Germany’s Central Bank and the Eurozone

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Introduction

The German Bundesbank was established in 1957 as the world’s first fully independent central bank with a simple but all-encompassing mandate: to keep the price of the German deutsche mark stable by limiting inflation. The Bundesbank’s anti-inflationary ethos stems from a searing recollection of the hyperinflation Germany endured amid the 1920s economic crisis, which ultimately triggered lasting political and social turmoil. Due to its political independence and unwavering commitment to its mandate, the Bundesbank became the most powerful central bank in Europe in the second half of the twentieth century--and, ultimately, the model upon which the European Central Bank was constructed when the eurozone came into being more than a decade ago. While the Bundesbank’s power has since been curtailed, its president remains a key player in crafting eurozone monetary policy at the ECB. However, in the wake of the eurozone sovereign debt crisis, the Bundesbank has been increasingly at odds with ECB, accusing it of overstepping its mandate and monetizing debt through its government bond buying programs.

History and Structure

The Bank Deutsche Länder was the central banking system established in western Germany by the United States and the other allied powers in 1948, which ultimately evolved into the autonomous Bundesbank with the Bundesbank Act of 1957. The legislation enshrined the newly developed central bank’s independence by giving it complete control over German monetary policy (or control over the money supply), leaving fiscal policymaking (or matters related to taxes and government spending) to elected officials. Largely free from political interference, the Bundesbank’s primary task through the 1990s was to control inflation and ensure the stability of the deutsche mark, the country’s postwar currency. The bank "gives priority to monetary stability and central bank independence, while sound public finances and free competition provide the prerequisites for economic growth," explains Daniela Schwarzer, a senior associate at the German Institute for International and Security Affairs and a visiting fellow at Harvard University’s Weatherhead Center.

In addition to regulating the "amount of currency and credit in circulation," the Bundesbank has achieved its goal of price stability by setting both monetary and inflation targets, explain Richard H. Clarida and Mark Gertler in their paper "How the Bundesbank Conducts Monetary Policy." By pursuing this narrow mandate, the Bundesbank helped keep German inflation relatively low and spur economic growth in the post-War period, instituting a new paradigm for central banking in Europe and throughout the world.

^{Bundesbank President Jens Weidmann at the bank’s headquarters. (Photo: Alex Domanski/Courtesy Reuters)}

The Bundesbank Council--or Zentralbankrat--is the primary policymaking body of the bank, and its arrangement "reflects Germany’s federal structure," writes André Szász for the book The History of the Bundesbank: Lessons for the European Central Bank.Below the Council sits the Directorate and its president and vice president, who are nominated by the federal government, and the Land--or regional--central banks and their presidents, who are nominated by the Land governments. The council "consists of up to eight members of the Directorate and the presidents of the Land central banks," explains Szász. By way of comparison, Clarida and Gertler liken the Bundesbank Council to the U.S. Federal Reserve’s Open Market Committee, adding that "from the perspective of political independence, any differences between the institutional setup of the Bundesbank and the Federal Reserve are not dramatic."

Despite the Bundesbank’s legal independence, it was not immune from German politics and was required to cultivate public support for its aims in order to maintain that independence. In the early years of the bank, the Bundesbank and its supporters tapped into the collective German memory of hyperinflation and the ensuing social unrest after World War I that led to the Nazi era, explains David Laidler of the University of Western Ontario. During World War I, Germany decoupled the mark from the gold standard and printed large quantities of banknotes in order to pay for the mounting costs of the war, ultimately triggering unprecedented inflation. In 1914, the dollar was worth 4.2 marks; in 1923, it was worth a staggering 4.2 trillion marks. "Germany had a long and really ugly history of monetary instability that the Bundesbank had going for it," says Laidler. Similarly, writes Jörg Bibow in the essay "On the Origin and Rise of Central Bank Independence in West Germany" (PDF), the Bundesbank’s role "as a political actor in its own right and in carving public opinion should not be underestimated in explaining a peculiar German tradition that was finally exported to Europe in the 1990s."

