Hamburgers vs Frankfurters: German Politics and the Euro

Hamburg, the second largest city in Germany, gave the Social Democrats a stunning victory in the weekend election. It won an outright majority. It is the party's best showing in any state election since 1998. Merkel's CDU drew a little less than 22% of the vote, nearly halved from the 2008 contest.

Local issues, like the failed education reform efforts and the controversial plans the dredge the Elbe River played a role, but it is hard not to draw larger implications from the election.

The lesson that some draw is that the CDU was being punished for bailing out Greece and Ireland. To be fair though the EFSF works on the basis loan guarantees not transfers. The center-right Free Democrats who are adamant in their objections to the creation of a transfer union actually did well in Hamburg. They received 6.6% of the vote, which is sufficient to get local parliamentary representation, something denied in 2004 and 2008. But this can be explained perhaps in that it picked up some of the more extreme CDU voters who felt the party had abandoned them.

The SPD's position is much more in line with what seems to be the EU's position and most of the euro zone members. Party officials seem more willing to consider, for example, an increase in the EFSF size and a European bond. They also seem more sympathetic to Greek and Irish claims that the interest rates they are being charged for aid is too high.

Both the Bundesbank and ECB are headquartered in Frankfurt. Under Weber, the BBK has come out forcefully against ECB bond purchases. It seems to see the crisis in terms of fiscal irresponsibility and the lack of competitiveness on the periphery. The banking crisis itself appears to have a bit part in their explanation. Some ECB members, including Trichet and Stark seem more sympathetic to the EFSF/ESM buying sovereign bonds, but this may be because it does not want the ECB itself to have to do so.. It will be interesting to see what position the incoming BBK head Weidmann takes.

Often officials change their tune a bit depending on the position that they hold. Weidmann was reportedly a close confident of Chancellor Merkel and the CDU/CSU/FDP just reiterated their objection to a joint bond issue or the EFSF/ESM financing bond buybacks.

February has been simply dreadful for Merkel. Not only was her party trounced in Hamburg, but her ECB candidate Weber took himself out of the game, resigning and won't help her give the reassurance she wants to German voters. And her "competitive pact", worked out with the French, was widely rejected by European finance ministers.

The German strategy appears to be rudderless at the moment. It is not clear what concessions it can elicit in exchange for offering a "comprehensive" solution to the debt crisis. Getting rid of wage indexing, a constitution amendment to enshrine fiscal prudence, and a common corporate tax rate seem to be non-starters at this juncture. At the same time, the Irish elections this Friday may mark the beginning of the end to the current strategy of encouraging the debtors to take on fresh debt so that the creditors do not have to realize losses.

The euro is currently pulled between the hawkish rhetoric of ECB officials ahead of next week meeting and the risk aversion sparked by the jasmine revolutions in Northern Africa and the Middle East. Given the EU summits and German elections in next month, the European debt crisis is likely to re-emerge as an important euro driver.