The Bundesbank in its 50th year: legacy of stability passed on to the Eurosystem - effective even after the big break

Keeping citizens’ money as stable as possible has always been the mandate of the Deutsche Bundesbank. As the central bank of the Federal Republic of Germany, it has fulfilled this mandate for half a century more consistently and successfully than almost any other monetary institution in the world – a period of almost 60 years if one includes its predecessor, the Bank deutscher Länder. The reputation of the D-Mark as a stable currency has lived on in the euro, our single currency, since 1999.

In the year of its 50th anniversary, the Deutsche Bundesbank is no longer on everyone’s lips when the subject of debate is security and vulnerability or the pros and cons of a stable currency. It is no longer the bank whose interest rate policy had to be followed by the other European central banks if they wanted to avoid a depreciation of their currencies. In 1999 the Bundesbank transferred its autonomous responsibility for monetary policy to the Eurosystem.

The Bundesbank in the Eurosystem: continuity and change

The Bundesbank is the central bank of the Federal Republic of Germany, the Bundesbank in the Eurosystem continues to play a major role in safeguarding the value of the currency and the stability of the financial system. The Bundesbank, together with the other central banks of the Eurosystem and the European Central Bank, is responsible for the euro. As a member of the Governing Council of the European Central Bank, the President of the Bundesbank is involved in formulating European monetary policy. The Bundesbank also performs key tasks for the Eurosystem through its implementation of monetary policy decisions in Germany, supplying the economy with cash, providing cashless payment facilities and managing the reserve assets. Under German law, the Bundesbank is also empowered to participate in banking supervision and to advise the Federal Government on matters of monetary policy importance. Finally, it has a major role in communicating European monetary policy to the German public (for its core business areas, see the detailed profile: The tasks of the Bundesbank).

However, the Bundesbank’s importance for the Eurosystem goes far beyond its current activities. This is because it has “bequeathed” the Eurosystem an institutional framework which is at once a sound basis for a stability-oriented monetary policy and a generator of confidence in the fledgling European currency. Key elements of the Bundesbank’s structure and ethos were transferred to the Eurosystem, in some cases in an even stricter form.

• The primary objective of monetary policy for the euro-area countries is to safeguard price stability; economic policy may be supported only if price stability is not put at risk.
• Monetary policymakers are independent of instructions from national governments.
• Interest rate decisions take account of monetary growth because, in the longer term, the money stock and potential output have to develop at more or less the same pace if prices are to remain stable.
• Like the former Central Bank Council of the Deutsche Bundesbank, the supreme decision-making body of the Eurosystem has a relatively decentralised structure: the members of the Executive Board of the ECB and the presidents or governors of the national central banks of the euro-area countries have voting rights on the Governing Council of the European Central Bank.

These principles were transferred to the European monetary union because they were seen to be the source of the Bundesbank’s success in maintaining price stability.

Lessons from the past: stability needs independence

“To safeguard the currency” – that was the statutory mandate conferred on the Bundesbank in 1957. The Bundesbank understood its primary objective as safeguarding price stability. This was very much the same thinking as at the Bank deutscher Länder, the Bundesbank’s forerunner institution, which had been established in 1948. The success of the German central bank in maintaining stability was quite impressive: between 1948 and 1998, the average annual loss in the purchasing power of the D-Mark was 2.8%; following the low rates of inflation in the 1950s, there were not many years in which the Bundesbank succeeded in achieving its aim of not overstepping an annual inflation rate of 2%, the rate which it deemed to be consistent with price stability. The loss of purchasing power in Germany was therefore still substantially smaller than in most other industrialised countries, which meant that, by comparison, the D-Mark was exceptionally stable. That was another reason why it became the second most important reserve and investment currency in the world. It became the anchor currency in the European Monetary System which was established in 1979, and the central banks in Germany’s partner countries increasingly endeavoured to reduce inflation differentials with the D-Mark in order to prevent depreciations of their own currencies.

The following factors were crucial in achieving the comparatively large measure of stability: in its monetary policy, the Bundesbank generally gave clear priority to price stability over other economic policy objectives, such as stabilising the economic cycle or exchange rates, unless other underlying conditions, such as its membership of fixed exchange rate systems, compelled it to purchase foreign currencies or to introduce low interest rates. Furthermore, the Bundesbank rarely lost sight of its medium-term objectives for achieving an appropriate rate of monetary growth. Whenever excessive inflation rates threatened, it checked the rise with higher interest rates.

However much the central bank and the Federal Government have invariably been interested in acting by mutual agreement, most of the Bundesbank’s monetary policy stability measures have illustrated how important it has been for the German central bank to be independent of instructions from the Federal Government, an institutional arrangement which was desired politically and which is enshrined in law. The reason for this is that, time and again, Federal Governments have pressed for lower interest rates, ie an easing of monetary policy, in order to strengthen the economy although that would have given rise to inflation risks in the medium term. The Bundesbank and its forerunner, the Bank deutscher Länder, would hardly have been able to cope with these conflicts without legal independence; the credibility of its commitment to stability would have become less credible, and greater inflationary expectations, for example on the part of management and trade unions, could have been reinforced and prices could have risen faster.

The legacy of the Bundesbank: a blessing or a source of annoyance?

The transfer of the Bundesbank’s regulatory stability framework to the Eurosystem has nevertheless also encountered some criticism. Time and again, there have been doubts, for example, about the importance of monetary growth or the broadly based study of monetary and credit aggregates (monetary analysis) for monetary policy. Not only has it been said that, in the euro area, no monetary aggregate can be found that shows a consistent relationship with price developments and can therefore be used for monetary policy purposes. It has also been argued that the Bundesbank has not used the money stock as the crucial reference variable for its interest rate policy decisions. Recent studies have now shown that this has indeed been very much the case in the medium term.

A stability-oriented monetary policy, such as the one the Bundesbank has traditionally promoted and pursued, has not only been a bone of contention but has also frequently been criticised in principle. The primary objective of price stability and the allegedly undemocratic independence of the central bank from government instructions quickly become targets for criticism. Not only are cyclical slumps said to be due to these two factors; it is also claimed that the weakness of growth and employment in Germany over a number of decades is also attributable to them. It is alleged, for example, that the high real interest rates arising from low inflation rates have greatly impeded investment.

It is true that the reduction in what, by German standards, were high inflation rates was often linked in the short term with a relatively sharp fall in growth and employment. It is also true, however, that this was the price to be paid for the underpinning of longer-term economic prosperity and one that was worth paying. The stability of the D-Mark protected savers and persons on fixed incomes against a massive fall in the value of money. And recent international studies confirm that monetary policy serves the real economy best when it stabilises inflation expectations at a low level. The Bundesbank succeeded in doing just that in the medium term and gained the reputation of being a resolute “inflation fighter” among market players and economic agents. The lower growth rates in Germany over the past 30 years and the constantly high level of unemployment were not the result of the Bundesbank’s excessively rigid monetary policy but were, instead, the result of structural weaknesses in the German economy; investment suffered less from real interest rates that were too high and more from returns from fixed assets that were too low.

The Bundesbank’s legacy of stability has so far proved to be effective in European monetary union, too. Contrary to some fears that were expressed, the purchasing power of the euro is just as stable as that of the D-Mark.