Bundesbank: the eurozone’s secret dictator

But, for whatever reason, over dinner in Brussels on May 23, Europe’s leaders raised the tantalising prospect for Spain of a rescue without a direct bail-out. Its crippled banks, they suggested, could be recapitalised from pooled eurozone funds with no austerity strings attached.

It was not to be. As early as this weekend , Spain was expected to apply for a formal European rescue. The money, as much as €100bn (£80.9bn), will be channelled through public finances and used to recapitalise the country’s stricken lenders.

When the details of the bail-out are agreed, it will almost certainly be presented as generous to Spain and evidence of Germany’s unstinting support for the eurozone project. Spain is expected to be pledged the funds from the European Financial Stability Facility (EFSF) or the IMF’s precautionary credit line — set up to help the “innocent victims” of the euro crisis. Under the deal, Madrid will borrow the money to recapitalise its banks at a rate it would not be offered in the market.

The cheap, state-backed funds will mean that Spain’s national debt rises from the 72pc of gross domestic product (GDP) forecast this year by the IMF to about 80pc — still lower than both France and the UK. But, crucially, neither the EFSF or IMF funds would come with any fiscal conditions attached.

Despite appearances, though, Germany will not have given an inch. The EFSF’s existing statutes say the funds can be used for a banking bail-out, and the only conditions attached will be financial sector reform.

More importantly still, the EFSF funds will not rank senior to other holders of sovereign debt — which makes them potentially preferable to IMF funds. Were the private sector subordinated to the bail-out fund, traders fear investors would be even less likely to buy Spanish government bonds, yields on which have spiked to unaffordable levels of more than 6pc. So long as the bail-out is less than €100bn, economists say, the bank rescue should stabilise Spain. Thomas Mayer, senior adviser at Deutsche Bank, is confident that the deal will help restore market confidence in Madrid, which has pushed through difficult but vital labour market reforms. But, Mayer added, there should be no mistake — at no point in the negotiations did Germany stop playing hardball. Chancellor Angela Merkel was never going to put taxpayers on the hook for the estimated €180bn of bad real estate loans made by Spanish banks.

Merkel may be the indisputably dominant force in the eurozone but it is the Bundesbank, Germany’s powerful central bank, that is increasingly seen as the power behind the throne. Since the creation of the euro, and the transfer of monetary policy for the region to the European Central Bank, its tools have been blunted. But, experts and officials say, it still dictates events through the soft power of political influence.

“It is held in extremely high esteem by both the public and the politicians,” one veteran gilts market expert said. “It sets the tone of debate in Germany. It would be incredibly influential in the decision-making process of who should stay in the euro and who should go.”

The Bundesbank has been the keeper of German inflation-fighting orthodoxy and, if anything, its sway is now stronger than ever. After all, its president is Jens Weidmann, who was Merkel’s top economic adviser for the five years before his appointment in February 2011.

“Weidmann knows the Berlin machine. At the same time, he understands how the Bundesbank works,” Mayer said. “He is now in a very good position to leverage the power of the Bundesbank. And the power of the Bundesbank really goes through its reputation among the German people. Weidmann has positioned the bank as the institution that speaks out in the German national interest. Berlin cannot ignore what the Bundesbank has to say.”

Weidmann took over after Axel Weber quit both the Bundesbank and his position on the ECB’s governing council in disgust at the ECB’s emergency bond-buying programme to prop up struggling eurozone members. Shortly after Weidmann’s appointment, Juergen Stark, the ECB’s chief economist, resigned for the same reasons.

While demonstrating how marginalised Berlin’s power was within Europe’s institutions, the two resignations fired up German public opinion and played into the political debate. And in the political arena, Germany still holds all Europe’s cards.

As Tobias Blattner, an economist now at Daiwa Securities, said. “The Bundesbank’s position in the ECB stands in complete contrast with Merkel’s position in the EU — as there she has a veto.”

Weidmann has clearly allied himself with Weber and Stark, recently writing to ECB president Mario Draghi to voice concerns about its €1 trillion emergency funding programme for Europe’s banks. According to David Marsh, author of books on the Bundesbank and columnist at MarketWatch, “the message of the Weidmann letter [was that] the Bundesbank could wield influence through the forcefulness of its own reputation”.

At a speech in New York in March, Weidmann laid down his strict economic orthodoxy. With German prices expected to rise just 2.1pc this year and the rest of the world worried about a global slump, he raised seemingly irrelevant concerns about inflation. “What we do in the short-term has to be consistent with what we are trying to achieve in the long-term — price stability, financial stability and sound public finances,” he said. “This implies a delicate balancing act — a balancing act we shall upset if we overburden monetary policy with crisis management.”

For Mayer, the Bundesbank’s influence in the eurozone crisis is clear.

“Without the Bundesbank, I think Mrs Merkel would have been much more accommodating of Brussels and the bail-outs,” he said. Citing her fickle stance over the years on both economics and nuclear power, he added: “She is not known for being extremely principled. She is pragmatic to the extreme. The Bundesbank is there to keep her virtuous.”

It is not the first time that the central bank has dictated events from behind the scenes. In 1992, Britain learnt the hard way that it was not to be trifled with. Although George Soros is remembered as the man who broke sterling on Black Wednesday, the Bundesbank played the vital role.

According to legend, Helmut Schlesinger, the Bundesbank’s hard-line president of the time, came to the opinion that the UK had joined the Exchange Rate Mechanism (ERM) at the wrong rate and wanted it out. At the time, post reunification, the Bundesbank was trying to contain a consumption-led boom with high interest rates. Britain was in a slump and running a completely inappropriate rates policy to stay in the ERM.

Soros’s right-hand man, Richard Medley, was receiving detailed briefings from Bundesbank officials, who were making it clear they believed that sterling was unsustainable and wanted to break it. Medley encouraged Soros to take big bets against the pound just as the Bundesbank went on record saying sterling would have to be devalued.

In one of the most humiliating moments in UK economic history, on September 16 1992, the UK was kicked out of the ERM. Shortly afterwards, Italy was ejected, with Soros and the Bundesbank again in cahoots behind the scenes. Only when the markets turned on France did the Bundesbank stop the rot. As Soros later said: “I felt safe betting with the Bundesbank. The Bundesbank clearly wanted the pound and lira devalued, but it was prepared to defend the French franc. I did better than some others by sticking to the Bundesbank’s side.”

Traders and economists have drawn analogies between 1992 and the current crisis. Like then, there will come a point when the Bundesbank decides enough is enough. Greece is expendable, as the Bundesbank recently made clear by saying its exit from the euro would be “manageable”, but Spain, Mayer says, is too big.

What is certain is that the Bundesbank’s primary focus is Germany’s long-term stability, rather than any immediate eurozone solution. By being attune to the German national interest, the Bundesbank is playing the role of Merkel’s political guardian — fending off the siren voices of Europe’s weaker members who want direct transfer from German taxpayers.

But the Bundesbank’s dominance means that the eurozone crisis will not be resolved any time soon. In Weidmann’s words, the only real solution to the crisis is “structural reforms and budgetary discipline” among the periphery.

Long-term, Weidmann sees only two ways for the eurozone to evolve. It will either move towards a complete fiscal union, or revert to the original treaties — albeit strengthened “so they are conducive to stability”.

Spain has set its stall by the former, with Mariano Rajoy, its prime minister, calling for more integration, as has Merkel. ­Weidmann is said to believe that the latter is more realistic. For those hoping for a resolution and recovery, though, it’s not an inspiring option.

By Philip Aldrick, Economics Editor