ECB vs Bundesbank: Central Bank Models and Monetary Policy

Introduction and Research Overview

This research examines whether the European Central Bank (ECB) can be successful at emulating the strategic model set forth by the German Bundesbank. The discussion focuses on the fact that the ECB is facing different problems as it is still in its developmental phases. The investigation seeks to determine whether the tools of the Bundesbank can provide support for the ECB in achieving economic stability in the European Monetary Union.

Research on this topic is important because the European Union is expected to expand in the years to come. In addition, many members of the European Union have opted to adopt a single currency. This means that economic stability is even more essential to ensuring that the European Monetary System operates efficiently.

The methodology for this research encompasses several forms. First, it contains background information about both the ECB and the Bundesbank. In addition, it includes a literature review to give the reader and the researcher an understanding of prior research. Data for the literature review were obtained from secondary sources such as academic periodicals.

The research also draws on information taken from the internet, limited to official websites for the ECB and the Bank of England, as well as accredited internet databases. Interviews were also conducted to capture various perspectives on the ECB. These interviews involved both members of the ECB and members of the public. The researcher sought to discover whether public perception of the bank's performance is an accurate reflection of its actual performance.

Once all data were gathered, they were used to compare the two institutions. This enabled the researcher to determine whether the ECB can successfully implement the standards established by the Bundesbank, and whether the structures of the two banks are analogous.

Overview of the Literature Review

The goals of central banks are broad-ranging but tend to focus on price stability. The current role of central banks is still developing, with many arguing that their current tasks remain inadequate, despite the model provided by the Bundesbank. Both Bob Mundell and Milton Friedman agree that when it comes to managing monetary policy, the overall record of central banks is very poor (Dowd, 2001).

Central banks have been in existence for centuries, but their roles and operations have differed greatly. Central banking texts often trace the beginning of central banking to the end of the seventeenth century and the creation of the Bank of England, with Britain's superior economic, financial, and military standing credited, at least in part, to the creation and operation of that institution (Weingast, 1992; North and Weingast, 1989).

The Bank of England has been essential to the economic stability of the United Kingdom. According to The Bank of England, 1891–1944, Vol. 2, since its foundation in 1694 the bank operated as a joint-stock company. Sayers (1996) also asserts that "Between 1890 and 1946 the formal constitutional arrangements of the Bank were modified only once, by a Supplemental Charter granted in 1896, though its duties, in relation for example to the issue of notes and payments in gold, were affected by twelve Acts of Parliament between 1913 and 1939" (p. 593). Indeed, the Bank of England was one of the first stable central banks in the world.

The Bundesbank has also received a great deal of scholarly attention and has served as a benchmark for central banks for many years. Frazer (1994) explains that the Bundesbank was once a dominant force in the re-establishment of the German economy, while Engelen (2002) argues that the once-dominant Bundesbank is now secondary to the European Central Bank.

The European Central Bank is now the primary bank for the European Union. Dyson and Featherstone (1999) argue that the ECB was created to provide the EMU with monetary policy. Dunn (2001) explains that there have been many problems associated with the management of the institution, noting:

"The years 1999 and 2000 have provided a difficult beginning for the European Monetary Union (EMU) and for its managing institution, the European Central Bank (ECB). The euro, which was almost universally expected to be a strong currency, has depreciated sharply and is now the source of widespread negative commentary. Citizens of Denmark voted against joining the monetary union by a considerably larger majority than had been anticipated, and there is now virtually no chance that a referendum for entering the EMU could pass in the United Kingdom or Sweden. The management of the ECB has been widely criticized, with its president being the frequent target of unkind press comments." (Dunn, 2001, p. 14)

The information found thus far asserts that the Bundesbank is a benchmark for many central banks, and suggests that the ECB has had trouble in the implementation of its banking system. The proposed research delves into these subjects in greater detail to determine whether the ECB has the ability to duplicate the success of the Bundesbank.

The Formation and Role of the German Bundesbank

To identify the association between the two institutions and evaluate the potential of the ECB to perform at the same level of professionalism and achievement as the Bundesbank, a better understanding of the Bundesbank is needed. This requires a detailed account of the Bundesbank banking system, including the developments that led to the success it experienced in the last few decades.

