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The Bundesbank has finally given in to demands calling for a higher inflation rate inside Germany (and the eurozone) in order to rebalance the European economy, as the Financial Times reports:

The Bundesbank, the most hawkish of central banks, has signalled it would accept higher inflation in Germany as part of an economic rebalancing in the eurozone that would boost the international competitiveness of countries worst-hit by the region's debt crisis.

That means that the German price level would be allowed to rise when the capital inflows finally generate above average rates of inflation. This in turn weakens international competitiveness, which is good. It allows the European periphery to increase their respective exports (to Germany) and repay the foreign debt run up during the last 10 years. German consumption and investment will rise, fueled by the available capital that now has returned to Germany. A real estate boom is in the making already. The question for the next couple of months is: Was it too little too late?

As the Greek political system starts to crumble and Spain is bailing out its third-largest bank, there are signs that those economies move into recession. This might pull Germany with it, since the transmission channel foreign trade is a very important one. Lower German exports would destroy employment there, leading to the question of how the available funds should be invested. After all, the government sector is subject to the debt brake. So if the private sector does not increase its debt, than the government sector cannot take over. A debt deflation is still in the cards.

It is right that the Bundesbank accepts higher inflation, although the ECB mission used to be a different one:

The European Central Bank and the national central banks together constitute the Eurosystem, the central banking system of the euro area. The main objective of the Eurosystem is to maintain price stability: safeguarding the value of the euro. We at the European Central Bank are committed to performing all central bank tasks entrusted to us effectively. In so doing, we strive for the highest level of integrity, competence, efficiency and transparency.

However, that mission does allow to trade in short-term price stability for long-term price stability -- and vice versa. In order to stabilize future inflation (and not see deflation), we need to run at a higher inflation now for some time. Only when macroeconomic imbalances have been reversed the support by the ECB can be withdrawn.

It can only be hoped that the move toward more inflation has the effect it is supposed to have. It might be too late now, with Greece and Spain in deep crisis and political instability threatening the European project. Many commentators have urged the ECB and the Bundesbank to move faster, as it was clear from the beginning that the economic imbalances must be reversed in order to get out of the crisis. (I published analysis in June 2009 -- almost three years ago -- that pointed that way; others did so too.) Getting out of the crisis will mean (realized) losses to many and gains (fewer losses) to a few, so not too much should be expected.

History will judge the performance of the ECB in its first 10 years. A part of that history is still about to be written, and the people at central banks all over Europe should now press jointly for a solution of the crisis. Rebalancing on part of the creditor countries, a partial default of those with unsustainable debt -- be them governments, banks, private sector firms -- and support for economic growth through all means necessary is what will restore balance sheets in the eurozone. Only then the confidence fairy will see that all is well in the eurozone and make a comeback in financial markets. If the rest of the world economy plays along, that is. It's called globalization for a reason.

Source: Bundesbank Embraces More Inflation (In Germany)