Moreover, in the complicated postwar years in Germany, the country’s stable currency became an important political symbol, Schwarzer suggests. "’National pride,’ which seemed displaced after the Second World War, was replaced by the pride in Germany’s economic success," she says.

Bretton Woods and the Bundesbank

The goal of the Bretton Woods international monetary system, established in 1944, was to "avoid a repetition of the economic chaos that had followed the First World War and done so much to precipitate the second," writes Laidler in an essay for the 2009 book Monetary Policy Over Fifty Years: Experiences and Lessons. Participating nations fixed their exchange rates by binding their currencies to the U.S. dollar, which was, in turn, linked to gold. As Laidler writes in his essay, the system "implied that stability of the exchange rate rather than of prices was the key goal." This tenet ultimately posed a significant challenge for the Bundesbank as the German economy gained strength and demand for its exports grew throughout the 1960s. "The Bundesbank was compelled ever more frequently to intervene in the foreign exchange market in order to counter appreciation pressures on the D-Mark," writes former Bundesbank president Axel Weber in Monetary Policy Over Fifty Years. As such, Weber explains, the bank was, for a period, torn between allowing the deutsche mark to appreciate vis-à-vis the dollar for the sake of external exchange rate stability and maintaining internal price stability at the expense of the international monetary order.

While the Bretton Woods system disintegrated in large part due to the Smithsonian Agreement of 1971, followed by former U.S. president Richard Nixon’s unilateral decisions to de-link the dollar from gold and subsequently adopt a flexible exchange rate in 1973, the Bundesbank also played a role in the monetary order’s demise. In the face of high U.S. inflation in 1969, the Bundesbank revalued the deutsche mark in order to limit the risk of external inflationary pressures. "The first nail went into the coffin [of Bretton Woods] when the Bundesbank and the Swiss National Bank and a few others broke away from the U.S. dollar in the face of U.S. inflation in the late 1960s," Laidler says.

In the first half of the 1970s, inflation, fueled in part by the 1973 oil crisis, rose throughout the developed world, including in Germany. But while inflation in the UK, for example, peaked at above 25 percent, in Germany it peaked at around 8 percent. Indeed, as Markus K. Brunnermeier of Princeton University explains, the Bundesbank’s deft handling of that crisis solidified its role as an unrivaled paradigm for central banking around the world.

A Model for the ECB

Following the collapse of Bretton Woods, European nations took steps to create a new monetary order in Europe and to harmonize their exchange rates. Most significantly, they established the European Monetary System in 1979, which employed an Exchange Rate Mechanism to stabilize exchange rates between European member countries, including Germany. The EMS was the precursor to the Economic and Monetary Union that was formalized in the Maastricht Treaty of 1992. The EMU paved the way for the establishment of the eurozone and the European Central Bank, the ultimate successor to the Bundesbank. "The ECB was the Bundesbank 2.0, but even a bit stronger in terms of its independence," explains Daniel Gros, director of the Center for European Policy Studies. Indeed, the ECB’s goals of price stability and independence were written into the Maastricht Treaty.

"The whole plan of the ECB was essentially to bring the reputation of the Bundesbank to the ECB," explains Brunnermeier. Indeed, throughout the 1980s, the "prevailing paradigm" of monetary policy had shifted from a Keynesian one, which sees a role for government intervention, to a Monetarist one, which favors a more laissez-faire approach, argues the London School of Economics’ Paul De Grauwe. To achieve price stability, an institutional design ensured that the central bank was governed by unelected technocrats who fell outside the purview of political accountability. The Bundesbank fit the bill, and, as such, Germany had a strong strategic advantage when negotiating its accession to the EMU, De Grauwe argues. Germany was able to insist that if it were to join the eurozone, the ECB would be designed as a "close copy of the Bundesbank," he says.

