Explaining Germany’s inflation angst

This is my latest Perspective column for Fund Strategy.

One of the most peculiar features of the world’s economic plight from an Anglo-American perspective is the behaviour of Germany. British and American commentators are frequently bemused by Germany’s reluctance to bail out Greece or to let the European Central Bank (ECB) become a lender of last resort. They also puzzle over Germany’s obsession with controlling inflation when to them deflation self-evidently seems like a more imminent threat.

Charles Dumas, the chairman of Lombard Street Research, is one of the lucid critics of Germany in this respect. He has consistently argued that the reluctance of German (and Chinese) consumers to spend is at the root of the problems of the global economy. If only Germany would consume more and save less the world economy would be, he argues, in better shape.

In a recent research note headed “China & Germany ensure Great Recession, round 2” his exasperation was evident: “Germany could have stimulated domestic demand, but would not. Suffused with malignant self-righteousness – German commentators refer to borrowers as “sinners”, and sometimes even to themselves as “saints” – they insist that the imbalances must be put right only by deficit-country deflation.” (September 23).

Whether or not this argument is true it is clear that Anglo-American politicians have a vested interest in pointing the spotlight away from their own culpability. But leave aside for the moment the question of who is right on global imbalances. Even Germany’s supporters acknowledge that it is particularly preoccupied by inflation and sound money. The tricky question to explain is why this obsession has come about.

To the extent that this phenomenon is explained in Britain it is usually with reference to the Weimar hyperinflation of the early 1920s. Photographs of people using wheelbarrows full of banknotes to pay for loaves of bread are dug up from the archives. Germany’s preoccupations are therefore explained as a folk memory of the terrible inflationary episode in the country’s history.

But there is something fundamentally wrong with this explanation, at least in the literal sense in which it is generally understood. Given that the hyperinflation peaked in 1923, for anyone to remember it they would need to be almost 100 years old by now. It is also not immediately clear why anyone who lived in Germany through the 20th century would single that out as the most traumatic event. In the past century Germany has undergone two world wars, near revolution, the Great Depression, the rise of Nazism and the division of the country. There is no shortage of shocking episodes in modern Germany history.

There are two key elements to understanding Germany’s obsession with fighting inflation. Most fundamentally there is the preoccupation with order as the basis for the German state. As David Marsh wrote in his authoritative history of the Bundesbank, Germany’s central bank: “The roots of the Germanic attention to stability … go … to the concept of order as the foundation of state power” (The Bundesbank: The Bank That Rules Europe, 1992, p29). Given Germany’s tumultuous history this emphasis is perhaps hardly surprising. It is also in sharp contrast to, for example, the attachment to “life, liberty and the pursuit of happiness” in the American declaration of independence of 1776.

Germany’s preoccupation with order is closely linked to the idea of sound money. The Weimar hyperinflation is not just seen as preceding fascism and war but in some senses being responsible for it. As Konrad Adenauer, West Germany’s first chancellor, argued in 1957 when the Bundesbank was first established: “Safeguarding the currency forms the prime condition for maintaining a market economy and, ultimately, a free constitution for society and the state”.

Such ideas emerged in embryo in the 1930s as a conservative reaction to the extreme dislocation of the previous decade. They were known under various names including Ordnungspolitik (with Ordnung meaning order in German), Ordoliberalism and neoliberalism (not to be confused with the contemporary usage of the same term). The supporters of this concept, centered on the University of Freiburg, argued for the combination of a market economy with a strong state. From this perspective the state should set the rules for market behaviour and enforce compliance with them. An independent central bank and low inflation became two of its main tenets.

Such ideas were put into practice by Ludwig Ehrhard, Adenauer’s minister of economics and his successor as chancellor, who was the architect of Germany’s post-war Wirtschaftswunder (economic miracle). The social market economy which he constructed was based on the principles of Ordnungspolitik.

In many respects this outlook has become more influential over time rather than less. Although Germany made a brief turn to Keynesianism in the late 1960s this was hotly contested at the time. Its reversal under the conservative* (see note at end) chancellorship of Helmut Schmidt from 1974-82 was met with great relief. The relative success of the German economy in recent years, during which wages have been curbed and welfare benefits reduced, has bolstered the faith in austerity.

The attachment to Ordnungspolitik has also meant that even before the recent troubles many Germans were worried about the advent of the eurozone. In particular they were concerned about the Bundesbank losing control over monetary policy to the ECB. In some respects Germany has succeeded in tackling the problem by shaping many European Union institutions to follow its model. But the pull to allow a large bail-out of troubled eurozone economies is now tugging strongly towards looser money.

Germany’s attachment to order and sound money is deeply held. The German elite is likely to resist strongly any attempt to undermine its core beliefs.

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[Box] The history of Germany in several currencies

1873 – The Goldmark introduced as the currency of the German empire.

1914- The Papiermark introduced as Germany’s currency following the break between the Mark and the gold price.

1924 – The Reichsmark introduced as the new Germany currency following the Weimar hyperinflation of the previous year.

1948 – The Deutsche Mark established as the currency of West Germany and the Ost Mark is introduced in East Germany.

1990 – The Ost Mark abolished in the run-up to German unification.

1999 – The start of the euro’s introduction.

2002 – The Deutsche Mark is replaced by the euro.

* NOTE: Although Schmidt was a conservative with a small “c” he was, and still is, a Social Democrat.