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Germany and the European Monetary Union

Germany played a major role in shaping the currency provisions of the Treaty on European Union signed in December 1991 in Maastricht, the Netherlands, especially in making certain that those provisions would assure a stable European currency. In broad terms, the agreement, often referred to as the Maastricht Treaty, provided for the same three phases earlier proposed in the Delors report, although with later deadlines for each phase. It also provided for a transitional stage to economic and monetary union to begin in January 1994 with the creation of the European Monetary Institute. The institute was given a mandate to coordinate EU members' monetary policy, to oversee preparations for the transfer to a European currency, and to create the right conditions for the final stage of monetary reform--a European System of Central Banks (ESCB), a single European Central Bank (ECB), and a common currency.

The ESCB and ECB agreed upon at Maastricht are the types of institutions the Bundesbank might welcome. Their common mandate was to assure price stability and a stable European currency, although the ECB was also instructed to ensure sustainable growth with high employment. The structure of the ECB itself was to resemble that of the Bundesbank (see The Bundesbank, ch. 5). Its council, like the Bundesbank's executive Direktorium (Directorate--see Glossary), would consist of an executive board and the presidents of those national banks whose currencies qualified for entry into the EMU. The ECB would be independent of political control, and the central banks of all European states would be independent of such control even before the end of the first stage of the EMU. Thus, the principles guiding the Bundesbank and the deutsche mark would also guide the ECB and the future European currency.

The Maastricht principals agreed that the final stage in the movement toward the EMU would begin in 1997 if the European Council decided that a majority of EU members had met five convergence criteria: inflation within 1.5 percent of the average of the three best (i.e., lowest) rates; long-term interest rates within 2 percent of the three best rates; a budget deficit of less than 3 percent of GDP; a national debt of less than 60 percent of GDP; and a stable currency, as shown by conformity with the narrow band of the ERM and an absence of devaluations within two years of the council's decision to move toward a European currency. If the majority of EU members did not meet these convergence standards, the EMU was to start in 1999 with as many members as had met the criteria. Britain was authorized to leave the system. At France's insistence, however, Germany was required to enter the EMU if France entered, thus ensuring that the Bundesbank could not conduct a policy independent of a European system.

The convergence criteria reflect the Bundesbank's determination to make certain that no unstable currencies enter the EMU. The criteria also put pressure on European governments and central banks to begin conforming to Bundesbank principles before a monetary union is accomplished.

The Maastricht formula represents a compromise between the monetarist and the economist camps on the issue of European integration. It pleased the monetarists--and thus the French--by establishing a strict calendar for the transitional stages to the EMU and by using monetary policy and the desire for a common currency to compel the European economies' acceptance of convergence. The formula pleased the economists--and thus the Bundesbank--by making EMU membership subject to the kind of criteria that would force governments and central banks to pursue similar policies even before the final stage of the EMU. Most important, from the standpoint of the economists and the Bundesbank, it created a standard for EMU membership.

Although the Maastricht arrangements were designed to please the Bundesbank and to assuage German concerns, the German people reacted negatively. Popular media depicted "Germany's beloved deutsche mark" vanishing into the distance or sinking into a swamp, and opinion surveys revealed fears that the politicians had surrendered the cornerstone of German prosperity for the sake of a united Europe. If the Maastricht provisions for the EMU had been subject to a referendum in Germany, they almost certainly would have failed to gain a majority.

The German government had to offer repeated assurances that it would never give up the deutsche mark for another currency that was not as strong or as stable. It took some time for the German public even to entertain the notion that savings might one day be held in a currency other than the deutsche mark, and the public consistently made clear that it would accept that prospect only if that currency were as strong as the deutsche mark.

The Bundesbank's Central Bank Council followed the Maastricht summit with a formal statement reiterating a number of well-known Bundesbank positions. In the statement, the council expressed regret that monetary union was moving forward more rapidly than a "comprehensive political union." It stated that such a political union was necessary if monetary union were to be effective. The council also warned that the success of any decisions taken on the path toward the envisaged economic and monetary union had to be judged "solely on their stability performance" and that "the fulfillment of the entry criteria of the convergence conditions must not be impaired by any dates set." The Bundesbank stressed that the policy unit of the EMU would be the ESCB--in which the Bundesbank could expect to have a strong voice--with the ECB to be subsidiary to the ESCB and thus subject to the Bundesbank's influence. It also stressed that the deutsche mark and the European currency would coexist for some time at fixed exchange rates until all the conditions had been set for a European currency that would actually displace all national currencies. The Bundesbank also reiterated the importance of having the ESCB and ECB remain completely independent of national governments.

