Review of David Marsh, The Most Powerful Bank: Inside Germany's Bundesbank (New York: Random House, 1994), 400 pp., $25.00.

The Bundesbank is one of the wonders of the Wirtschaftswunder that was ushered in by Ludwig Erhard's great reforms of 1948. Before the establishment of the Bundesbank in 1957, the Bank Deutscher LŠnder, a creation of the allied military government, had emphasized the importance of monetary policy in ensuring price stability. Both banks owe their independence and prestige to two catastrophes. The first was the great hyperinflation of 1920-23. This expropriated the wealth of the German middle classes and paved the way for Hitler; the gutter became the government. The second catastrophe was the hyperinflation of 1945-47--a consequence of the massive deficit financing of World War II. The Reichsmark currency was completely destroyed and the currency reform of 1948 ushered in the deutschemark, the Grail of which the authorities of the Bundesbank are the guardians.

During the early 1870s, the numerous states of Germany had fragmented currencies which were unified by the creation of the Reichsbank in 1876. From its inception the Reichsbank was completely dependent on the government. But as Germany had joined the gold standard, such dependence was not a matter of great concern. One of the central principles of international monetary economics is that if one fixes the exchange rate, then there is little or no scope for an independent monetary policy...a simple lesson that is forgotten more often than learnt. So, although Germany rarely obeyed the implicit rules of the old gold standard (it was a notorious hoarder of gold), the convertibility requirement prevented any inflationary financing until the abrogation of the standard in 1914. Then, at the behest of governments, the Reichsbank, by monetizing the large government deficits, ensured the hyperinflation of 1920-23.

As a result of the advocacy of Montague Norman, the powerful Governor of the Bank of England, and the pressure exerted by the Allies in May 1922, the Reichsbank was made independent of government by the Autonomy Act. The monetary reform of 1923 and the creation of the new stabilizing Rentenmark--"backed by the real estate of the Reich"--paved the way for the establishment of a new currency, the "Reichsmark," which was based on the gold exchange standard. The Reichsbank remained independent of government.

With the accession of Hitler, however, the Reichsbank was soon put in its place. Through one encroachment after another, the independence of the Reichsbank was repudiated. In 1937 the Reichsbank was made subject to the instructions of the Fuhrer and Reichskanzler Hitler. In January 1939 six of its eight directors were dismissed when they criticized the excessive borrowing required to finance Hitler's spending plans. Thus Germany was all set for the great inflation that followed World War II.

It is not surprising that the German people developed a dread of inflation. Just as the hyperinflation of 1920-23 was important in projecting Hitler into power and to the devastation of war-time defeat, it also caused the complete collapse of the currency and of the economy after World War II. Never again. The independence of the central bank from government became the basis for the forerunner of the Bundesbank, the Bank Deutscher LŠnder, which was set up to implement the currency reforms of 1948. And with the establishment of the Bundesbank in 1957, a high degree of independence was written in the Bundesbankgesetz (charter).

All this is described in considerable accurate detail in David Marsh's book. Alas, he could not resist the temptation to dwell on the Nazi-party membership of some of the distinguished staff and councils of the Bundesbank. Such smear jobs might have been omitted. Yet Marsh is a gifted journalist and his command of events is most impressive. But he does not have the same respect for ideas as he does for the nitty-gritty of reportage.

In my view the change in ideas was of great importance in converting a collectivist Nazi state into the liberal market economy of the Federal Republic. The context of these great changes in Germany was the development of ideas behind the Sozialwissenschaft--the social market economy. A small band of German intellectuals, led by two great liberal (in the European and literal sense) economists, Walter Eucken and Wilhelm Ršpke, bravely opposed the increased socialization and central planning of the Hitler economy and developed the ideas of Ordo-Liberalism (notably in Walter Eucken's book GrundsŠtze der Wirtschaftpolitik, Tubingen, 1952). The primary focus was through Ordnungspolitik, the "constituent principles" of a market economy (monetary stabilization, free entry, private property, and above all maintaining competition). But this Ordo-Liberalism was modified by Alfred Muller-Armark (Erhard's state-secretary) and other scholars who felt that, as a subsidiary matter, state intervention was needed in order to ensure a safety-net. They wanted to avoid the alienation of dispossessed and disaffected groups that had provided such a fertilizer for the poseurs and demagogues of fascism and communism. This modified Ordo-liberalism was called the "social market economy." Eucken, above all, emphasized the need for price signals, undistorted by inflation, for the market to work efficiently and thus the requirement of a stable general price level. It seems that Eucken, rather like Milton Friedman in our day, would have preferred to bind the central bank to strict monetary rules. But the preponderant opinion was in favor of the conduct of monetary policy by an independent central bank.

