01/03/2012 04:22 pm ET Updated Jan 03, 2012

German History Weighs On European Central Bank

In the wake of the financial crisis, the Federal Reserve took drastic measures to shore up the U.S. financial system. Now as Europe enters its worst economic debacle since World War II, economists and politicians are calling on the European Central Bank to pull off a similar rescue.

So far, it has not.

The reasons for the Frankfurt-based central bank's reluctance can be traced back to Germany's troubled past, which includes both world wars and the enduring legacy of Adolf Hitler.

History is proving an inescapable weight on the continent's ability to save itself from economic peril. "German memory of the hyperinflation in the early 1920s and then the absolute destruction of the economy and money by 1945 -- those are things that people haven't forgotten," said University of Pennsylvania political science professor Ellen Kennedy, author of "The Bundesbank: Germany's Central Bank in the International Monetary System." "Those are well within living memory."

In 2008, the Federal Reserve faced down the financial crisis by lending extensively to banks and buying large amounts of troubled securities. While these bank bailouts are not without controversy, most economists agree that these moves helped prevent an all-out depression.

Now, economists say that the ECB could halt the sovereign debt crisis in Europe by purchasing large amounts of government bonds, as the Fed did with mortgage-backed securities. The belief is that such a move would lower borrowing costs for eurozone countries and stabilize the European banks who are holding that debt, staving off economic disaster.

But while the ECB freely lends to banks, it refuses to buy much government debt. When the Financial Times asked ECB President Mario Draghi in December if he would consider buying large amounts of government bonds, he replied, "We have to act within the Treaty."

That is, no.

Jens Weidmann, president of the Bundesbank, Germany's central bank, is even more adamantly opposed to government bailouts. "Financing state debts through the money printing press is, and remains, forbidden by treaty," he said in December.

The founders of the European Union modeled the ECB after the Bundesbank, which was founded in 1957 and has since been singularly focused on curbing inflation; the Bundesbank is not allowed to buy any debt directly from the government. Until 2000, the Bundesbank managed the German government's debt and kept some government bonds on its books, but it never has provided financing for the federal government, according to Bundesbank spokesman Peter Trautmann.

Unlike the Federal Reserve, which uses purchases and sales of Treasury bonds as one of its primary weapons, the Bundesbank historically has relied on interest rate adjustments for monetary policy, according to Kennedy. It has consistently resisted political pressure to finance government debt, she said.

The Bundesbank's minimalist approach to monetary policy is steeped in a 60-year reaction against the causes of two German economic collapses. The first took place in the early 1920s when the Reichsbank, then the German central bank, snapped up government bonds in order to devalue the overwhelming debt that Germany owed to the victors of World War I. The Reichsbank thought that it was "a patriotic duty" to do so, said Princeton history professor Harold James, who wrote two histories of Deutsche Bank and "The German Slump," a book on the interwar depression in Germany.

The currency became worthless. By September 15, 1923, one dollar was worth 200 trillion marks, according to University of Pennsylvania history professor Jonathan Steinberg, who wrote the official report on Deutsche Bank's gold transactions during World War II.

A 1924 treaty imposed a ceiling on the amount of government debt that the Reichsbank could buy: less than 1 percent of German economic output, according to James.

However, when Hitler came to power in Germany in 1933, he found a way around the Reichsbank's nine-year independence and used the central bank to finance the militarization of Germany.

"He wanted to spend very soon and regularly enormous amounts of money for rearmament," said Gerhard Weinberg, an emeritus history professor at the University of North Carolina who has written extensively about Nazi Germany and World War II.

Hitler's central bank did all it could to fund the German military during World War II. It stole gold from the Netherlands and took gold teeth out of victims' mouths in concentration camps. By 1941 the German mark was plunging in value. And by the end of the war, it was worthless. Between 1945 and 1948, the black market was almost the only way Germans could obtain goods. Some used lucky charms as currency, according to Steinberg.

"Goods just disappeared after 1945. There wasn't anything in the shops," Kennedy said.

When West Germany instated a new currency and central banking system in 1948 during the Allied Powers' occupation, it made a renewed commitment to monetary stability. A 25-year economic boom followed.

The Bundesbank, which was founded in 1957, was vested first with defending the value of the currency, according to Kennedy. "In practice, it didn't buy government debt," James said of the Bundesbank.

Considering this tragic history, Germany now adheres to monetary stability like a constitutional decree, according to Kennedy. German law describes property as not only a right, but also a "duty," she said: implying that inflation is "financial repression" by taking away property.

Today the ECB is steeped in the same past, since it was modeled mainly after the Bundesbank, and because the Bundesbank wields the most influence today over the ECB's policies. Both central banks are not allowed to buy debt directly from governments, and they view their primary responsibility as curbing inflation. Other European central banks were "far from being so exclusively focused on price stability," according to Paris School of Economics economist Jean Imbs.

"They see the sovereign debt question in the same light that they see inflated money," Kennedy said of the Germans. "It's bad to run up bad debt, and it's bad to let your money become valueless through inflation."

Some economists believe that the danger of a banking collapse or eurozone breakup far outweighs the possibility of inflation. They say that though controlling inflation should be a long-term priority, the ECB needs to address the immediate crisis first.

"There is no evidence" that countries that stay on the euro are in any danger of experiencing runaway inflation in the coming years, said Nicholas Economides, economics professor at New York University's Stern School of Business.

"If we don't get out of the crisis, and banks start collapsing, or the euro collapses or Italy collapses, I mean these are such catastrophic events that worrying about inflation three years from now being 3 percent instead of 2 percent is trivial," Economides said.