Both the German government and the Bundesbank wanted the new ECB to be located in Frankfurt am Main. To this end, the Bundesbank and German officials indicated that they would make every effort to enhance the appeal of Germany and Frankfurt in particular as financial centers, although the bank warned that Germany should not take steps that could jeopardize financial stability for the sake of competitiveness by loosening German financial standards. The Institut für Kapitalmarktforschung (Institute for Research on Capital Markets) urged fast action to boost Frankfurt, warning that a more financially integrated Europe would tend toward a single financial capital and that London and Paris were not only better placed than Frankfurt but also were making much greater efforts to emerge as dominant financial centers.

But Bundesbank officials had more on their minds in early 1992 than the Maastricht conditions for the EMU and the location of Europe's future financial center. The bank was attempting to establish German monetary union within the recently united Germany, as well as to prepare for European unity, and was finding neither task particularly easy. The Bundesbank could have been expected to react guardedly to the Maastricht Treaty no matter what its terms might have been. But the fact that the treaty was signed as the bank was trying to deal with the German government's large fiscal deficits and the resulting upsurge in the German money supply made the Bundesbank both more hesitant about proceeding toward the EMU and more assertive in its insistence on what it considered the proper conditions.

Since the early 1970s, the Bundesbank had effectively controlled European monetary policy. The deutsche mark had been the anchor currency of the snake and of the EMS and ERM. But the Bundesbank would become only one of many banks with a voice on the new council. The president of the ECB might well be a German, and the ECB might be based in Germany, but many different banks would have a voice in European monetary policy, in effect removing the Bundesbank's virtual monopoly of authority. Some of those banks, even if they were to meet the Maastricht convergence criteria, might occasionally want to pursue policies different from those of the Bundesbank.

More problematic for the Bundesbank was the recognition that those other banks, through their influence on European monetary policy, would have a voice in German monetary policy, because the EMU could not function if separate states and central banks could ignore any ECB policy they disliked. The Bundesbank might not only lose control over European money but perhaps over German money as well. Such a situation could violate the bank's own basic mandate, and it would certainly violate its stability doctrine if the ECB failed to pursue what the Bundesbank perceived as the right kind of policy.

The Bundesbank responded to these multiple challenges by setting forth on a course that was designed to put the indelible imprint of its philosophy on the new bank and the new currency, or, if that were not possible, either to break up the EMU or to make it so selective that only a few countries could join. Thus the bank became engaged in a rigid, even doctrinaire, assertion of the primacy of currency stability. It proceeded to raise short-term interest rates throughout 1991 and much of 1992, before and after Maastricht. Although it did so primarily for domestic reasons, it was certainly mindful of the effect that its policies would have on other European currencies.

As German interest rates rose, other European currencies and central banks found it difficult to match German policies at home. The recession that had hit Germany spread throughout Europe, in part for cyclical reasons but also because of the forced emulation of Bundesbank policies by countries interested in joining the EMU. As the recession spread, several countries could not support their currencies except at the cost of an ever-greater slowdown.

An exchange-rate crisis erupted in September 1992, after several countries had decided that they could no longer keep up with German interest rates. As those central banks began to lower short-term rates, investors began to abandon their currencies, and speculators began to dump them. In response to desperate pleas from abroad and from large segments of the German political and economic communities, the Bundesbank lowered its Lombard rate (see Glossary), but only by a quarter point. Within days, the Italian lira had to be devalued and taken out of the ERM. The British pound also came under attack. This triggered "Black Wednesday," September 16, 1992, when the pound crashed while the Bundesbank refused to support it. As a result, Britain withdrew the pound from the ERM.

