Richard Werner Reichsbank
The Revival of the Reichsbank
In many countries today ... monetary policy making is entrusted to an independent central bank. This reflects the human wisdom that has been nurtured by history. -Yasushi Mieno, governor of the Bank of Japanl
The Fed, the European Central Bank and the Bank of Japan together set monetary policy for a zone that accounts for 80 per cent of the world's industrialized economic activity .... Rarely, if ever, can so much power have been wielded by such a small number of institutions sitting outside the direct democratic process. -Goldman Sachs economic research2
Greenspan is part of a trend that's been sweeping the globe in recent years: Central bankers are running the world nowadays. An unelected economist, he's been holding America's economic reins .... In Europe, 12 countries have adopted a single currency and effectively forfeited economic sovereignty to the European Central Bank. -William Pesek Jr., columnist, Bloomberg News]
Recession-But Nothing We Can Do
Commentators seem to agree that today central bankers are in charge. In his article entitled "When Central Bankers Run the World," Bloomberg financial columnist William Pesek wonders why "there's been minimal backlash against this new world economic order, save the occasional protest at meetings of the World Trade Organisation or IMF." He suggests it is because of "voters and politicians alike finding comfort in knowing that a tested economic policy maker is at the controls.,,4 In
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other words, we are happy with the rule of the central bankers, because we believe this will ensure lasting economic growth and prosperity. It is a comforting belief. When the German economy started to slow down visibly in 2001, German politicians, including finance minister Hans Eichel, increasingly felt the need to implement stimulatory policies.5 However, just like their Japanese colleagues in 1999, they found that there was little they could do. Normally, three types of policy tools are available to governments in order to influence and stimulate an economy: regulatory policy, fiscal policy, and monetary policy. Since Germany, like many countries today, is committed to deregulation, privatization, and liberalization, there was no leeway for new regulatory intervention. Due to fiscal tightening imposed by the European stability and growth pact, stimulatory fiscal policy also had to be ruled out. This leaves us with monetary policy, which is the most powerful policy tool to influence an economy. However, politicians had no power over it. The ECB is independent from any government. Thus the government had been left without any serious macroeconomic policy tool. Even if the Bundesbank, Germany's central bank, felt that it needed to act to stimulate the German economy, there was nothing it could do. Once one of the most powerful central banks in the world, the Bundesbank has been transformed into the Frankfurt branch office of the European Central Bank. The ECB decides German monetary policy, whether German politicians or Bundesbank staff like it or not.
The End of the D-Mark
On January 1, 2002, new paper money and coins were introduced in most of Europe. What still seemed an unlikely scenario to many observers as recently as the mid-1990s happened without major obstacles or upsets: Twelve European countries gave up their national currencies. With the introduction of fixed exchange rates in January 1999, their governments and national central banks had already relinquished all control over monetary policy to the new power center of Europe: the European Central Bank.6 Most astonishing to outside observers was the fact that Europe's largest economy, Germany, had given up its deutsche mark. The strong attachment the Germans had developed to their mark during the postwar era had bordered on the religious. Many economists attributed the postwar German economic miracle to the stability of the mark and to the reliability of its guardian, the Bundesbank. With the demise of the deutsche mark, the history of the Bundesbank also came to an end. British observers called it "a puzzle": "The DM became the key currency of the EMS [European Monetary System] and one of the world's major currencies; by the 1980s it was second to the U.S. dollar in terms of the proportion of world trade that was invoiced in it. That so much was achieved in such a relatively short time makes the history of the currency remarkable. What is perhaps even more remarkable is its future. That a currency which achieved so much, and which was for that
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reason so popular with the citizens of the country that used it is to disappear into EMU [European Monetary Union] in 2002 is, at the least, surprising .... One could not but be surprised that a currency at once a cause and a symbol of Germany's recovery should be abandoned in a democracy."7
The Primacy of Politics
Economists knew all the while that there was no good economic rationale for abandoning the mark. Many of the economists at the large German banks, for instance, wanted to issue warnings about the costs and dangers to Germany of the introduction of the euro. However, the boards of their banks did not allow them to publish such research. To the contrary, only positive analyses were allowed to be published.s There can be little doubt that the reasons for the creation of the euro were not to be found in the realm of economics.9 Monetary integration had been used as a tool to accelerate the unification of Europe and push toward the establishment of a fully fledged "United States of Europe."lO Despite the public information campaigns and the occasional muffling of intellectual opponents of the euro, grassroots resistance to the single currency remained strong in many major European countries, including Germany and France. Opposition is probably still strongest in the United Kingdom, whose population is aware of the inevitable loss of sovereignty and control over its destiny if it gives up its own money. Referenda held in Denmark and Sweden were uncomfortable for politicians, because the population turned out to have a different opinion than they did. Thus they will be asked to vote again and, if necessary, again after that. It would also have been difficult for any referendum in Germany to achieve a majority in favor of the abolition of the mark and the adoption of the euro. That is why no such referendum was ever held. Instead, politicians used taxpayers' money to fund expensive publicity campaigns to make the euro popular.