This background of ideas was quite different from the post-Keynesian ethos which dominated the Western clerisy in Britain and the United States. In the academies, free markets were much distrusted. Most Westerners thought that their economies were being outpaced by the USSR and its satellites, and that central planning was much more efficient than capitalism at producing the goods. (For many academics and institutional economists--particularly those who believed Khrushchev's boast that the USSR would overtake the United States before 2000--this proposition remained obvious even until the early 1980s and the imminent collapse of the Soviet Union!) In fact when the Erhard reforms were introduced in 1947, the occupying powers were vehemently opposed to all the liberalizations--and they were supported by much of the German establishment. The occupation authorities told Erhard that their economic advisors were adamantly opposed to the reforms; it is said that Erhard gleefully replied "Yes, so are mine." And virtually all academic economists in Great Britain and the United States condemned them in various degrees from "ill-advised" by Walter Heller--later Council of Economic Advisors chairman for JFK and the architect of the "new economics"--to "wicked and evil" by Lord Balogh, economic advisor to Prime Minister Harold Wilson. Indeed Balogh went on to forecast that an economic miracle would occur in East Germany and that West Germany would disintegrate in rapid economic decline. As for monetary policy, the dominant idea of the post-Keynesian thinkers was that it should be completely subservient to the aims of fiscal policy by financing whatever deficits were deemed to be in the interest of promoting full employment. The job of monetary policy, in the words of Lord Kaldor, was to keep "orderly financial markets." Even to this day, prominent professors at Cambridge have urged that there is nothing wrong with inflation at 10 percent, provided it does not vary too much. This is all a far cry from Eucken, Ršpke, Erhard, and their ethos.

In the Wirtschaftswunder years of the 1950s and 1960s, the Bundesbank provided a stable deutschemark. No big deal, you may think, since the deutschemark was in the Bretton Woods system of currencies that, pegged to the dollar (which was in turn convertible into gold at $34 an ounce), was the main success of international monetary systems for the years while it was formally operating from 1947 to 1971. Thus all the Bundesbank had to do was to pursue interest rate policies that ensured the exchange rate peg remained in place. But this is a distortion of reality. In the 1940s and 1950s the major currencies were all largely inconvertible. International capital movements, which were so disruptive to pegged systems like Bretton Woods, could be largely contained by the regulators, and consequently it was not too difficult to stay on the pegs. Even so, because of expansionist fiscal and monetary policies, Britain, then a major force in international monetary matters, was forced to devalue in 1947 and in 1967. (There were many French and Italian adjustments over this period, but neither the franc nor the lira could approach the importance of sterling.) And, because of the increasing exchange restrictions imposed by Britain from 1964, the demise of Bretton Woods occurred de facto long before the sterling devaluation of 1967. Of course the end of Bretton Woods was much hastened by the inflationary policies of the Johnson administration.

Throughout these turmoils the Bundesbank tried to cling to its policy of monetary containment of inflation, and in particular tried not to import it from the United States. Revaluation helped but the capital flows were too large even for the tolerant United States. The vast expansions of monetary growth had their effects in the 1970s. Although lower than any other OECD country, the German inflation rate (1970-79) was 4.9 percent (in terms of consumer prices) and in 1980-91, 2.9 percent. The inflation was rather higher than their preferred target of 2 percent. But relative to other countries this has been a splendid performance.

This achievement has given the Bundesbank enormous prestige and has promoted much emulation, particularly with regard to its "independent" status and its main objective of price stability. Constitutionally, the objective of price stability is pursued subject to the overriding condition that it is expected "to support the economic policy of the government," but only insofar as its functions (that is to support price stability) are not impaired. Bonn cannot issue directives to the Bank. I believe, however, that the extent of the powers of the Bundesbank does not depend primarily on this constitutional independence, but more fundamentally on the widespread respect and support afforded by the electorate. Germans appreciate that the Bundesbank defends their precious deutschemark and woe betide politicians who try to subvert this sacred trust. (I would also add that there are several central banks throughout the world which are nominally subservient to government, and do wield considerable independent power by virtue of public understanding and support. An example in this hemisphere is Canada.)

But how is this power of the Most Powerful Bank exerted? Here, unfortunately David Marsh explains little. No one who wants to know how the monetary management of the Bank is actually carried out should bother to read this book. It does not discuss the techniques of monetary management. But he does survey, rather superficially, the "intermediate targets" of monetary policy.

Since 1974 the underlying targeting of monetary growth has been, as Marsh concedes, "monetarist." To this day the Bundesbank announces targets for monetary growth over the coming year. And it is clear that from all the discussions in Zentralbankrat (Central Bank Council), where monetary decisions are made, the dominant concern is monetary growth. Occasionally the arguments turn on whether the monetary figures are misleading and should be reinterpreted, a development which Marsh conceives as "pragmatism" and clearly a welcome change from the "foolish" monetarism of Mrs. Thatcher's Medium Term Financial Strategy, where monetary growth rates and borrowing requirements were targeted in 1980 for four years. In his anxiety to dish Mrs. Thatcher--one of the chronic neuroses of the so-called "quality" press--Marsh appears to forget that in the British case the program was to bring inflation down from a peak of 22 percent to 3 or 4 percent, not the Bundesbank's task of reducing inflation from 6 percent to 2 or 3 percent. He also fails to recall that in early 1981 a Thatcher review of policy showed indeed that the broad monetary aggregates were misleadingly high and that in 1981 Mrs. Thatcher decisively eased fiscal policy to offset the inadvertent fierce monetary squeeze. All this "pragmatism" contrasts with Marsh's fabulous (in the literal sense) "orthodoxy." As an alleged "orthodox monetarist," I can find as little to complain of in the Bundesbank's thirty-five year record as in the Thatcher record of 1981-6.