Only the French franc and the smaller currencies traditionally tied to the deutsche mark (such as the Belgian franc, the Dutch guilder, and the Danish krone) did not devalue, thus remaining in the ERM. All other EC currencies effectively devalued against the deutsche mark. The defense of the French franc cost the Bundesbank and the Banque de France tens of billions of deutsche marks, on which they realized a small profit after the French currency had stabilized. More important, however, it cost the Bundesbank its reputation for objectivity, at least in London, because the British complained that their currency had not been supported as the franc had been.

In August 1993, a similar crisis erupted, but this time the currency under attack was the French franc. With French inflation rates lower than those of Germany, the Banque de France began lowering short-term interest rates during the spring of 1993 and continued lowering them throughout the summer. The French bank may have assumed that the background of firm French monetary policy since the mid-1980s would give it some leeway to lower short-term rates below the Bundesbank levels without weakening the franc. In the event, this proved incorrect. A full assault on the franc erupted in August. Even a coordinated intervention by the Bundesbank and other institutions failed, and the franc weakened rapidly.

To help protect the franc, and to avoid having to expend more resources in a futile fight, the ERM countries agreed that they would widen the bands in which currencies could diverge from each other from 2.25 percent to 15.0 percent. They assumed, correctly, that this change would stop the speculative assault on the franc. However, it also signified the collapse of the franc, one of the main currencies of the EMS. Only a few minor currencies remained as stable as the deutsche mark. However, the franc was able to recover later in 1993 to virtual parity with the deutsche mark.

The two ERM crises left the prospects for the EMU uncertain. It seemed unlikely that more than two or three minor currencies would be able to meet the convergence criteria by 1997, and the system could not then come into effect because it would not include the majority of the countries of the EU. Under those circumstances, the earliest possible date for the EMU to take effect would be 1999, and even that target date would come into question if the EMU at that point were to encompass nothing more than the deutsche mark, the French franc, and some minor currencies. The German minister for economics, Günter Rexrodt, predicted in mid-1994 that the EMU might not come about until 2001 or later.

The Bundesbank had shown its readiness to exercise its power to shape and even to dictate the policies of other central banks. It had shown that, if Europe were no longer to be dominated by the Bundesbank itself, it should at least be dominated by the Bundesbank's ideals. The bank's Central Bank Council hoped that others would come to appreciate the value of stable money through the experience of having unstable money. But in case all central banks did not agree, Bundesbank president Tietmeyer said after the September 1992 crisis that the bank was prepared to accept what he called "gestaffeltes Vorgehen " (membership by stages), a process by which some states would join before others. The bank was clearly prepared to forego the EMU, or at least to postpone it, if the EMU might bring unqualified members into a common European currency system. And it was prepared to split the EMU, if necessary, to create at least a partial zone of European currency stability.

The bank's stern views should not lead to the conclusion that the Bundesbank opposes a European currency. Indeed, several senior Bundesbank figures have at various times expressed their conviction that a common European currency is desirable. Such a currency would ease one of the burdens felt by the Bundesbank: it must now defend stability with only its own reserves and those of its immediate allies instead of with the reserves of an entire continent. Former Central Bank Council member Leonhard Gleske once spoke with envy about how the large domestic market of the United States helped the dollar adjust more easily than any single European currency to global fluctuations and crises. Gleske also observed that one of the objectives of a European currency would be to assume the leading international role that even the deutsche mark could not assume and that such a European currency could gradually replace the dollar as a transactions and reserve currency. This prospect must be a powerful incentive for the Bundesbank, which has long distrusted United States monetary and fiscal policies.

The crises of 1992 and 1993 did not discourage other EU members from accepting Bundesbank discipline. They agreed later in 1993 to place the new European Monetary Institute as well as the future ECB in Frankfurt. That decision was a vote of confidence, or at least acceptance, for Bundesbank policies and attitudes, because Frankfurt is not only the home of the Bundesbank but is also regarded as the capital of German monetarist thinking.

A full EMU will come about when the Bundesbank is satisfied that all European governments are fully committed to stability and when they have shown this commitment by adhering to the convergence criteria and by passing whatever other tests the bank may yet pose. As Bundesbank officials have said on every possible occasion, the Bundesbank believes that a stable currency is more important than a common currency. And the German government, although it supports the EMU, must accept the Bundesbank's policies if it is to secure the support of the German people for a common European currency.

Data as of August 1995

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