Today's shocking resignation of

Oskar Lafontaine

, Germany's finance minister, illustrates a growing tension between German and

European Union

institutions. In recent months, Lafontaine had been calling on the

European Central Bank

to cut rates to stimulate Germany's sluggish economy -- but to no avail.

In the wake of the minister's resignation, the euro is rising against the dollar, suggesting that the market believes German-EU relations will improve with the combative finance minister's departure. But the causes of Lafontaine's frustrations with the ECB are very real -- and must be addressed by whoever fills his post.

Here's why.

With the adoption of the euro, the currency's 11 member states agreed to operate with a single interest rate. But at 3%, this rate is too high for Germany. As a result, the country's economy is stuck in a slump, which, if it persists, will test Germany's commitment to the constricting structures that make up economic and monetary union, or EMU.

The German economy shrank by an annualized rate of 1.5% in the last quarter of 1998, which is much worse than most other EU countries. Deflation is a real problem. This year, Germany will not grow by more than 1% compared with 2.2% for the rest of euroland, economists at

Salomon Smith Barney

predict. The unemployment rate is 9.4% -- and is expected to stay at that high level for months, or even rise.

The ECB -- which has the task of setting a rate it feels best suits all 11 countries -- had refused to follow Lafontaine's advice.

True, the

Bundesbank

, with its anti-inflation obsession and jealously guarded independence, was a royal pain in the neck for German politicians. It even helped topple more than one postwar government. But, unlike the ECB, it at least set rates to suit Germany's economic conditions. But if the Bundesbank were still in charge, German rates may already have been lower.

Restraining Gulliver

That Germany would be hemmed in like this surely comes as no surprise to the 10 other countries in the eurozone. In the pre-ECB days, they were forced to tag along slavishly with Bundesbank policy because of the size and historical soundness of Germany's economy.

Indeed, the other 10, particularly France, favored EMU precisely because it would limit Germany's power with administrative structures like the ECB. Now, the Bundesbank's president, currently

Hans Tietmeyer

, is just one voice on the ECB policymaking bodies.

"Germany now has to adapt to what other countries want to do," remarks Michael Saunders, an economist at Salomon Smith Barney in London.

Using bureaucratic structures to equalize the balance of power is a frequently used tool in international politics. Writing in the

New Republic

last week, the polemicist Charles Krauthammer, summed it up: "The project of liberal foreign policy is to build an entangling web of interdependence; the point is to tie down Gulliver with a million little strings."

But how long can the 10 other countries expect to keep the ropes on Germany? Or, perhaps a better way of putting it is: What would provoke the country's government and people to want to shake them off?

Without doubt, it would take a lot more economic pain and disillusionment with EU institutions than currently exists in Germany. The Germans have no current desire to be labeled "Euro Wreckers." Or, even worse, to be blamed for ushering in a new age of full-blown European

Machtpolitik

.

That said, Europe is entering a very new era, in which predictions are tough to make. Never before in recent history has a set of supranational European institutions had so much power. And it's a long time since Germany's economy made it the sick man of Europe.

Deutschland's Diseases

Common sense suggests that, if Germany's large economy were in the doldrums, the rest of Europe would start to slow down as well. The ECB would, under that scenario, cut rates to a level that would help Germany out of its trough.

But it's not that simple. For example, Holland's economy, often thought to be closely tied to Germany's, accelerated at a swift annualized rate of 2% in the last quarter of 1998.

Saunders believes that other EMU members will be sheltered because Germany is hampered by a range of domestic factors, like above-average labor costs, large exposure to the depressed capital goods sector and high inventory levels. This divergence is going to be around for a while. "It'll be a lasting issue," he says.

In fact, the wider the gulf in economic fates gets, the harder it would be for the ECB to loosen, especially if inflationary pressures return to several other euroland countries. This is where EU relations could get really tense. Instead of settling Germany into an increasingly integrated EU, the Gulliver policy could horribly backfire and prompt the German people to seriously question the practice of pooling sovereignty.

"The risk is that if you do get rising unemployment and worsening economic conditions, the Germans begin to feel that everyone in the EU is ganging up on them," says Bernard Connolly, chief economist at

AIG International

in London and author of the 1995 book

The Rotten Heart of Europe

.

Under these conditions, the Germans would stop listening to the very effective emotional blackmail at the heart of most European federalist thinking. A belief among European integrationists -- including the German advocates like former Chancellor

Helmut Kohl

-- is that Germany cannot be trusted outside of EU structures. It springs from an understandably deep fear of the country's dreadful past. The British historian

AJP Taylor

, writing in the last days of World War II, expressed this pessimistic sentiment most pithily: "The history of the Germans is a history of extremes. It contains everything except moderation."

Mitterrand's Mistake

But, from 1945, West German history was marked by moderation -- and unified Germany has also been surprisingly stable. Therefore, it looks like it was an overreaction to lock the country into EMU. And

Francois Mitterrand

, the former French president, was almost certainly wrong to demand a single currency in return for agreeing to reunification.

At the moment, German policymakers, still stuck in their self-flagellating mindset, will not want to rock the boat. But deep economic pain could change that faster than some think. Of course, if Germany did dump the euro, France could react badly and unpredictably. The markets would suffer a long period of volatility. And the U.S. would have to profoundly reassess its Europe policy. But when the dust settled, the EU would probably survive, only euro-less.

So far, this piece has been speculative and a tad alarmist. This difficult period in German-EU relations could, of course, play out much less eventfully. But don't bet the farm on it (even if it is subsidized by Brussels).

In theory, Germany could reform its way out of stagnation. Yes, the government of

Chancellor Gerhard Schroeder

has shown little taste for instituting deep structural reforms. But if Germany's performance falls well behind that of its EU partners and capital starts leaving the country, Schroeder could be forced to embrace tough measures, especially as competitiveness can no longer be gained through currency devaluation.

But Keynesian economists make a compelling point: The structural measures take time and Germany needs looser money

now

. "Structural reform is at best a medium- to long-term business. Shortage of demand must be met in the short-term by stimulating economies in which inflation is not a problem. Believe it or not, inflation is down to 0.2% a year in Germany. Is anybody in Frankfurt listening?" William Keegan recently wrote in the UK's Sunday

Observer

.

The ECB's Unholy Trinity

Germany can also step up behind-the-scenes pressure on the ECB to cut rates. While the ECB committees do reduce German power, the country does of course have significant influence outside of formal decision-making bodies.

ECB chief

Wim Duisenberg

, Tietmeyer and French central bank chief

Jean-Claude Trichet

regularly confer before key ECB policy meetings, says AIG's Connolly, who was not prepared to reveal the source of this insight. This mini-council, he says, drives decisions over monetary policy in the ECB, which declines to publish minutes from its meetings or voting records (unlike the

Federal Reserve

or the

Bank of England

).

So why hasn't Tietmeyer -- a German, after all -- used his influence to force a rate cut? One explanation could be that he is outnumbered even in this small group. More likely, Tietmeyer is himself against rate cuts. He's no friend of the Schroeder government and has no desire to help it achieve its agenda. Moreover, he is a fierce believer in the independence of the ECB and resents Lafontaine's recent attempts to browbeat it.

However, Tietmeyer is scheduled to step down as head of the Bundesbank in August. His successor could be much more in step with the German government and a looser monetary policy could be soon coming.

But that may only buy some time. If inflation flares up elsewhere in the EU, other countries' ECB members will not hesitate to use their votes against Germany, which will then face an awful choice: to accept unsuitable diktats from unelected committees of bankers or defy the ECB and bury the euro.