Power in the Hands of a Few
The area where the euro is used includes a population of about 290 million, with a GDP of more than €7 trillion. This closely rivals the United States, with a population of about 280 million and a GDP of about €8 trillion. The handful of decision makers at the European Central Bank control the amount and ultimately also the allocation of money circulating in the twelve countries in this region. I I This is no small matter. History has shown that the power to create and allocate money easily rivals, and usually dominates, military might. Yet the often dismal performance of politicians has convinced many observers that it may be preferable to hand power over to objective technical experts, such as the central bankers. There are several problems with this argument. First, even technical experts are humans. As such, they are as prone to errors and acts of selfishness as anyone else. What they need is the right incen
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tive structure to limit these tendencies. This means meaningful accountability for their policies. Second, are central bankers really always objective? In the words of the chair of the economic and monetary committee of the European Parliament, the German Christa Randzio-Plath, "monetary policy is never neutral. It affects growth and employment."12 That is why, before the establishment of the ECB, RandzioPlath was pushing for greater transparency and accountability of this institutionin vain, as it turns out. Especially given Europe's-and Germany's-disastrous experiments with unaccountable and opaque control regimes in the twentieth century, it is astonishing to find that yet another experiment with centralized control is being attempted. How was it possible that such enormous power over such a vast region has been handed to such a small number of people?
For the Sake of Low Inflation
The European Commission, an unelected group whose raison d' etre is to build a United States of Europe with all the trappings of a unified state, had an interest in weakening individual governments and the influence of the democratic parliaments of Europe. What better way than creating an independent European Central Bank? What is not so easy to see is why Europe's parliamentarians should have agreed to their own castration, which the creation of central bank independence entailed. They agreed because they believed that economic theory as well as historical reality had proven this to be the best solution. Just as in Japan's case, the creation of the strongly independent ECB was justified with the argument that this was the "human wisdom nurtured by history," to use Mieno's words--especially the history of the Bundesbank. Indeed, the German experience with the Bundesbank has been largely positive. But as we see from this book, that is the exception in the relatively short history of central banks. The experience with the Bundesbank's predecessor and with the central banks of other countries has not been as happy. This raises three questions: What made the Bundesbank so successful? Is the same ingredient for success also to be found with the ECB (and the Bank of Japan and other central banks)? What, indeed, is the definition of "successful" monetary policy? Inflation is usually considered the main policy mistake that central banks or governments can commit. Pundits have boiled the message down to the formula that central bank policy is successful if there is little inflation. Indeed, during much of the postwar era, German inflation has been modest by international comparison. The same commentators usually argue that the main ingredient of the Bundesbank's success of low inflation was its independence. This view has become accepted wisdom, so much so that we hardly ever ask whether there is any real evidence for it. 13 Several influential academic studies have offered such evidence, showing statistically that the degree of independence of a central bank is
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correlated with lower inflation. The less influence governments can exert over central banks, the more stable the currency, they say. It turns out that the scientific evidence for central bank independence that was relied upon in the Maastricht Treaty derives from a single study that was commissioned by none other than the European Commission itself-an interested party. Published in 1992 under the name "One Market, One Money," the study purported to demonstrate that central bank independence leads to low inflation. 14
Phony Findings
How reliable are the findings of this study? A closer look reveals that there is no such scientific evidence. The study arbitrarily selects a number of countries, then arbitrarily determines the degree of independence of their central banks and then finds that this is correlated with the past inflation performance of the country concerned. There were no tests to determine whether the results vary if one uses a different time period for the average inflation than the one chosen by the authors. There were no tests to demonstrate whether a different selection of countries, other than the seventeen picked by the study, would yield a different result. IS Most damning, however, is the methodology employed to determine the degree of central bank independence of the countries that were examined. Since there is no official index of central bank independence, the authors set out to create one. James Forder, an independent economist at Oxford University, has examined whether the researchers carefully followed their own definitions of independence and hence were at least internally consistent in their argument-the most basic and necessary (but not sufficient) requirement for scientific research.16 His findings are shattering. He uncovered a string of manipulations of the data by the original authors, which happen to produce the desired answer that a high degree of independence is associated with low inflation. Correcting for these apparent "mistakes," Forder finds that some of the data points from the countries most crucial for obtaining the result suddenly differ. After his correction, no more statistically significant correlation could be detected between independence and inflation. Forder's conclusion: The data and method used by the economists commissioned by the European Commission do not provide evidence of any relationship between central bank independence and inflation. The European Commission used this flawed study as the main argument for the introduction of the Maastricht Treaty of 1992, which signed Europe up for rule by the ECB under a single currency.17 We must conclude that statistically no robust link exists between central bank independence and low inflation.