The German Bundesbank came to prominence following the Second World War. Its steady development was a response to the political and economic climate of the era. Ultimately, the Bundesbank became the benchmark for many other European banks and played an important function in the creation and development of the ECB.

According to Fifty Years of the Deutsche Mark: Central Bank and the Currency in Germany since 1948, Article 3 of the Bundesbank Act asserts: "Bundesbank regulates the amount of money in circulation and of credit supplied to the economy, and arranges for the execution of payment transactions. Its goal is to safeguard the currency, meaning to safeguard the value of money" (Baltensperger, 1999, p. 219).

The Bundesbank was very successful in its endeavours to maintain economic stability and has been historically regarded as one of the finest banking systems in the world. The founding of the Deutsche Bundesbank — also called the Bank deutscher Länder — came at a pivotal time in European history.

Today, Germany may be viewed as shaped by post-World War II allies and the influence they had on the economic and political climate of the country. In particular, both the Soviet Union and the United States sought to influence the region according to their own interests and vision for the future (de Haan, 2003). This political scenario aided the development of the Bundesbank. Germany was in a strategic position, and during the Cold War the former allies believed that Germany was essential to prevailing — a belief based on the premise that Germany was a conduit to mainland Europe.

In 1949, the German constitution was created under American influence (Uwe, 1994). The Grundgesetz (the Basic Law) established two authorities: the Bund, comparable to the federal authorities in the United States, and the Land, akin to state authorities (Uwe, 1994). This revived the federalist tradition that had existed in Germany previously. Notably, Article 88 foresaw the need to create a central bank in the future, but details concerning how it should be formed were left open for future legislation (Uwe, 1994).

Prior to the creation of the Bundesbank, the Bank deutscher Länder (BdL — Bank of German States) dictated monetary policy and had the task of co-ordinating the central banks of the regional states known as the Länder (Uwe, 1994). The Bank deutscher Länder was independent — not controlled by the government — and organised into regional offices based in the Länder. However, its policies required a level of approval from the Allied Banking Commission governing the western zone. The bank held the power of veto (Uwe, 1994), though that veto was never used, partly due to the way Wilhelm Vocke, the president of the Bank deutscher Länder, managed the difficult political situation, successfully negotiating and co-ordinating policies with the Commission (Uwe, 1994).

By 1950, legislation for the creation of a central bank had begun, formed under Chancellor Konrad Adenauer. Differences emerged between the parties involved regarding the appropriate relationship between the central bank and political authorities. Fritz Schäffer, the finance minister, argued that the veto formerly held by the Allied Banking Commission should be transferred to the Federal Government, with the Bundestag overseeing the bank (de Haan, 2003). Adenauer similarly argued that central bank policy should be controlled by the government (Uwe, 1994). Vocke, by contrast, believed the bank should be independent of government control, a position also supported by Ludwig Erhard — a government minister known as the "father of Germany's economic miracle" (de Haan, 2003). These differences of opinion created a difficult relationship between Adenauer, the Bank deutscher Länder, and its successor the Bundesbank, and it was 1957 before the Bundesbank Act was finally passed (Uwe, 1994).

A key area of success for the Bundesbank was price stability and the control of inflation. The 1920s had seen severe difficulties caused by hyperinflation, and following Germany's defeat in the Second World War there was renewed pressure on the economy and a strong demand for stability — a culture that was inherited and adopted by the Bundesbank and retained as a core value throughout its history (de Haan, 2003).

During the Weimar Republic era, hyperinflation caused the currency to collapse. Before the First World War the exchange rate had stood at 4.2 Reichsmarks to the dollar; by 1919 the Reichsmark had halved in value (Hetzel, 2002). The downward spiral was eventually halted by the Reichsmark reforms of 1923, following the peak of hyperinflation. A new currency was introduced, backed by a guarantee from a non-governmental body, laying the foundation for a period of economic stability lasting from 1924 to 1928 (Hetzel, 2002).

