Merkel's Italian ally at the ECB

When Angela Merkel backed Mario Draghi to become president of the European Central Bank in May last year, many in Europe assumed it was with resignation, a setback for her and Germany.

Axel Weber, the hardline head of the Bundesbank had resigned in a huff months before, leaving the German chancellor little choice but to throw her weight behind the slick Italian who was Weber's only real rival for the prestigious central bank job.

More than a year later, however, as the euro zone descends ever deeper into crisis and fears of a humiliating break-up grow, it is becoming increasingly clear that Merkel got the man she needed after all.

On a visit to Canada last week, she offered a robust defense of Draghi, after he triggered a stormy debate in Germany by promising to do "whatever it takes to preserve the euro" and signaling his readiness to resume the European Central Bank's controversial bond buying program.

Draghi's comments on July 26 fuelled fears that the ECB was now in the hands of a southern cabal, willing to bend the rules of sound monetary policy to shield stricken countries like Spain and Italy.

Strong resistance to Draghi's course from Weber's successor as Bundesbank chief Jens Weidmann has added to the perception in Germany that the bank is veering dangerously off course. Because Weidmann is a former adviser to Merkel, his hardline stance was seen by some to reflect her own views.

But the chancellor's remarks in Ottawa on Thursday - she said Draghi's strategy was "completely in line" with that of Europe's leaders - should dash once and for all the notion that she opposes the ECB president's flexible stance.

That is significant. Without tacit approval from Berlin, the ECB president would find it virtually impossible to explore the limits of his powers in order to keep the euro show on the road.

And this is precisely what Merkel needs him to do.

"For the Bundesbank, buying bonds is a no-go area. This stance is based on principle, and there is no degree of flexibility," said Guntram Wolff, deputy director of the Bruegel thinktank and a former Bundesbank official. "Merkel is pragmatic; she wants a solution that is least costly in political terms."

Tape and Glue

One of the biggest fears in her entourage is that the euro zone could go off the rails before Germany holds a federal election one year from now, dashing her hopes for a third term.

Merkel's own solution to the crisis - the creation of a "fiscal union" in which euro zone members cede control over their budgets to a central authority in Brussels - is a project that will take years to realize, if it comes together, people close to the chancellor concede.

That leaves the ECB as the sole actor capable of keeping the euro zone intact over the coming year. Even if Draghi is forced to do so with tape and glue, alienating German monetary traditionalists, expect Merkel to support him.

"The list of problems that would emerge following a dissolution of the monetary union is long and appalling," says Joerg Kraemer, chief economist at Commerzbank.

He sees the German government tolerating what he calls an "Italian monetary union" in which higher inflation and a weaker currency support the debt-laden countries along the currency bloc's southern periphery.

If Europe does succeed, with the help of the ECB, in muddling through for another year and Merkel wins re-election, it could give her the political freedom to take new steps to stem the crisis.

Her most likely coalition partners if she emerges victorious are the centre-left Social Democrats (SPD), who support common euro zone debt issuance, a step Merkel has resisted so far.

Pragmatism over Ideology

In truth, the pragmatic Merkel always wanted a pragmatist instead of an ideologue running the ECB in Frankfurt.

That is why her support of Weber's candidacy was lukewarm, and ultimately contributed to his decision to pull out of the running.

It also explains why she put forward Joerg Asmussen to replace Juergen Stark, another disillusioned German hawk who bolted the ECB board in protest half a year after Weber.

Asmussen, a former deputy finance minister, is a member of the opposition SPD and a pragmatist with close ties to Draghi. He sees himself as a defender of European, as much as German, interests.

He returns to Berlin, where his family still lives, on a weekly basis and continues to meet with Merkel regularly. Asmussen, more than Weidmann, seems to have evolved into her point person at the ECB.

As head of the Bundesbank, aides to the chancellor say, Weidmann must adopt a hard line and show he is not beholden to his former boss. Merkel, in turn, must give him the space to play this role, keeping her distance.

People close to Merkel reject the notion that she is tolerating steps that violate the ECB's mandate, as German hawks claim.

They point to extraordinary policy measures taken by Bundesbank presidents Karl Otto Poehl and Hans Tietmeyer in the 1980s and 90s under pressure from former Chancellor Helmut Kohl.

Their independence was not questioned, they say. The implication is that Draghi is under fire because he is Italian rather than for the substance of his policies.

Still, there are risks to Merkel if the perception sinks in that she is happy to give Draghi free rein and leave Weidmann dangling.

A Deutschlandtrend poll for public broadcaster ARD showed this month that 39 percent of Germans believe the central bank should focus solely on keeping prices stable, while only 12 percent want the ECB helping to finance troubled euro states.

Germany's monetary hawk establishment - led by former ECBers Otmar Issing and Stark, as well as private economists like Ifo president Hans-Werner Sinn - is already crying blue murder over the course of the ECB.

The normally diplomatic Issing published a book earlier this month in which he criticized Merkel, indirectly but sharply, for trying to solve the euro crisis through closer fiscal integration, an approach he said was doomed to fail and would force the ECB to bridge the gap.

"These hardliners are really rumbling, and their views are shared by a significant faction of Merkel's party, the Christian Democrats, so she needs to be very careful," said Wolff of Bruegel.

"But from her point of view this is not the biggest risk. The biggest risk would be going back to the Bundestag to ask for hundreds of billions of euros for Spain or Italy."

For now, Draghi is doing his best to delay that day of reckoning.

[Source: By Noah Barkin, Reuters, Berlin, 19Aug12]

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