TWISTED LOGIC: WHAT POLICY WOULD THE BUNDESBANK RUN?

ECB policy is hurting German savers. That belief seems to be widespread across the country. Over the weekend, Bundesbank president Jens Weidmann chimed in, saying that if the Bundesbank „would conduct its own monetary policy – which we do not – the policy would look different“. But is that really correct? Would Germany have higher central bank rates and higher bond yields if the Bundesbank would run its own monetary policy geared solely towards German needs? Maybe Weidmann should give his colleague in Zurich, Thomas Jordan, a call to find out more. As a safe haven country with its own currency, Switzerland has 10year bond yields at half the German level and a massively bloated central bank balance sheet.

As usual in European matters, we have to distinguish between simple textbook logic and reality. On textbook logic, Weidmann has a point. With a 4.1% yoy rise in its nominal GDP in Q1 2014, Germany is well ahead of the 1.8% Eurozone average. In a textbook world, the central bank rates and bond yields for Germany would be higher than for the Eurozone. And by the same logic, central bank rates would ideally be much higher for West German Frankfurt upon Main with its booming housing market than for East German Frankfurt upon Oder with its very different regional economy.

But we do not live in a simple textbook world, and we never have. Before the advent of the euro, Europe was haunted by frequent currency crises. Germany earns almost half of its GDP in exports. Specialising on capital goods, the German business cycle is often driven by the ups and downs in European and global business confidence and hence European and global demand for top-notch machines and flashy cars. As pre-euro experience has taught us time and again, Germany gets a triple whammy when trouble erupts in the neighbourhood: Demand for German exports falls and German businesses stop investing amid escalating uncertainty while safe haven flows into German assets drive up the exchange rate.

A Germany with its own monetary policy would be more like Switzerland writ large. In the wake of two great financial crises, the Lehman crisis and the subsequent troubles across the Southern and Western rim of Europe which started with the Greek debt crisis of early 2010, a massive capital inflow would have driven up an independent German currency. Of course, the precise nature of these turbulences would have been shaped by circumstances. What would have been the hypothetical alternative to the current situation, a euro that would have been dissolved or a euro that had never existed, with perhaps a German currency still being the anchor of a fragile and troublesome DM-zone? In both cases, the Lehman disaster and the problems at the Southern and Western rim of Europe would likely have caused a vicious crisis.

In the absence of a decisive policy to contain the turmoil, such as the policy which the ECB finally adopted in July 2012, the troubles across the European periphery would likely have been worse, hitting German business confidence, business investment and German exports even more than they have done anyway. A German central bank could have contained the fallout in the end. But to do so, it would have been forced to run an even more aggressive monetary policy than the ECB is currently conducting.

Just ask the Swiss. The main interest rate of the Swiss National Bank has been at 0% since July 2011; the yield on 10year Swiss sovereign bonds oscillates around 0.6%. That is half the paltry 1.2% yield for 10year Bunds. With massive foreign exchange interventions at the height of the financial turbulences, the SNB has also blown up its balance sheet in a way which dwarfs everything the ECB has done since the start of the Lehman crisis.

The conclusion is obvious: even those German savers who do not dare to venture far beyond the perceived safety of German bonds should be grateful that their country is part of the euro. Outside the euro, Germany would have even lower bond yields than it does today. Simple textbook logic which neglects the financial and economic linkages between countries and the lessons of experience in Europe does not apply.