Germany and Italy battle for control of the ECB

There’s more at stake than just macroeconomic policy

Of all the disagreements among the European Union member states – migration, foreign policy or even the socalled European Green Deal – economic policy is by far the most contentious.

Since 2001, 19 of the 27 EU members have adopted a single currency, the euro, and they thus share one monetary policy. In good times, this facilitates trade and lowers borrowing costs for the weaker economies.

When facing an external crisis, however, the flaws of a one-size-fits-all policy become clear. Today, the EU is again facing a crisis.

The rival visions of a common European monetary policy are best represented by Germany and Italy. The two countries often clash over macroeconomic issues, but their conflict reflects a clear geopolitical reality: Rome and Berlin often disagree over monetary policy because of their contrasting approaches to pursuing economic growth and socio-political stability.

Though both have secured their mainland, mostly thanks to their NATO membership, the challenge of preserving internal unity in the face of constant pressure remains. The ways they go about this differ greatly given their distinct compositions and geographies, ultimately pitting them against one another.

What Germany Needs

Prior to unification in 1871, modern Germany was a bunch of small states and cities under constant threat of attack from outside. This chronic sense of vulnerability, the result of a lack of natural barriers, was one of the main factors that drove the German states together. Hardly three-quarters of a century after union, Germany was redivided into east and west in the wake of World War II.

The socio-economic disparities are still visible today. For example, in 2018, the unemployment rate was higher in former East German states (6.9%) than in former West German states (4.8%). Wages and salaries, to say nothing of productivity, tell the same story. The per capita gross domestic product in Bavaria in 2018 was more than 47,000 euros, while in Saxony it was just 31,000 euros.

Geography contributes to these regional disparities. Consider Hamburg, with its connections to the northern seas and maritime routes, which make it the most productive state in Germany and one of the most important ports in Europe. Then consider SaxonyAnhalt, just over 100 kilometers southeast of Hamburg, which in 2019 had the lowest per capita GDP of all the German states.

Despite these differences, Germany’s federal structure, generous welfare state and redistribution of wealth among states help Berlin to mitigate the socio-economic divides between the former German Democratic Republic and the Federal Republic of Germany and dampen calls for greater autonomy.

German economic stability ultimately rests on the German economic model. Germany is an export country: Basically half (about 47% in 2019) of German GDP comes from abroad. As a result, Berlin needs two things: First, to preserve the integrity of the eurozone and the

European single market, which is an important destination for German exports (59.1% in 2018).

Being part of a monetary union in which other countries cannot devalue their currencies to gain competitiveness is a significant advantage for Germany – one it needs to keep. Second, Germany needs price stability, i.e., low inflation. Price increases render a country’s exports less competitive, a nightmare for an exporting powerhouse like Germany. This is why Berlin is hyperfocused on keeping prices in check and therefore insists on tight monetary policy for itself.

What Italy Needs

One of the first prime ministers of the Kingdom of Italy right after unification in 1861 said, “Now that Italy is made, we need to make Italians.” Italy, like Germany, is ultimately a union of many different kingdoms, dukedoms and city-states. Like Germany, it is still working to overcome the regional disparities resulting from its geography and history. Italian unification was a top-down process, driven by cultural and security concerns and led by the Kingdom of Piedmont-Sardinia.

The Apennine mountain range runs the length of the Italian peninsula, separating the east and west. Rivers are not navigable, contributing to regional dislocation. Poorly developed infrastructure is inadequate to overcome Italy’s geographic hurdles.

In this context, economic disparities prospered: Per capita GDP in the Lombardy region was 48,100 euros in 2019, while in Calabria or Sicily it was less than 20,000 euros. Unsurprisingly, the northern regions, which claim to be the engine of Italian growth, have been asking for more

fiscal autonomy – frankly, fewer handouts to the poorer south. Regionally focused political parties are able to channel this frustration into votes.

Like Germany, to ensure unity and to reduce regional differences, Italy needs economic stability. When crises like 2008 hit, Italy’s southern regions suffer the most; employment, investment and GDP tend to fall far more in the south than in the north. This translates into greater social and political unrest, and heightened friction between regions.

And this is where Italian and German interests start clashing. Being a member of the eurozone has certainly brought benefits to Rome in terms of trade, although, again, these benefits were not equally distributed among the regions.

