European Central Bank Fights for its Soul

FRANKFURT -- Juergen Stark is not the kind of man who enjoys drawing attention to himself. But the Eurozone crisis pushed him over the edge.

People who know the career finance official and central banker use words such as loyal, reserved and solid to describe the man from a small town in Germany's western wine region. He enjoys the simple things in life, such as the Rindswurst, or beef sausage, on sale each Saturday at the covered market in Frankfurt. A longtime colleague characterizes the 63-year old with a retro-mustache as the classic Prussian civil servant -- so dedicated that he would never let anything get in the way of his duties.

That explains why his abrupt resignation last month from one of the most important positions at the European Central Bank (ECB) was such a shock. Stark's departure came in the midst of a deepening debt crisis that threatens to tear Europe's single currency apart. The news that he would step down from the central bank's six-member executive board, nearly three years before his term was up, rocked global markets.

Stark is someone who was behind the euro from the very start. As an adviser to former German Finance Minister Theo Waigel, he helped write the fiscal rules enshrined in Europe's Stability and Growth Pact. Now he was abandoning his post at the worst possible moment.

In a statement issued on September 9, the ECB said Stark was resigning for personal reasons. But the real trigger, according to more than a dozen central bankers and senior government officials interviewed for this article, was Stark's deep concern about the direction the ECB has taken under its French president, Jean-Claude Trichet, and his conviction that things were unlikely to improve under Mario Draghi, the Italian who will succeed Trichet next month.

The entire financial and monetary policy in Europe at the moment is completely at odds with the professional beliefs Stark built up over the past 30 years, said one senior euro zone official who is privy to ECB deliberations.

Under Trichet, the central bank has ventured beyond its core goal of fighting inflation, buying up the bonds of floundering euro members such as Greece to prevent the currency bloc from collapsing. For Germany's monetary hawks - hardliners brought up on horror stories about hyper-inflation between the two world wars - this foray is misguided and perilous.

Stark is one such man. So is his compatriot Axel Weber, who announced abruptly in February that he was resigning as head of the Bundesbank, Germany's central bank, and withdrawing his name from consideration as a successor to Trichet because of frustration at the ECB's new direction.

Stark's departure, on the heels of Weber's defection, shows that the ECB is at a crossroads. Trichet, the former head of France's central bank, has been a key figure in the euro zone since it was founded 12 years ago. He seemed to bridge the divide between the strict German approach to monetary policy and a looser southern European attitude. Now Draghi is poised to take over on November 1. Some hope he will prove more Germanic than Mediterranean and push the ECB back to its monetarist roots, but it will take time before his intentions become clear.

Little wonder, then, that there is so much angst at the bank. A German official who has known Stark for more than a decade said Stark had felt increasingly isolated on the ECB board and agonized for months before finally submitting his resignation.

He was in a really bad way. You could see the burden he was carrying on his face, the official said.

EARTHQUAKE

Twelve years after German Chancellor Helmut Kohl pushed through the monetary union over the objections of a majority of his country's citizens, the bloc is crumbling under the burden of huge debts. And the one institution that Germans were told would ensure stability, the ECB, is in deep crisis itself.

In the absence of decisive action from Europe's leaders, the bank has come under enormous pressure to fill the gap. It has bought up 160 billion euros ($211 billion) in Greek, Irish, Portuguese, Italian and Spanish bonds over the past 16 months to ease pressure on the bloc's weakest members.

Both Stark and Weber were critical of the quantitative easing, or massive bond purchases, made by the U.S. Federal Reserve and Bank of England to protect their economies. And they were dead-set against allowing similar steps in the euro zone. Crisis or no crisis, they believe buying bonds has blurred the line between monetary and fiscal policy, compromising the bank's independence and inflation-fighting credentials. Many Germans agree.

What is left of the ECB's credibility? top-selling German tabloid Bild asked last month next to a doctored image of the ECB tower in Frankfurt crumbling into ruins. Its answer: Just this pile of rubble. This week, a poll conducted for Stern magazine showed that 54 percent of Germans favor a return to their former currency, an identical figure to a poll taken in May, 2010.

But privately many ECB colleagues, including those from stricken southern states, will say that it is the Germans who are short-sighted and out of step, insisting on archaic monetary orthodoxy at a time of unprecedented financial turbulence.

KOHL'S LEGACY

During the negotiations leading up to the currency bloc's founding Maastricht Treaty, Helmut Kohl, who came to power in West Germany in 1982 and then oversaw the end of the Cold War and reunification with the east, used the German public's reluctance to give up the Deutschemark as leverage. For Germany to get on board, he told Europe's other leaders, the future ECB had to be a virtual clone of Germany's own central bank, whose focus on inflation busting was legendary. And Kohl largely got his way. The ECB's structure closely mirrors that of the pre-euro Bundesbank, with a central board and a broader governing council.

The six-member ECB board, which has always included one German, takes care of day-to-day business. The 23-member council, which includes both the board members and the central bank governors of the 17 euro member states, is responsible for setting monetary policy on a monthly basis. Decisions of the ECB council, like those at the old Bundesbank, are taken on a one-person, one-vote principle.

In late 1998 the bank's inflation guidelines were drawn up with a nod to lingering German angst over the destabilizing hyper-inflation of the Weimar Republic. Price stability was defined as an inflation rate below 2 percent, fine-tuned in 2003 to below but close to 2 percent.

The Germans, supported by others, including my own country, were intent on carving the independence of the central bank in marble, former Dutch Prime Minister Wim Kok told Reuters.

