistake because they fear it would only trigger inflation.

Almost two years after Greece's government acknowledged that the country was much more indebted than previously known, the currency crisis has reached a whole new stage. Until now, euro-zone governments have been trying to protect the common currency by piling more and more money into bailout funds. But that's not enough for investors anymore. Now they're demanding that the net-payer states offer practically unlimited guarantees for almost every conceivable amount, even when it comes to seriously indebted countries, such as Spain and Italy.

Germany's Tough Choices

"Germany is in the driver's seat," says  George Soros, the major investor and hedge fund manager based in New York. As he sees it, Germany's government is facing a difficult decision: Either it accepts that the ECB will provide long-term assistance as a financer of state debt, or it clears the way for the introduction of so-called "euro bonds," ones common to all euro-zone member states. In effect, the latter option would mean that Germany would automatically be jointly liable for any loans taken out by fellow euro-zone countries, such as Italy or Greece.

German Finance Minister Wolfgang Schäuble opposes this second option and believes that economic assistance should only be given out under strict conditions. "We're not going to bail out countries at any price," Schäuble told  SPIEGEL in an interview published this week. Although he left open the question of potential consequences, there's no denying they would be significant: Greece would go bankrupt and possibly abandon the monetary union. The whole euro zone could break up.

Indeed, with ECB President Trichet saying this "is the worst crisis since the second world war," it's hardly surprising that the government coalition in Berlin -- made up of Merkel's center-right Christian Democratic Union (CDU), its Bavarian sister party, the Christian Social Union (CSU) and the business-friendly Free Democratic Party (FDP) -- is getting increasingly nervous. Senior party officials are worried they might not secure majorities in the upcoming votes on the euro bailout package in the Bundestag, Germany's federal parliament. What's more, they're afraid that Trichet's controversial bond plan might spark opposition within their own ranks. "It would be a serious matter if we reached the point where Germany was outvoted on the ECB's governing council by the debtor countries," says Alexander Dobrindt, the CSU's general secretary. "The ECB needs to regain its political independence as quickly as possible and only make decisions based on stability principles."

Such displeasure is understandable given the considerable political pressure the ECB has been facing in making its decisions. For example, when the risk premiums on Italian government bonds rose to all-time highs in early August, the ECB initially bought up Irish and Portuguese bonds, just as it had already done a number of times before.

'We Cannot Give Way to Panic'

When it became clear that the measures were having little effect, Trichet summoned the other members of the ECB's executive board and the central bankers of euro-zone countries on Aug. 7 to join an evening conference call to debate how Spain and Italy should be helped.

Trichet sensed he would have a hard time making his case. To soften up his colleagues, he wrote a harshly worded letter to the Italian government relaying his conditions for granting support. Together with Mario Draghi, the president of Italy's central bank and his designated successor at the helm of the ECB, Trichet called on the Italian government to implement far-reaching reforms to the labor market, pensions and the deficit-ridden public health-care system. He also urged Rome to privatize state assets. Likewise, he stressed that Italy had to balance its budget by 2013, a year ahead of schedule.

Although Rome promptly signaled it would agree to such terms, Trichet still knew that the ECB's governing council would be deeply divided. Indeed, the cleft had already become apparent the previous Thursday. Bundesbank chief Weidmann had led the group arguing against anything involving the buying of government bonds. Doing so, he reasoned, would be tantamount to dissolving the border between monetary and fiscal policies. Following in the footsteps of his predecessor, Axel Weber, Weidmann urged his colleagues to keep the greatest distance possible between the central bank and the finances of individual states.

Actions Upsetting to Merkel

Weidmann's actions were deeply upsetting to Chancellor Merkel. Just a few months earlier, Weidmann had been serving as one of her economic advisers. She had called him right before the conference call on Sunday evening urging him to relent. Shortly thereafter, the members of the ECB's executive board hustled into Trichet's office to use his secure telephone line. On the call were the other 17 members of the ECB's governing council all across Europe, some of whom had been forced to cut their vacations short. In dramatic terms, Trichet pleaded with his colleagues to act. If they didn't, he warned, Italy, the world's third-largest bond market, would implode -- and no one could predict how this would affect the euro and the global economy.

Nevertheless, Weidmann, ECB Chief Economist Jürgen Stark and the representatives from Luxembourg and the Netherlands held their ground. They argued that the ECB's sole mandate was to safeguard the stability of the euro's value and that it wasn't its job to prop up heavily indebted countries or even to protect the capital markets from themselves.

