Germans are inflation hawks. This is with good reason: The hyperinflation of the Weimar period is widely seen as contributing to the rise of Hitler, who promised to bring stability to Germany again. After WWII, the German Bundesbank was famous for its inflation fighting. Germans were rightly proud of their post-war currency, the Deutsche Mark, and were resistant to giving it up. Germany enjoyed low and stable inflation. This stability allowed the German government to borrow money at low interest rates (it also helped that the German government tended not to borrow much money in the first place, though).
Germany no longer controls its own interest rates, however. Interest rates are set for the entire euro area by the European Central Bank (ECB), headquartered, at Germany's behest, in Frankfurt am Main, Germany. The ECB has done an "impeccable" job at maintaining stable inflation, its former head Trichet said. It's true: eurozone inflation has been stable since the euro was introduced. And yet Germans continue to warn of high inflation. The problem is, Germans don't seem to understand that inflation in Germany is only one part of the eurozone inflation picture.
Countries like Greece, Spain, Italy, and Ireland all have to accept swingeing cuts to government spending and are suffering a credit crunch. This is likely to lead to low or even negative inflation rates in those countries (Ireland experienced deflation of 7% near the end of 2009!). The correct response from the ECB in that case, if this low inflation meant the average weighted inflation throughout the eurozone was under 2%, would be to cut interest rates and try to keep inflation from falling any lower. Because Germany is not suffering austerity or a credit crunch, it's economy is growing. Inflation there will be higher as a result. If Germany is the fastest-growing economy in the eurozone (as it currently is), it is not unreasonable to expect it to have one of the highest inflation rates (or the highest). If everyone else's inflation rate is 1%, Germany's would need to be significantly over 2% (maybe 3, 4, or even 5%) in order for eurozone inflation on the whole to average 2%.
This terrifies Germans, but it shouldn't. This is not the Weimar Republic. The ECB has not abandoned all orthodoxy (in fact, compared with the Fed, the Bank of England, and the Bank of Japan, it's still quite conservative). A decision to cut rates when inflation has fallen due to reduced domestic demand is not madness, it's sensible policy. Higher inflation in Germany is also sensible. The euro crisis occurred due to imbalances within the single currency. Wages and prices (inflation) rose too quickly in the crisis-hit countries. They lost competitiveness, importing and paying for it by borrowing (a bit like the US, but more extreme). Much of the money borrowed came from Germany and France, by the way. In any case, prices and wages in Greece, Spain, and Italy (Ireland's have fallen again a lot already) need to fall relative to those in Germany to restore competitiveness and ease the imbalances in the zone. For this to happen, inflation would have to be low or negative in those countries for quite some time, or higher in Germany, Austria, the Netherlands, and Finland for quite some time. Or a little of both. If the ECB targets average inflation of 2% and Germany does not instate its own policies to try to cap inflation, that's what will happen.
Prices and wages need to rise faster in Germany and other "creditor" countries in the eurozone than in the debtor countries. That's just math. Allowing this to happen is not dangerous, it's sensible. Inflation is ugly, but deflation is even uglier. Germans need to accept this and let the ECB continue its "impeccable" management of the European economy. The euro crisis is the result of structural problems within the euro, which the ECB could not correct all by itself. It did not warn (or not enough) of the dangers of the bubbles in Spain and Greece (but neither did most other experts), so it's management has not been perfect, but as far as inflation is concerned, it has a good record. Germans have no reason to fear eurozone hyperinflation and should accept somewhat higher inflation in Germany. Germany has profited from the euro, too, though many seem to be unaware of this. I'll get to that in another post.
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