Following the Bundesbank

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Author David Marsh

Publisher Times Books

Year 1993

Pages 331 pp.

Price $25.00

Three to four decades ago, it was commonplace to speak about the marked difference between Great Britain, which had a deeply entrenched fear of unemployment, and Germany, which had a deeply entrenched fear of inflation, and the effect of those contrasting national attitudes on public policy. Since those days, with the independent Bundesbank playing a powerful role, Germany has greatly strengthened its reputation for resisting inflation and safeguarding the currency. Meanwhile the United Kingdom, for better or for worse, has grown accustomed to levels of unemployment far in excess of what the nation would have thought desirable or even tolerable in those earlier periods and, like many other nations, is now considering fundamental moves toward central bank independence in the hope of capturing the benefits of price stability for its economy.

Indeed, a wave of change toward greater independence for central banks is sweeping across the globe. In Europe, central bank independence has become a prerequisite for participating in the final stages of monetary union; major structural changes for independence are in place or have been proposed in Belgium, Italy, France and Spain. With its reorientation toward open economies and market-based policies that has followed the debt crisis, Latin America has seen major moves toward greater central bank authority or independence in Chile, Venezuela and Mexico, and the process has begun in Argentina. The transitional economies of Eastern Europe are experimenting with alternative approaches. New Zealand has introduced an imaginative scheme for targeting inflation. South Africa has fortified the powers of its central bank. China is drafting comprehensive bank legislation. The list goes on.

Against this background, to read a detailed account of the activities and inner workings of Germany’s Bundesbank, whose name has long been synonymous with central bank independence and the fight for sound money, is especially timely. In The Most Powerful Bank, David Marsh has written a readable, comprehensive and extremely engaging account of the activities of the Bundesbank and the policy debates surrounding it. As European Editor of the Financial Times, he has benefited from extensive interviews with scores of major and minor participants, but he has also probed the historical records of the Bundesbank and its predecessor bodies back through the Hitler, Weimar and empire periods to the origins of central banking in Germany. If Marsh exaggerates the significance of the continuity and connections between Hitler’s Reichsbank and the Bundesbank, his analysis of more recent and current policy issues is balanced, fair and informed.

Not all of it is flattering. He writes, "The Bundesbank has replaced the Wehrmacht as Germany’s best-known and most feared institution," holding sway across "a larger area of Europe than any German Reich," and "those who trifle with the Bundesbank do so at their peril." For example, he says that the economic clout of the Bundesbank council became "painfully obvious during 1992," when the United Kingdom and Italy had to quit the Exchange Rate Mechanism.

THE CHANGE IN THINKING

Former Federal Reserve Chairman Paul Volcker has commented on the major turnaround in thinking that has occurred since the early years after World War II when many central banks were losing autonomy. He described "the cumulative and eventually debilitating effects of the then widely accepted idea . . . that some inflation could reasonably be accepted as a price for stimulating growth in employment and production." The process "may work for a while, until the public begins to anticipate the inflation, and by its own actions accelerate the process." Then the stimulus is gone, and speculative excesses in domestic and international markets are encouraged. That was "the lesson of the 1970s and early 1980s," which has provided "the essential public support for the sustained effort in Europe, in North and now South America, and in other countries to restore price and monetary stability."

Charles Goodhart has described this change in more technical terms. He notes that "the basic ideas which have driven the case for independence have been provided by economic theory." In the 1950s and 1960s, thinking behind the Phillips curve, which posited a negative relation between inflation and unemployment, suggested that governments "could choose an optimal combination, or trade-off" between those two indexes. But by the 1970s, as the expectation of inflation caught up with the reality, the rate of inflation consistent with any level of unemployment kept on rising. The result was "stagflation", a record of poor price performance without achieving employment goals. It became apparent that in the long term there was no Phillips curve trade-off. Goodhart describes another concept that supports independence, time inconsistency, which holds that if a public knows that its government can switch policies when it is politically convenient (say from tight money to easy money to win an election), government commitments will not be believed, and the public will behave in ways that undermine stated policy goals. Finally, he points out that the move toward central bank independence is not based only on theory: "A whole series of econometric/statistical tests have shown that countries with more independent central banks have had generally lower inflation rates, led by Germany and the Bundesbank," and countries that have recently adopted independent central banks, such as Chile and New Zealand, "have moved from the bottom of their class toward being best performers."