Economic Commentary: New stresses at the Bundesbank

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One of the unwritten rules of the respectable financial press in Britain and elsewhere in Europe appears to be that the Bundesbank can do no wrong.

Unlike the central bankers of other less fortunate nations, who can be vilified along with the rest of us, the inhabitants of the grey barrack-like building in Frankfurt are depicted as the principal creators and unique defendants of the post-war German economic miracle, and subject to no hint of criticism.

It is hard not to respect Bundesbank officials. They have a shared purpose to achieve a single objective - low inflation in Germany - and they go about their business in the most efficient of ways.

They are welcoming to visitors, to whom they are eager to proselytise their message. Like all great institutions, they target their fire more towards the outside world than towards internal bickering.

And, like all elites, they can be dismissive of ideas from outside. Indeed, they are perhaps Europe's leading subscribers to the 'not invented here' syndrome.

Bundesbank economic orthodoxy is interesting to analyse. It does not have much time for theoretical 'advances' in the subject of economics. Other central banks have developed a cottage industry in the past decade, publishing important discussion papers that are often near the cutting edge of academic technology.

It is almost as if this activity compensates for the fact that many of them do not actually control monetary policy in their own countries. Their economic departments are more like commentators than participants in the real decisions.


The Bundesbank, in contrast, keeps its intellectual feet firmly on the ground. Its commentaries are highly practical, numerate rather than econometric. It knows that it takes the real decisions and sees no particular need for embroidery.

Nor does it fall for economic fashion. Rational expectations, and other false gods of the 1980s, never seeped into Bundesbank thinking. Instead, the bank sticks to a few simple beliefs - that the money supply is linked to inflation, that a high public sector deficit causes high interest rates, that the balance of payments matters, that fixed exchange rates are generally a bad thing, that the deregulation of financial markets - so beloved of Anglo- Saxon politicians and bankers in the 1980s - should be viewed with the utmost suspicion.

If we compare the consistency with which these basic concepts have been applied by the Bundesbank to the vicissitudes in approach that have occurred in equivalent institutions elsewhere - the British Treasury, for example - it is clear that Germany has indeed been fortunate in the past 40 years.

The German system for setting monetary policy has worked in spades. So much so that the other 11 disputatious members of the European Community were willing simply to import the constitution of the Bundesbank into the Maastricht treaty, with barely a protest.

Can anyone imagine this happening to the 'best practice' in any other field? Was the Westminster system slavishly copied when the European Parliament was established? Would the Napoleonic departments of France (shorn of their recent corruption) simply be replicated in community law? What about the Italian

football league? Clearly 'best practice', but the San Siro stadium might look out of place in other countries that do not share the Italian obsession with the sport.

Even in this area Bundesbank officials themselves have severe doubts about the desirability of change. They are willing to admit that the success of the Bundesbank might owe as much to the economic and political system in which it operates as to anything else.

On the economic front they have benefited greatly from the stability of the demand for money function in Germany, which means that there has been a continuing stable relationship between money growth and national income.

This fact, which is no doubt linked to the relative lack of financial reform in Germany, implies that simple monetary rules have continued to work there to a much greater extent than anywhere else. Monetary targets have therefore been much easier to operate.

Much more important, the consensus- driven institutions of the German labour market are a dream for central bankers, especially when compared with the equivalent in other countries. Highly centralised wage bargaining means that the labour market has a chance of responding in advance to a tightening in monetary conditions, so that the consequences of tight money are felt more quickly in declining inflation and have less adverse effects on the real economy.

An important article by Professor Peter Hall, of Harvard University, published recently in the Independent and so far given insufficient attention, argues that the structure of labour market institutions is a much more significant determinant of national economic performance than the degree of independence enjoyed by the central bank. The Bundesbank has therefore been sowing its seeds in fertile economic soil.

Fertile, too, is the political soil in which the Bundesbank operates. At the end of the day, as Bundesbank officials will readily testify, their independence is not founded on any particular clause in their written constitution but on the strong support of the public for a counter-inflationary monetary stance.

Much more than, say, the Federal Reserve in Washington, the Bundesbank knows that it can 'face down' politicians who want to tamper with its independence.

Certainly there are limits to this, as the Bundesbank discovered to its cost when Chancellor Kohl set the terms of German monetary reunification (almost) over its dead body in 1990. The exchange rate mechanism is also a subject on which the central bank has frequently been overruled. But on the question of domestic interest rates Frankfurt continues to reign supreme.

All this suggests that if the Bundesbank constitution were ever to be transplanted into the less welcoming territory of other European countries the results might be much less happy. But, more interestingly, there are also questions about whether conditions in Germany itself may be starting to change.


New generations might be less hostile to inflation than their forebears and the labour unions are certainly becoming more cantankerous. It is getting more and more difficult to hold the ERM together while simultaneously giving unequivocal and coherent monetary signals on the domestic front.

What is worse, there are burgeoning doubts about the Bundesbank's approach to domestic monetary policy in the past 12 months. The decision to increase interest rates last July, just when the economy was beginning to tumble into a severe recession (see graph) was not just fatal for the stability of the ERM but also now looks singularly ill-timed from the domestic point of view.

The Bundesbank defends itself by pointing to the continuation of high rates of monetary growth, excessive public borrowing and dangerous rates of wage inflation in eastern Germany. But will these factors be remembered if the economy falls into a deepening recession this year?

There is little doubt in my mind that the European recession of 1993 will greatly dampen the enthusiasm of the rest of Europe for the ERM and for independent central banks, both of which could be electoral pariahs before the year-end. But it will be fascinating to see whether Germany itself begins to question its favourite institution if things go badly wrong this year.

(Graph omitted)