The Bundesbank and the Euro Crisis

While the Bundesbank president only has one vote on the governing council of the ECB, it’s a position that has nonetheless maintained an outsized influence at the bank since its inception over a decade ago. Current Bundesbank President Jens Weidmann echoed this sentiment in July 2012 in an interview marking the bank’s fifty-fifth year: "We are the central bank that is most active in the public debate on the future of monetary union," he said.

Throughout the ECB’s short history, it has largely acted in line with the Bundesbank’s approach to monetary policy. However, in the wake of the eurozone sovereign debt crisis, significant differences between the Bundesbank and the ECB have emerged over the latter’s efforts to shore up the euro and arrest the burgeoning crisis. The rupture between the two banks first began in 2010 when former ECB president Jean-Claude Trichet initiated the Securities Markets Program in order to buy Greek government bonds on the secondary market. The Bundesbank forcefully opposed the move, arguing that the ECB was overstepping its mandate. Ultimately, former Bundesbank president Axel Weber--then considered the most viable candidate to succeed Trichet as ECB president--resigned his post nearly a year early, in 2011, in protest over the bond-buying program.

The Bundesbank-ECB rift further widened in mid-2012 after current ECB President Mario Draghi unveiled a new--and potentially unlimited--program to buy the government bonds of struggling eurozone sovereigns on the secondary market, known as Outright Monetary Transactions. Weidmann was the only member of the ECB’s governing council to vote against the move, which he likened to "state financing via the money presses" (DerSpiegel). The Bundesbank, explains an October 2012 Economist report, holds two deep-seated concerns over ECB bond buying: "First it exposes taxpayers in northern countries to risks that belong to those in southern states, but does so opaquely within the Eurosystem. Secondly, it takes monetary policy too close to the realm of fiscal policy and thus compromises the ECB’s independence."

The Bundesbank believes that monetary financing of budget deficits violates the ECB’s independence while undermining its objective of ensuring price stability. This line of thinking, De Grauwe says, has been used by the Bundesbank to "argue that any bond-buying program should be ruled out because of its inflationary potential and because of a fear it would make the central bank dependent on the political world." But De Grauwe suggests this argument disregards the fact that the ECB bond buying programs have been restricted to the secondary market, which means it would be buying government bonds from financial institutions and not directly financing budget deficits.

Moreover, despite the ECB’s commitment to enact the OMT program, it has yet to begin buying government bonds. In this regard, Brunnermeier argues, the Bundesbank can "still have an influence on the extent to which the ECB program will be conducted." While the Bundesbank is not "at the center of the ECB’s decision making," Brunnermeier says, its opposition to OMT will likely have an impact on the speed of the program, if it is enacted.

Separately, the Bundesbank has voiced concerns over plans for a new EU banking supervisor, which would be housed within the ECB. Weidmann has called for large eurozone states like Germany to have a greater role in the future banking supervision process at the ECB, notes Schwarzer. More significantly, she explains, "Weidmann has questioned whether the ECB should supervise banks at all, as the banking supervision activities may not be sufficiently separated to ensure the ECB’s independence."

Additional Resources

The book Monetary Policy Over Fifty Years: Experiences and Lessons offers a series of essays on the recent history of international monetary policy.

The book The History of the Bundesbank: Lessons for the European Central Bank provides a series of essays on the development of the Bundesbank and its influence on the ECB.

In the essay "On the Origin and Rise of Central Bank Independence in West Germany," Jörg Bibow examines postwar central banking in Germany and its "early emphasis" on independence.

In the essay "How the Bundesbank Conducts Monetary Policy," Richard H. Clarida and Mark Gertler discuss the history of the Bundesbank’s primary goal of controlling inflation.

This Der Spiegel piece provides an overview of the period of German hyperinflation in the 1920s.

This CFR Backgrounder discusses the role of the European Central Bank in the ongoing eurozone crisis.