As far as I can oversee the problem the best way to use accent letters in this (HTML rendering) environment is to use 'ä' etc. since every visitor can make sure his browser can render it correctly. NN and IE can already do it since version 4 or even earlier.
You mean every umlaut should be shown in the EditBox as it's entity? That would make most German articles very hard readable. It should be possible to enter entities, but they should be shown as umlauts to the 'normal' user. If foreign contributors don't see umlauts but strange characters in their EditBox, maybe they could have an option in their preferences so that they are shown as entities. But I haven't heard of this problem.
Perhaps the Wikipedia software could try to translate ae and such to the appropriate HTML abreviations like ä but that would be risky, because it would have to know in what language each word was written. In Dutch we have the 'oe' as a valid combination which is not equal to 'ö', so if Dutch and German were mixed in an article it would cause problems.
I would never suggest this, because 'oe' is also a valid combination in German (e.g. the musical instrument "Oboe", or a city I lived in, "Itzehoe"). Same with "ae" and "ue".
Kurt