POLARIZATION

Fast forward to 2011 and the picture has changed dramatically. The 11 countries that launched the euro in 1999 have expanded to 17, raising the risk that a big fish such as Germany can be outvoted by economic minnows. The five most recent joiners - Slovenia, Slovakia, Malta, Cyprus and Estonia - have a combined population of just over 10 million, compared to 82 million for Germany.

Economically, Germany outweighs Malta by 500 times - but the president of the Bundesbank has the same vote as the Maltese governor, David Marsh writes in his 2009 book The Euro - The Politics of the New Global Currency.

In practice, the ECB's governing council does not take decisions by a show of hands. Under both Trichet and his predecessor, Dutchman Wim Duisenberg, the bank has set policy by broad consensus. The president gets a feeling without counting heads, a euro zone central banker said.

That worked fine until the crisis hit. Then policy differences became more pronounced, forcing Trichet into a more authoritarian role and raising the level of tension on the board, several officials said.

The tone of the discussions at these board meetings is getting more strained every week, a euro zone central banker said. There is a kind of polarization.

The ECB declined to comment, when asked about the confidential meetings. Stark, Weber and Trichet also declined to be interviewed for this article.

AT ODDS WITH TRICHET

The Germans have not always been at odds with the bank's recent policies. They supported the ECB's decision to raise interest rates twice this year as inflation levels in the bloc pushed above the 2 percent mark. In retrospect, these steps appear to have been ill-judged. With the bloc now facing the risk of recession, the ECB may soon be forced to shift into reverse and cut rates.

But on other issues, the German official who knows Stark said, Trichet had been stubborn and refused to listen to others. For example, in early summer he rejected the idea of a second Greek aid package in which banks would take a haircut, or partial write down, on their holdings. This hard-line stance needlessly exacerbated the bloc's problems, according to this official. Trichet eventually backed down after euro zone governments agreed to provide guarantees for Greek bonds.

Both Stark and Weber objected when Trichet first pushed through a plan in May 2010 to buy Greek bonds on the open market. But while Weber came out publicly against the decision, Stark kept silent.

Less than a year later Weber, the frontrunner to replace Trichet, announced he would step down early from the Bundesbank - a decision that weighed heavily on Stark, according to people who know him.

He was pushed over the edge in August, when Trichet and other ECB colleagues decided to re-open the bond buying program and, in a late night conference call with council members, gave a green light for the purchase of Italian and Spanish bonds.

Behind the scenes, the German government scrambled to convince Stark to delay his resignation because of the acute nature of the euro zone crisis, officials in Berlin told Reuters. Stark, a member of Angela Merkel's right-of-center Christian Democrats, was warned that an ill-timed resignation would make it more difficult for the German chancellor to get conservative allies on board for a make-or-break vote in parliament on boosting the powers of the euro zone's rescue mechanism. But those entreaties failed.

Stark's resignation took some central bank governors by surprise when Reuters broke the news on September 9. Trichet, who had been informed the night before, launched into an unusually emotional defense of the ECB's inflation-fighting record at a news conference that day.

We have delivered price stability over the first years of the euro - Impeccably! Impeccably! Trichet roared. We are in the worst crisis since World War Two. We do our job. It is not an easy job.

ENTER DRAGHI

How the ECB evolves in the post-Stark era has become a source of great concern in Germany. Next month, Trichet will be replaced by Draghi, who as governor of the Bank of Italy has sat in on meetings of the ECB's policy-setting governing council for years but, according to people who have watched him close up, only rarely spoken out.

He is very discreet, very introverted, very reserved, a senior Italian official who worked closely with Draghi told Reuters. I don't think you can describe him as hawkish. He is very pragmatic. He has political intuition. He's not dogmatic in his approach. Every move will be very closely calculated.

Complicating Draghi's task will be unprecedented turnover on the ECB board. By the middle of 2012 all six members will have been replaced in a span of just two years. Many Germans fear the changes will mean that Jens Weidmann, who replaced Weber as head of the Bundesbank earlier this year, is the lone remaining inflation hawk in the policy-setting council.

This new team will have to navigate through treacherous waters. A Greek debt default, recessions and a backlash against austerity in the southern periphery, and rising euroskepticism in the north are just a few of the immediate challenges. Pressure is also building on the ECB to reverse the rate hikes that it put in place earlier this year, and to adjust the unlimited liquidity taps it turned on for banks after the collapse of U.S. investment bank Lehman Brothers in 2008.

Then there is the controversial bond-buying program. Can the bank count on the euro zone's rescue fund - the European Financial Stability Facility - to take over this task? And what of the ECB's balance sheet, so weighed down with toxic assets that some Germans now refer to the institution as Europe's bad bank.

For Draghi it's going to be a very difficult situation, said Guntram Wolff, deputy director of the Bruegel think tank in Brussels and a former Bundesbank official. He will have a completely new team, a team that is very young with little central banking experience.

The German official was more blunt. The question is less how he will lead but whether he can lead, he said, pointing to Draghi's silence in recent months on the big questions confronting the central bank and broader euro zone. On November 1 he will have to spell out where he wants to lead the ECB.

In his first public appearance since announcing he would step down, Stark seemed to have a message for the central bank colleagues he will soon leave behind.

Speaking in Vienna on September 15, he stressed the importance of rules and principles, saying these could not be thrown out the window at the first signs of turmoil. On the contrary, they become absolutely decisive in a time of crisis.

Should I flood the markets only to realize afterwards that the water damage has become bigger than the fire damage? Stark asked. (Reporting by Noah Barkin, Andreas Framke, Eva Kuehnen and Marc Jones in Frankfurt, Annika Breidthardt and Matthias Sobolewski in Berlin, Michael Shields in Vienna, Martin Santa in Bratislava, Dan Flynn in Paris; editing by Sara Ledwith, Michael Williams and Lee Aitken)