The debate focused on key issues of financial and monetary policy. For the Bundesbank, it had always been taboo to finance the state by purchasing its sovereign bonds. Behind this belief was the terrifying example of its predecessor, the Reichsbank, which had printed money with abandon in the 1920s in order to support the budget of the Weimar Republic. The result was a hyperinflation  that has become deeply entrenched in the collective memory of Germans.

Indeed, Axel Weber, Weidmann's predecessor, was so opposed to the idea of purchasing sovereign bonds that he prematurely retired  from his position as Bundesbank president and withdrew his name as a candidate to succeed Trichet as head of the ECB. As he saw it, the fact that ECB higher-ups had even discussed breaking this still-unbroken taboo in May 2010 in response to the crisis in Greece was an unforgivable error.

'A Clear Violation of the Treaty'

This led Weber to write an impassioned e-mail on May 7, 2010 to his colleagues on the ECB's governing council. Though the contents of the letter had not been made public before, last week's developments make it particularly relevant to the current situation.

"We must not panic" he warned them. Although he believed the ECB had to respond to the crisis by making an unlimited amount of liquidity available, he vehemently argued against purchasing sovereign bonds. Doing so would be "a clear violation of the treaty" that had served as the basis for establishing the bank. He also wrote that the ECB was standing at a crossroads and that the governing council had to "resist government pressure." The risk of damaging the ECB's reputation, he argued, by far outweighs any short-term gains that might be made by buying sovereign bonds. "Let us not disappoint our people" Weber warned -- and he announced that he would go public with his opposition.

Despite the passionate appeal, Weber was only able to convince four other colleagues on the ECB governing council to join him in voting against the plan to buy up sovereign bonds. The vast majority of its members bought the argument of Trichet, who already at that point viewed the world as teetering at the edge of the abyss.

Within a few months, the ECB purchased almost €80 billion ($115 billion) in government bonds from Greece, Portugal and Ireland, which everyone was eager to unload. Together, the national central banks that are part of the euro system and shareholders in the ECB, including the Bundesbank, have been forced to make billions in writedowns.

Even with such bad experiences behind them, on Aug. 7, the majority of members on the ECB's governing council voted to support Trichet's new proposal. Weidmann and his three confederates were outvoted.

This was a bitter outcome for the Bundesbank. As a result of this decision, already last week it was forced to buy up massive amounts of Italian and Spanish sovereign bonds. This results from the fact that, within the context of the euro system, the ECB also uses the Bundesbank as a vehicle to make billions in such purchases. As one Bundesbank official put it, doing so "goes against our genes."

The ECB's Sweet Poison

Those in the Trichet camp, on the other hand, view the ECB as the last functioning institution in Europe. ECB experts argued that this is why the bank was forced to take action after interest rates on Italian bonds rose to dangerously high levels in recent weeks. In their view, failing to act threatened to dry up lending to companies and private clients.

The ECB was happy when the interest rate on Italian bonds dropped from 6 percent to 5 percent in the wake of its actions. But even if that sounds like success, Trichet knows that his strategy won't work in the long term. If, as in the case of Greece, the markets have made up their mind that a country will never pay back its debts because it is bankrupt, then there is also little the ECB can do. In fact, the central bank would be constantly pumping more money into the markets without really helping the country.

Even worse, such actions could also get politicians in the entire euro zone quickly used to the ECB's sweet poison. After all, it's much easier to fall back on ECB money than to get parliament to agree to tax increases. This has led former Bundesbank officials, including Weber, to accuse the ECB's measures of only delaying the inevitable introduction of the kind of radical reforms necessary in countries like Italy.

More than anything, buying up sovereign bonds is damaging the reputation of the ECB itself. If the ECB adds huge amounts of questionable sovereign bonds to its portfolio and that country one day becomes insolvent, it could result in considerable losses. In that case, it would be forced to write down parts of its assets and beg euro-zone governments for fresh capital. Doing so would risk damaging the central bank's reputation and independence, and the ECB could be tempted to start up the money-printing presses purely out of its own self-interest.

The ECB's questionable decision has also alienated members of the governing parties in Berlin. So far, members of parliment with the CDU/CSU and FDP have reverently accepted ECB decisions related to bailing out the euro, including the first and second bailout packages for Greece, the establishment of temporary and permanent euro-bailout funds -- the European Financial Stability Facility (EFSF) and the European Stability Mechanism (ESM), respectively -- and the aid programs for banks.