The failure of the Weimar Republic ultimately contributed to the rise of the Nazi Party and World War II. During the war, the German mark retained its value — not through genuine economic strength, but through the coercive enforcement of Nazi leaders (Hetzel, 2002). After Germany lost the war, many forms of exchange shifted from a market system to a barter system. Goods such as chocolate and tobacco obtained from occupying forces held greater market value until the introduction of the Deutschmark on 20 June 1948 (Hetzel, 2002).

Implementation of the Deutschmark occurred in several stages. Initially, individuals were allowed to exchange forty old marks for Deutschmarks. In August 1948, twenty old marks could be exchanged for twenty new Deutschmarks at a rate of ten old marks to one new Deutschmark for those with bank accounts. October 1948 saw the receipt of 65 pfennig on marks held (de Haan, 2003; Hetzel, 2002). This move re-established the German economy and later served as a model during the 1990 reunification of East and West Germany. The principal purpose of all these strategies was the creation of price stability and confidence in the economy.

The implication is clear: where there is economic failure, political collapse can follow. When the Bank deutscher Länder was established, currency protection was its central purpose, and to achieve this the bank needed independence from the government (Wood, 1993). This approach appears to be supported by comparative evidence: during this period Britain, where the central bank was not independent, saw a 1,600% increase in prices, while the United States saw 48% and Switzerland 300%. By comparison, Germany saw only a 250% increase (Wood, 1993).

This belief is evidenced in statements made by Bundesbank leadership on numerous occasions. President Helmut Schlesinger was known to hold that there was no such thing as "only a little inflation" (de Haan, 2003; Schlesinger, 1995). His successor Hans Tietmeyer, who took over in 1993, stated: "On one thing we are all in agreement: without a stable currency there can be no lasting economic prosperity and political stability" (Tietmeyer, 1993).

Within the Bundesbank's policy framework there is an accepted rate of unavoidable inflation, determined by the real rate of growth and changes in output prices (Kole, 1995). The Bundesbank Law supports this, stating that the bank shall "regulate the amount of money in circulation and of credit supplied to the economy, using the monetary powers conferred on it by this Act, with the aim of safeguarding the currency" (Bundesbank Law, paragraph 3, Lexis, 2004). No other central bank in Europe has this clear a statutory definition of purpose — nor does the American Federal Reserve (de Haan, 2003).

The concept of protecting the currency has two dimensions: externally, measuring the Deutschmark against other currencies; and internally, measuring the price of goods and services (de Haan, 2003). Both dimensions grew more important from the 1960s onward in an increasingly globalised economy — a lesson directly relevant to the ECB.

Beginning in the 1960s there was increasing instability in global currencies. Germany was a member of the Bretton Woods agreement and complained about its obligation to support the price of the dollar under the fixed exchange-rate scheme, which caused the Deutschmark to become too strong, increasing the money supply in Germany (de Haan, 2003; Cardwell, 2001). The eventual demise of Bretton Woods did not perturb the Bundesbank. In 1978, when the European Monetary System (EMS) was created, the Bundesbank reportedly opposed it but was forced to accept due to pressure from Chancellor Schmidt (de Haan, 2003).

The EMS was created in March 1979. Although it had many positive features, the development was problematic, mirroring difficulties seen under Bretton Woods, including currency speculation that central banks could not address. In 1993, there was an economic crisis in France and the bands within which currencies operated were enlarged, bringing relief to the Bundesbank (Smith, 1993). The Bundesbank's experience demonstrates a clear and proven ability to manage the economy, both independently and when constrained by international agreements.

The Bundesbank also operated differently from other banks by using only four tools to manage the economy: two interest rates (the discount and the Lombard rate), open market policy, and the setting of minimum reserve requirements (de Haan, 2000). Unlike some other banks, the Bundesbank did not directly control credit ceilings or interest rates; its influence was indirect, intended to affect long-term market conditions through "fine adjustments" (de Haan, 2000).

It may be argued that in the past, problems within the European banking system were not caused by the Bundesbank's management of the economy, but rather by other countries' inability to meet the same standards. The experience of Black Wednesday — when the UK joined the EMS at a rate the markets deemed too high, leading to a dramatic single-day interest rate increase and the pound's forced withdrawal — illustrates this point.