Indeed the countries of the Community found the German record so convincing that they formed the European Exchange Rate Mechanism (ERM) in 1979, which essentially meant that they pegged their exchange rates to the deutschemark. They wished to borrow the "credibility" of German monetary policy via the deutschemark peg so that their markets would be convinced of the seriousness of the disinflationary policies of the early 1980s. Among the major countries of Europe, Britain was the only one that did not join this deutschemark club until 1990. The ERM was planned to introduce a "sea of stability" to the nominal exchange rates in Europe. Later it was taken over as the route to the "convergence" of economies, and through the Single European Act and Maastricht treaty, to the economic and monetary union (EMU) of the Community, now dubbed the European Union (EU).

The ERM was the brainchild of politicians, mainly Helmut Schmidt and ValŽry Giscard d'Estaing. The motives behind it were mixed, but both leaders were anxious to build a monetary area and currency, the ECU, that would have some counterweight to the dollar. The Bundesbank was adamantly opposed to the ERM. It was concerned about the support that the Bundesbank would have to give to ailing currencies (it negotiated a much more limited line of support)â and to the whole idea of the deutschemark as an important reserve currency. Rightly it saw that this would make domestic monetary management in order to achieve price stability more difficult. Although the Bundesbank changed its mind later, their initial reaction was justified by the subsequent history of the ERM. As soon as exchange controls in France and Italy were abolished in 1990, the ERM started to exhibit strains--aided by the fact that the Bundesbank raised interest rates to contend with ballooning monetary growth. Massive capital movements anticipated that the weaker currencies--the lira, peseta, and sterling--would be unable to hold their pegs. This promised a potential fat profit for those who shorted them and an equally fat loss by the Banks of England, Spain, and Italy. By September 1992, the EMS had a welter of devaluations so that it had largely disintegrated...and George Soros pocketed his billion dollars. With the abdication of +/-15 percent bands (the amount of variation allowed between currencies), the ERM had a complete collapse in August 1993. The old ERM had gone for good.

But only a few months before the start of this ignominious disintegration, the countries had signed the Maastricht treaty, the main purpose of which was to achieve the monetary integration of Europe through convergence of the ERM with absolutely fixed exchanged rates and, eventually, the monetary union of Europe with one central bank issuing one currency. This would mean the demise of the existing central banks, including the Bundesbank; at most they would be operating departments of the European Central Bank (ECB). Similarly the Germans would have to swap their beloved deutschemark for ECUs or whatever jazzy name was cooked up for the Eurocurrency. The deutschemark would die.

One would consider it remarkable that the Bundesbank would consent to the destruction of the one great success story of central banking for the dubious mish-mash of a Eurocurrency issued by a tower of babel in the ECB. The answer is, of course, that the Bundesbank is quite convinced that no such thing will ever occur. The obstacle course to EMU is strewn with impossible conditions, and the Bundesbank keeps arguing that there should be absolutely no relaxation to these requirements. Furthermore, the Bundestag will have the final vote on the death of the mark. Only the most naive would consider the ECB and its currency achievable in the foreseeable future.

But there is an alternative, a stealthy alternative, which in my view is most likely. The old ERM was a system of exchange rates pegged de facto to the deutschemark. The Maastricht process was to tighten the pegs until they were absolutely fixed on the mark--with no band in which to wobble and no possibilities of realignment. Then the Bundesbank would be the de facto central bank of Europe and the deutschemark would be its currency. This is what was in the late Nicholas Ridley's mind when in 1990 he claimed that the ERM/EMU was "a German racket designed to take over the whole of Europe"--an idea which Marsh dismisses as "infantile."

This would lead to a final irony. One of the powerful motives behind the French promotion of the ERM and EMU is the desire for "symetrie," which is defined in the lexicon of French bureaucrats as "French control over German monetary policy." And there is little doubt that, if there were a Eurocurrency and an ECB, it would be dominated by the French and they would realize their ambition. But now it looks as though, if there is to be monetary integration of Europe, it will be the Bundesbank and Germany in control--precisely the opposite of the aims of ValŽry Giscard d'Estaing, Jacques Delors, and the great coterie of very able chauvinists in French public life. A delicious irony indeed.

Europe once again enslaved by the Germans? "Infantile?" As the Germans will rightly say, it will be a voluntary enslavement. No country is forced to fix its currency to the mark. And in economic terms it would not be a bad solution, provided the Bundesbank retains its independence and integrity. A big proviso indeed! Would we want to bet Europe's shop on it?

Essay Types: Book Review