Opposition Grows in Berlin

Indeed, the coalition government has already made more than €140 billion available for efforts to bail out the euro. Given this generosity, politicians in the coalition parties are alarmed that the ECB's governing council has apparently now decided to routinely act against the reservations of its German members.

"The ECB cannot become an institution that can compensate for the failures of the budgets of individuals states, such as Italy, over the long term," says Volker Bouffier, governor of the western state of Hesse, where the ECB is based. "That doesn't correspond with its mandate, and that takes the pressure off the affected countries to put their budgets in order by themselves."

Stanislaw Tillich, the governor of the eastern state of Saxony, holds a similar view and believes the ECB program has to "remain an exception." To do otherwise would "only prove correct the people who were afraid at the time of the euro's introduction that the ECB would be less diligent in safeguarding monetary stability than the German Bundesbank."

Even Rainer Brüderle, the senior FDP official who recently stepped down as economics minister to become his party's parliamentary floor leader, views the ECB's policy of buying sovereign bonds to prop up troubled nations "with very mixed feelings." Things cannot be allowed "to go on like this forever," he says.

Still, the greatest resentment can be found within the ranks of the CSU. Many of its members share the fears of Thomas Silberhorn, a party expert on European affairs, who says that the ECB's "institutional independence … is gone." As he sees it, by introducing these measures, the ECB has overstepped its competencies in terms of monetary policy, and made a "shambles" of the foundations of the EU treaties.

Even Erwin Huber, former head of the CSU and finance minister of the state of Bavaria, believes the ECB's reputation has been damaged. "The Bundesbank would never have financed state debt at the expense of the currency's value," he says. "That is a serious violation of the entire euro blueprint."

By breaking this taboo, the ECB has bred mistrust in the most recent bailout measures  and is giving fresh impetus to the euroskeptics within the coalition parties. About a dozen members of parliament from the FDP are considered to be euroskeptics, and more and more members of the CDU/CSU are calling for an emergency gathering to discuss the debt crisis.

To respond to this growing resentment, coalition leaders in Berlin have started making futile attempts at appeasement. CDU higher-ups hope to calm the base in coming weeks at so-called regional conferences. Economic Minister and FDP chairman Philipp Rösler has announced plans to set up a stability council at the EU level -- though the announcement took even Finance Minister Schäuble by surprise.

'A Country Like Italy Can't Be Saved'

Even the bailout experts in Merkel's Chancellery are trying to allay worries among it supporters by noting that the ECB is only temporarily supposed to purchase sovereign bonds, until late September. On July 21, the heads of state and government of the euro-zone member states decided that the EFSF euro bailout fund would take over such responsibilities at that time.

But, until then, the ECB will be obliged to prop up the euro's value. The only problem with that is that everyone wants to get rid of the risky sovereign bonds from Spain and Italy, but hardly anybody wants to buy them. In other words, the ECB will be bleeding money for weeks.

Experts even fear the ECB might buy several hundred billion euros in Italian and Spanish bonds. If it took a similar proportion of bonds from those countries as it previously did from Greece, Ireland and Portugal, it would have to pay €300 billion.

A Risk of Inflation

In theory, the ECB can afford such sums, since it will be the one printing the money. And that's what makes this kind of intervention so attractive to many. As they see it, the ECB has unlimited firepower at its disposal to deter the markets from continuing to speculate against Spain and Italy.

In doing so, however, the ECB runs the risk of triggering inflation. What's more, there's some doubt as to whether the EFSF will be able to take responsibility from the ECB for purchasing sovereign bonds in September, as planned, because only limited means are at its disposal. At the moment, the amount of loans the EFSF can issue is capped at €440 billion. But a major portion of that has already been earmarked to help Greece, Portugal and Ireland. As a result, the bailout fund won't be able to afford to keep up for long the constant pace of purchasing that the markets have grown used to.

Given these circumstances, many political players believe an increase in the funds at the EFSF's disposal will be inevitable in order to impress the markets. This group includes European Commission President José Manuel Barroso, but even the French government has shown some sympathy for the idea.

Backers of the Barroso plan argue that this use of means will boost credibility. But the Germans don't agree. In their view, each time the EFSF's resources are increased, it sends a fresh invitation to the markets to test new boundaries.

Experts surrounding Finance Minister Schäuble suspect it would be almost impossible to win this kind of race with the markets, at least when it comes to Italy. As they see it, if the financial markets fail to recover their faith in Italy's government, even those in Berlin who favor a bailout would have nowhere else to turn.

As one official put it: "A country like Italy can't be saved."


Translated from the German by Josh Ward
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