Ever since it's cash-in-a-wheelbarrow Weimar days, Germany has been an inflation hawk über alles. That's been good enough for Germany, but bad for countries that have outsourced their monetary policy to Germany despite needing lower rates themselves. Britain made this mistake when it pegged the pound to the deutsche mark as part of the European Exchange Rate Mechanism in 1990. But when speculators, led by George Soros, pushed the pound down, Britain decided that the ERM wasn't worth the deep recession that raising rates enough would cost.
Europe faces the same dilemma today, only worse. See, joining the euro means ceding control of monetary policy to the German-influenced ECB. That's a problem, because almost all of the eurozone economies, not just the crisis countries, need easier money than Germany. But they can't ditch the euro as easily as Britain ditched the ERM, because bringing back their old currencies would set off the mother-of-all bank runs, as people tried to move their money from countries where it would get devalued to ones where it wouldn't. So Europe is stuck trying to convince Germany to let the ECB do more—which isn't easy.
In fact, that's been the whole story of the euro crisis. Germany has forced countries to try to cut their way back to health, and, as Peter Spiegel extensively reports, only allowed the ECB to do what was needed all along when the alternative was a financial crisis. But Germany has been even more reluctant to allow the ECB to do what is needed now despite Europe's slow-moving economic crisis.
It's called "lowflation," and it's crippling Europe. It's, simply enough, inflation that's well below target. Now, there's a common misconception that low, positive inflation is alright, but low, negative inflation is the end of the world. As the IMF points out, though, these are continuum of the same problem. See, it doesn't really matter whether prices aren't rising enough or are actually falling. In either case, it's harder to pay back debts, harder for real wages to adjust, and harder for countries to regain competitiveness. Of course, deflation is worse than lowflation, but not so much that we should fear the former and not the latter. We should fear them both.
The ECB has made the mistake of letting inflation fall to just 0.5 percent. That's why real borrowing costs, at least for businesses, have risen even as headline borrowing costs have fallen. You can see this passive, yet destructive, monetary tightening in the chart below from the Council on Foreign Relations. It looks at what German and Spanish companies have had to pay to borrow in both inflation-adjusted and unadjusted terms since the crisis hit. Nominal rates fell a little after ECB chief Mario Draghi promised to do "whatever it takes" to save the euro. But real interest rates, which are the ones that matter, have risen since then, because inflation has fallen more than headline rates have.
This isn't just a Spanish or an Italian or a Portuguese or a Greek problem. It's a European problem. Lowflation, together with austerity, have sent unemployment up even in "core" countries like France, Finland, and the Netherlands. That's why Euroskeptic parties outside of the crisis countries, such as Marine Le Pen's National Front, did so well in the recent European Parliament elections. They aren't happy just to be in the euro. They feel like they did nothing wrong to deserve their trouble now, and they're starting to blame the eurocrats in Brussels for their problems.
In other words, the ECB has won the financial war for the euro, but it hasn't won the political peace. It will take a real recovery to do that, and that means reversing their Japanese-style slide toward deflation.
As a first step, the ECB is expected to start charging banks to hold money with them overnight, which should help weaken the too-strong euro and increase inflation a bit. But that's only a first step. At some point—and the sooner the better—it's going to need to do what Germany really doesn't want to do, and start buying bonds with new euros. If it doesn't, Europe's growth will stay in neutral, and its anti-euro politics might accelerate.
The only way to save the euro is to print more of them.