What’s best for Germany?

German politicians, especially Ms. Merkel have come in for a lot of flak over the past two or three years, not least from me. However, as politicians, they are faced with the extremely difficult task of reconciling domestic and European political considerations, a task that would tax even Solomon.

Domestically, fiscal conservatism and the unwillingness to be the milch cow for the eurozone have been powerful forces. The economic narrative has been one of a prudent Germany and a profligate periphery. As usual, this is only half the story. The fact that Germany through deficient domestic demand and the concomitant capital flows to the periphery were an important factor in the credit booms (and busts) is barely acknowledged.

German politicians, to their credit, have sought to be “good” Europeans. Within the constraints of domestic political considerations, they have done their best to shore up the eurozone, often going way beyond the cautious rhetoric aimed at reassuring domestic voters. Bail out funds have been agreed and the LTRO are both examples where the actions of the eurozone (with the tacit agreement of Germany) have gone much further than expected.

Even so, eurozone policy has tended to be quite slow with Germany acting as a brake on more extensive and unorthodox policies. If M. Hollande is elected, then the balance of the eurozone may start to tip in a different direction with less emphasis on fiscal discipline and structural reform.

What will Germany do if its narrative of the crisis is challenged? If the best interests of Germany are no longer served by the euro and the broader European Union, what will Germany do?

The next elections to the Bundestag are in autumn 2013, so I think we will see an increasingly domestic bent to the political rhetoric in the latter part of this year and into next. Unfortunately, I suspect, we will see little quality debate on what really benefits Germany and Europe. Rather we will see the politics of recrimination and populism.

There’s no doubt that Germany has benefited enormously from the euro. The boom in the periphery up until 2007 enabled Germany to restructure its economy providing strong external demand to offset weak domestic demand. Higher inflation allowed Germany to reduce relative costs without deflation.

In the aftermath of the crisis, the deflationary policies of the periphery have helped to hold down German inflation despite a strong labour market. The travails of the euro have also ensured that the euro exchange rate is competitive for Germany (although not for many of its euro partners).

While the exchange rate of the euro is still a major positive, it seems to me that many other factors are becoming less attractive for Germany’s continued participation in the eurozone. The most obvious is the continuing demands of other members that Germany back stops the system and indulges in a covert financial transfer.

Germany is also accruing a potential problem in Target2 balances. No-one seems quite sure how this might work out. Thirdly, like China, Germany might face increasing inflationary pressures in one form or another. Rather than CPI price rises, this might be in the form of wages rises. Indeed, industrial relations might deteriorate as unions demand a reward for previous wage restraint.

Unions and workers may also face pressure from immigrant workers competing for jobs. While this might offset inflationary wage pressures, it could cause social unrest. Apparently there’s a huge demand in Spain for German (and English) language lessons.

On the political front, there is increasing resentment of German imposed austerity measures. With unemployment rising, this is likely to get worse. In the same way that the German narrative of the crisis is focused on the lazy and profligate Club Med, the members of Club Med are increasingly using Germany as a scape goat for their problems, some of which are self inflicted.

As the German elections approach, I expect to see the rhetoric to get increasingly rancourous. It will be interesting to see if there is any real debate over leaving the euro. The powerful German business lobby is likely to favour the status quo. However, the general public may become more euro sceptic, perceived that Germany is damned if they stay in and damned if they leave.

It is possible that the Bundesbank will view an exit as increasingly desirable. It is clear that the establishment is unhappy with the ECB’s latest actions. The BB is hamstrung in its inflation aversion and desire to protect the German financial system by its inability to operate monetary policy. Regaining its old powers must seem increasingly attractive.

A return to the DM would give a one off, potentially significant, increase in German living standards and tame the perceived inflation threat. It would be negative for corporate German profit margins, but companies have coped with this in the past and the high value added nature of German production should cushion the impact somewhat.

An interesting question that I can’t answer is whether the German political establishment feel they have sufficiently atoned for the Second World War and are willing to strike out for German interests at the risk of breaking with the post-war order.

My feeling is that if Germany is subjected to more and more vociferous hectoring, they will be inclined to break the Franco-German axis which dominated Europe for sixty-odd years. There would be a huge opportunity for the UK to forge a new relationship with Germany and re-cast the EU into more of a free trade zone than a political union.

Viewed from the outside, it seems that Germany’s best interests would be best served by an exit from the eurozone. The next eighteen months may provide the political impetus to facilitate this.

I am off to walk across Scotland next week and won’t be back until near the end of May. It’s tough being retired!