Exit polls in North Rhine Westphalia (“NRW”) indicate that the centre-left opposition of the SPD and Greens will gain a clear majority in Germany’s most important state. The CDU’s share of the vote declined to 26%, from 35% in 2010 and is the CDU’s worst result in the post-war period. The results also confirm a clear rejection by voters of the strict austerity measures proposed by the CDU. With a general election due in late 2013 and calls by the vast majority of countries in the EZ for growth measures and not just austerity, Mrs Merkel is losing control of the both the agenda and the situation. As most of us have banged on for a very long time, the German prescription to date has been nonsensical and way beyond it’s sell by date. Do the German’s have a plan B – personally, I don’t believe they have, but a number within the CDU must be scrambling around starting today to produce one.

A couple of chinks of light have appeared. The head of the economics department at the Bundesbank last Wednesday suggested that Germany would have to accept a higher inflation rate and Schaeuble called for higher wages in Germany, combined with a rate of inflation above the current 2.0% threshold. Schaeuble has proposed that an “acceptable” rate of inflation in Germany could be “in a corridor between 2.0% – 3.0%”. Personally, I believe inflation will end up higher.

A higher rate of inflation and increased consumption in Germany (resulting in a smaller current account surplus) is a basic necessity to begin to resolve the crisis in the EZ. The penny, finally, seems to have dropped in Berlin.

The recently elected French President Mr Hollande meets with Merkel this week. It’s going to be a particularly interesting discussion. The view was that Mrs Merkel would completely overwhelm him – given the recent political backlash against austerity measures, this is likely to be far from the truth, in my humble view. The reality of the situation, given that Germany wants the Euro/EZ (OK maybe without Greece) to survive, is that the current policies needs to be changed. Essentially, some growth measures are necessary, but I fear that what will be announced will be a joke. The most important issue is that the EZ population needs to believe that there is some “light at the end of the tunnel” – to date there has been none. Current policies have resulted in the ousting of Sarkozy, over 50% of the Greek electorate voting for anti bail out parties, the loss of NRW, a much less popular Monti and the new Spanish PM, Mr Rajoy, etc, etc. The situation will just get worse if not attended to promptly.

As a first step, EZ banks (including German) need to be sorted out. You cannot have a recovery in the EZ if banks are retrenching, given regulatory demands to increase their capital as a percentage of risk weighted assets and, most importantly, given the level of bad debts in the system. The private sector will not provide the funding necessary – EZ governments will have to provide the funding necessary. However, I believe that this time around, existing shareholders/bondholders will have to take the first hits. The tax payer cannot and must not take on the burden, wherever possible. Clearly depositors will have to be protected.