Good to see Dirk at Goldman is pretty much spot on:

German Economic Commentary : Chancellor Merkel not keen on more a proactive ECB stance

Published November 18, 2011

Chancellor Merkel gave a speech in Berlin yesterday where her main message with respect to stabilisation measures was essentially: No! Merkel rejected the introduction of Eurobonds but also any commitment from the ECB’s side to be the lender of last resort for Euro-zone governments.

There are several arguments the German government/Bundesbank are putting forward against a more pro-active stance of the ECB. First, a more pro-active role would not be in accordance with the treaties. Second, it would create moral hazard as it would reduce the incentive for governments to consolidate and reform. Third, debt monetisation, sovereign debt purchases by the ECB, leads to inflation. The latter argument was echoed by the chairman of the council of economic experts Franz, who said in an interview with FAZ newspaper that debt monetisation is a “deadly sin” for a central bank.

These are valid arguments, but only up to a point. In particular the worries about the inflationary impact of debt monetisation are exaggerated. Sovereign debt purchases of a central bank do not necessarily lead to inflation (see the example of Japan, although it can, see the example of Zimbabwe). It can lead to inflation if these purchases are used to finance an expansionary fiscal policy that will lead to strong growth and demand outpacing supply such that price setters will increase their prices. Fiscal policy, however, will be quite restrictive in the Euro-zone in the coming years. Italy, for example, aims at tightening fiscal policy by almost 3% next year on our estimate (we calculate this as the change in the structural primary fiscal balance). And while it remains to be seen whether the fiscal targets will be met, it is a safe bet that fiscal policy will not be expansionary in the Euro-zone for quite some time.

It can also lead to inflation if there is an excessive debt overhang, i.e. the fiscal position of a country is clearly unsustainable. Put differently the expansion of the monetary side is, even in the long run, not backed by a similar expansion of the real side of the economy. As we have argued in the past we see this only as a remote risk.

What the ECB is currently doing under its SMP is essentially swapping one savings instrument (peripheral sovereign debt) for another (cash) as private sector investors, for various reasons, no longer want to hold peripheral debt. But this has no inflationary implications unless one assumes that investors are spending the cash thereby stimulating demand which then leads to inflation. But these investors are not holding cash because they want to increase their spending, but because they think, rightly or wrongly, that cash is more rewarding from an investment point of view.

There are no easy choices and it would have been, no doubt, better if the ECB had never got in the position it is in now. But the current situation demands a careful weighing of the risk involved with any decision taken. The inflationary risk thereby seems to be getting an unduly high weight in the consideration of German policy makers.

Dirk Schumacher