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.


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."

Adam Posen has raised a fundamental question, applicable to all countries, of whether a causal link connects central bank independence to low inflation. He argues that the strength of political support for low inflation is responsible for both central bank independence and low inflation, and he attributes this political support to the influence of a narrow interest group, the financial or banking sector. Others agree on the importance of political support for central bank independence but contend that public opinion both provides support for central bank independence and is influenced by the actions and successes of the central bank in a positive association that can foster price stability.


Marsh discusses one question that has long intrigued observers: Just what is the basis for the German nation’s profound attraction to and support for monetary stability? Clearly that seemingly invulnerable foundation of public support is a powerful booster of the Bundesbank’s influence and success.

Most Germans have conventionally said that this attitude reflects Germany’s unique history, the trauma of seeing its currency debauched and savings destroyed twice in 30 years, including the unparalleled experience of the early 1920s, when prices increased by two billionfold in a single year and the mark was devalued to one trillionth its prewar level. Marsh goes even further, arguing that the roots of the Germanic attention to stability extend not only to the two hyperinflations but "go deeper, to the concept of order as the foundation of state power." The view is that "stable money brings stable government, and stable government brings a stable society." In one of the passages stressing the ties with the 1930s he asserts:

For a land with shifting boundaries and a contorted history, the stable mark allows an escape from past traumas; it establishes one fixed point in an ocean of flux and change. The yearning for sound money was as strong in the 1930s as it is today. The Reichsbank carried out the will of a totalitarian state; the Bundesbank serves a democracy. But both were allotted the same statutory objective. Taken fully under Hitler’s control in 1939, the Reichsbank was placed, for the first time, under the legal obligation to "safeguard the currency." When the Bundesbank was set up . . . it was legally enjoined to pursue "the aim of safeguarding the currency."

As Marsh vividly illustrates, the Bundesbank has broad public support in monetary policy disputes with the government. In one incident, in 1979 Manfred Lahnstein attended a Bundesbank council meeting for the Finance Ministry and unsuccessfully contested a modest interest rate increase favored by the Bundesbank. A decade later, "Lahnstein admitted that he realized all along that making a public stand against the Bundesbank was a losing battle." In fact Marsh says the action stigmatized the government in the eyes of public opinion and the conservative press as being "on the wrong side of sound money."

According to Marsh, about a dozen serious disagreements have arisen between the Bundesbank and the government over interest rates or the exchange rate. On interest rates, the Bundesbank "nearly always got the better part of the squabble." On revaluations, where "in formal terms final decisions rest with the government," more often than not the Bundesbank was "on the winning side." By Marsh’s count, three chancellors, Erhard, Kiesinger and Schmidt, owe their downfall directly or indirectly to the Bundesbank. All three were defeated not in general elections, but through "shifts in conditions, sparked by controversies over monetary policy." Even in Willy Brandt’s downfall, the Bundesbank played a role.

Marsh concedes that the field in which the Bundesbank can unambiguously apply its independence is "rather narrow", its competence is "massively concentrated on monetary policy." In assessing the Bundesbank’s clout, Marsh acknowledges its limitations in disputes with the government; the government makes "the ultimate decisions" on the exchange rate, he says. Chancellor Helmut Kohl in the end agreed to monetary union with its goal of a single European currency, to anchor the anchor, despite Bundesbank misgivings that were shared, according to Marsh, by "a large majority of the German electorate." And the government, overriding Bundesbank concerns, made the basic decisions (many would say, from the financial view, the basic mistakes) on monetary union with eastern Germany. Of course bank power has limits: "No central bank, whatever its independence, operates in an environment free of political complications. The crucial condition for successful monetary policies is that they are understood and supported by the general public."