Northern Italy is much more integrated with German markets than is the south; situated in the Po River Valley in the north, those regions have better access to continental infrastructure. Furthermore, as the most productive part of the country, the north has strong appeal for investors.

For example, trade between Lombardy and Germany in 2016 amounted to 39.4 billion euros, nearly equal to total trade between Germany and Japan (40.3 billion euros). Trade between Germany and Veneto reached 16.7 billion euros, about the same as between Germany and Brazil (16.3 billion euros).

At the same time, membership in the single currency has limited Rome’s options for how to solve financial problems. In the 1990s, to gain competitiveness, Rome used to devalue the Italian lira, and whenever needed, it could inject more liquidity into the market.

With the euro, the situation changed: Italy cannot unilaterally devalue its currency and cannot regulate the amount of liquidity in the market. Monetary policy is the exclusive competence of the European Central Bank, and policy is often a compromise between the eurozone states.

This leaves Italy with only one option: to compress salaries to regain competitiveness. What’s more, low inflation – which is what Germany needs – slashed Italian consumption and investment. Most important, Italy needs easy money for its debt sustainability. From 2014 to 2019, Italy’s debt-to-GDP ratio fluctuated around 134% before hitting 155% last year amid the economic downturn brought on by the pandemic.

Monetary Policy Battlefield

The ECB was modeled after Germany’s central bank, the Bundesbank. This means throughout its history its primary goal was price stability, with full employment subordinated to a lower priority. Germany was effectively the leader of the eurozone.

But Germany’s de facto leadership came into question after 2008 and the eurozone crisis.

The ECB began loosening its monetary policy to avoid slipping into deflation. In late 2014 and early 2015, under the leadership of an Italian, Mario Draghi, the ECB launched its Asset Purchase Program.

The official purpose of APP was to reduce the risks of a prolonged period of low inflation, but mostly it helped states like Italy to sustain their public debt. The ECB restarted the program in 2019, and in 2020 it implemented a similar measure, the Pandemic Emergency Purchase Program, to combat the economic downturn caused by COVID-19. These measures were the result of the fact that, to prevent some countries from defaulting and therefore to maintain the integrity of the eurozone, the ECB had no other tools.

Although Germany needs to keep the eurozone together, it is unsurprising that Berlin was dissatisfied with the ECB’s new monetary measures, given that those measures were intended to stimulate inflation.

The anger was so great that Germany’s Federal Constitutional Court in 2020 ruled that one of the bank’s bond-buying programs was partially unconstitutional and that the ECB had acted beyond its mandate, starting an ongoing legal quarrel between Germany and the European Union, which accuses Berlin of setting a precedent that could put into question the primacy of EU law.

Recently, moreover, German central bank chief Jens Weidmann said the ECB’s job is not to “take care of the solvency security of the states.” Amid fears of rising inflationary pressure, Weidmann also urged the ECB to end its pandemic program as soon as conditions allow and to consider ending APP as well.

However, the ECB no longer follows Germany’s lead as closely as it once did. Differences of opinion have grown among the bank’s board, reflecting the divergent needs of the eurozone’s member states. Rebutting the claims of hawks like Weidmann, the ECB says current inflation is only a temporary phenomenon, and it does not exclude measures to recovery.

The amount of inflation needed, and the resulting monetary policy, is not only a matter of macroeconomic theory – it’s also a geopolitical issue among eurozone member states, which need different measures to ensure economic, political and social stability.

ECB policy can’t always suit every member state. And this split is perfectly summarized by Italy and Germany, which, besides monetary policy, are also at odds on the bloc’s fiscal rules. The question of when these rules should be reinstated – and in fact, what the rules should even be – pits states like Italy, France and Spain against states like Germany, the Netherlands and Austria.

The idea of a monetary union was supposed to bring cohesion among the European countries, but management of the common currency and the consequent economic policies have instead increased tensions. The situations in different eurozone members require different solutions.

Italy, as the third-largest economy in the EU, is too big to fail, and its hypothetical default would have serious consequences for the whole eurozone. Germany can’t afford a collapse of the eurozone, but it also can’t agree to an open-ended loose monetary policy.

As is often the case, the EU needs compromise. The result will likely be insufficient and disappointing for both parties.

further accommodating facilitate the post-pandemic