The Predictable is Starting to Happen

Well I think it was obvious really: the European institutions cannot simple sit back and watch a coach and horses driven through their midst. Some response was inevitable, and my guess is that we will see more. It is also noteworthy that this couldn't have come at a worse moment (or perhaps abetter one - depending on his strength of character) for Trichet. Being French he now has to convince the planet that he will not simply lie down and do what he's told to do. At least his term of office promises to be more lively than the Duisenberg one.

The European Central Bank was on Monday embroiled in a harsh exchange with Germany, the eurozone's biggest economy, over the collapse of the European Union's fiscal rules. Jean-Claude Trichet, ECB president, warned that the suspension of the stability and growth pact could undermine confidence and hold back Europe's recovery. "I don't think the spirit or the letter of the pact should be amended," he said. But Germany, which engineered the suspension of the pact last week, said the single currency interest rates set by the ECB were hurting its economy.Hans Eichel, German finance minister, speaking in Frankfurt, said: "Its [the ECB's] monetary policy leads to Germany having the highest real interest rates in the eurozone, which is not enhancing growth."
Source: Financial Times
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On the question of monetary policy, it seems to me the Germans have a stong point. The problem is this was always an accident waiting to happen with the whole conception of the currency union. To try to make clearer what I think, I am reproducing an extract from a comment I made on Fistful on Saturday:

On the question of Germany it occurs to me that maybe I should clarify something in order not to appear to be inconsistent (maybe I am inconsistent, but i don't like it being too obvious).

Last spring I called on my blog for the German economy to be freed from the shackles of the stability pact. I did this for two principal reasons. Firstly the German economy is probably the one which has suffered most at the hands of the 'one ring to fit them all' monetary policy which forms an integral part of the euro project. The German economy has long laboured under the weight of an unduly high real rate of interest due to the need to hold rates up for the benefit of the more inflation-prone economies.

Secondly, and this is more a pragmatic question, the German economy has a tremendous specific weight inside the eurozone and is running perilously close to entering a deflationary cycle. If Germany should cross the threshold and enter deflation land, it seems to me it will be extremely difficult to haul them out given the constraints which would apply to using what Bernanke calls the 'unconventional tools' in the context of a currency union.

So it is better to avoid the problem first if possible.

This brings us back to the points often made about mobility and budgetary solidarity. Most of the ways of presenting this are far too abstract for my taste. If the euro were to work, cross border solidarity of a high order would be needed. The current German situation is the ideal place to demonstrate this. But this would mean using due process for decision making, and taking Germany as a special case. The precedent shouldn't be too hard to swallow, since many of those asked to sacrifice have been willing recipients of German aid via structural funds.

Would this work, can the German economy resurect itself? I don't know, but it would seem worth a try, since doing nothing and allowing them simply to follow Japan along the deflation road will probably mean the de facto death of the euro as an economic reality in any event.

What we have now of course is a complete mockery of this. In the place of due process we have a polite wave of two fingers in the direction of the ECB and the Commission, and instead of stong 'exemplary exceptionalism' we have a jumping on the 'special case' bandwagon by both France and (implicitly) Italy.