Central bank independence has traditionally been greatest in Germany, Switzerland and the United States, three states of federalist structure with some separation of powers. The United Kingdom looks at the issue of central bank independence from its particular perspective, as a parliamentary democracy with a unitary rather than a federal structure and no tradition of separation of powers, and as a country with an inflation record over the postwar period that is far from admirable. An independent panel decided against recommending a "generalized" mandate of the Bundesbank model, feeling that it relied too heavily on the Bundesbank’s unquestioned credibility and the German electorate’s strong support of price stability, and that it was not appropriate for Britain. The panel chose instead a model with a more precise numerical inflation target, closer to the approach of New Zealand, a country whose anti-inflation credentials, like Britain’s, were not so firmly established. It recommended that "price stability" be the sole statutory objective of the Bank of England and that the bank formulate and announce short-run targets for inflation and control short-term interest rates. The government could in extremis overrule the bank and resume control of monetary policy but only by parliamentary action to suspend for six months the bank’s objective of price stability. In Europe the proposed European Central Bank is patterned on the Bundesbank, and Maastricht adherents may support that model. Beyond that, a variety of forms and features may appear as each nation understandably seeks to take appropriate account of its own circumstances.

Surprisingly, today the United States seems to be the only nation in the world where there are serious efforts to swim against the tide and move toward limiting the autonomy and responsibilities of the central bank. Of course control of the Federal Reserve has never been very far below the legislative surface; one study reported that from 1979 to 1990 no fewer than 200 bills were submitted to the U.S. Congress containing 307 proposals on 56 "issues" that would alter the structure of the Federal Reserve System in its conduct of monetary policy. Recent proposals for change have come from both Congress and the Clinton administration. The Federal Reserve has expressed particular concern about proposals to remove it from directly supervising the nation’s banks.

A number of eminent bankers have powerfully stated the case against such proposals. In the debate on this same issue ten years ago, Paul Volcker pointed out that those supervisory functions predate and are additional to the more purely monetary functions of open market and foreign-exchange operations. A basic Fed responsibility, and the reason for its founding, was to assure a "stable and smoothly functioning financial payments system" and to "head off and deal with financial disturbances and crises" to the extent possible. Similarly, Fed Chairman Alan Greenspan argues that a hands-on supervisory role is "indispensable" for maintaining the Fed’s "unparalleled knowledge" of financial systems, markets, institutions and relationships needed to carry out its key responsibilities "at the nexus of monetary policy, the payments system, and bank supervision and regulation." President of the New York Federal Reserve Bank William J. McDonough warns that "sooner or later there will come a crisis," and the Fed will fight "with absolute determination and dedication" to safeguard the economy, but that "Congress should not strip us of the weapons we need, it is simply too dangerous."

The Bundesbank, Marsh reports, has no direct responsibility for bank supervision; the federal bank supervisory office carries out this function. But in fact the federal banking office makes its decisions after consultation with the Bundesbank, helping ensure that the Bundesbank has access to the information it needs. Every central bank must operate within its own environment with its own banking and financial system, national constitution and legal structure, and history and culture, but each central bank must have direct knowledge of and involvement with the banking system in order to carry out its responsibilities effectively.

The precise characteristics of each proposal for central bank autonomy will vary. The crucial question is whether reform will depoliticize the process of money creation and develop the required public determination for monetary stability. Bundesbank Chief Economist Otmar Issing puts the case for central bank autonomy succinctly and fervently: "Resistance to making the central bank independent always reflects the intention of reserving access to money creation to policymakers. This has never been good for the value of money anywhere."

An independent central bank does not guarantee victory over inflation; witness the experience of the Russian central bank in recent years and the nominally independent Reichsbank in 1922-23. Conversely, the experience of Japan and recently of France shows that some governments can bring inflation under control without formal central bank independence. But these are the exceptions. The hope is that during the current period of widespread support for central bank autonomy, when memories of the flawed concepts and failed policies of the past are fresh, positive results will accrue and political support for price stability will grow. If the public sees the benefits of depoliticizing the process of creating money and provides the essential foundation of political support, today’s trend toward central bank independence may bring lasting benefits for price and financial stability and will not be a passing fad.

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  • Sam Y. Cross is Executive in Residence at the School of International and Public Affairs, Columbia University.
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