Not by Low Inflation Alone
But we saw that inflation is not the only example of central bank policy mistakes. Japan's inflation rate has been lower than the German one for the past decades.
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Hence by the traditional definition of the success of monetary policy, the Bank of Japan beat even the highly respected Bundesbank at its game. Japanese consumer price inflation averaged 1.5 percent in the last twenty years, compared to 2.5 percent in Germany. Consumer price inflation even turned negative in the late 1990s, averaging 0.8 percent during the decade (compared to 2.3 percent in Germany). Yet we all know that Japanese monetary policy cannot be called a success over the last decades. This proves the point that low inflation must not remain the only way to measure a central bank's achievements. There are many other serious problems that central banks can create, such as recessions. In this case, inflation may be low, but the economy may suffer from large-scale unemployment induced purely by monetary policy. Central banks can also create deflation, which increases the real debt burden of borrowers, such as homeowners with mortgages. This is what happened in Japan and several Asian and Scandinavian countries. Again, by the measuring rod of low inflation, the central banks would have been doing a good job. But in reality they were not doing their job at all. Central banks can also cause excessive speculative booms through their policies. That is the story of the United States, the Scandinavian countries, Japan, and most of Asia, where asset booms were accompanied by stable consumer price inflation. Once again, if measured solely by low inflation, central bankers seemed to be doing their job. But asset inflation stored up enormous trouble for the future, ultimately causing the bankruptcies of a large part of the corporate sector and pushing the economy into recession and high unemployment.
Independence Does Not Guarantee Good Policies
There is no evidence that the central bank policies leading to asset inflation and th8n deflationary recessions in the above countries were determined by other actors, such as governments. Instead, they were made by central banks that were largely independent from government interference concerning their crucial credit quantity policies. This shows that central bank independence alone does not guarantee economic success of monetary policy. The Swedish Riksbank, for instance, independently created a credit boom in the 1980s and a credit crunch in the 1990s. The U.S. central bank leadership was not influenced by political pressure when it increased credit creation steadily throughout the 1990s, thus creating a vast asset bubble. The central banks of Thailand and Korea independently encouraged their banks to lend excessively to the real estate sector and independently set policies that encouraged their entire corporate sectors to borrow from abroad, thus placing a precarious time bomb at the heart of their economies. IS After this they took excessively tight policies, creating deep recessions. 19 This happened against the will of the respective governments. Most of all, the Bank of Japan acted independently when it forced the Japanese banks to create the 1980s asset bubble and then independently prolonged the subse
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quent ten-year recession of the 1990s, which brought down the once mighty Japanese economy. By comparison, the Bundesbank did a reasonably good job also by our broader definition of success, as unemployment, while rising especially in the mid-1980s and late 1990s, remained significantly below that of other European countries.20 Economic growth was fairly high throughout the postwar era, clocking up over 6 percent in real terms in the 1950s and 1960s, and averaging 2.7 percent in the 1970s, the 1980s, and again the 1990s. This is among the best of all industrialized countries. Moreover, there has neither been a deflationary credit crunch nor a nationwide asset bubble based on excessive speculation in financial investments in Germany-as happened in so many other countries the world over. We learn two things. First, the measure of monetary policy success must be more than inflation, namely, the combination of low inflation with stable and positive economic growth. As we saw in chapter 4, growth is largely determined by the central banks, because only the creation of new purchasing power enables new growth. Central banks can manipulate their own credit creation as well as that of the private-sector banks. Increased credit creation pushes up nominal GDP. The link to inflation is simple: Growth will remain without inflation until the economy reaches the maximum potential growth rate. Credit creation beyond that may produce inflation if the newly created money is used for unproductive purposes. But whenever growth remains below the maximum potential growth rate, creating additional credit does not necessarily produce inflation. Second, the main reason for the high esteem that is accorded to the Bundesbank by the German population is its growth orientation. If the German central bank had pushed Germany into ten years of deflation, very few commentators would have considered its policies a success despite the absence of inflation. So the crucial question is this: Did the Bundesbank achieve its policy combination of low inflation and high growth thanks to independence from the government?
The Reichsbank Was Also Independent
Many economists who argue that the Bundesbank's success was due simply to legal independence from the government forget that even the Bundesbank's prewar predecessor, the Reichsbank, was legally independent from the government. This independence existed to a great extent de facto since its foundation in 1875, because the central bank was largely privately owned and accountable to the shareholders.21 Independence was explicitly written into law in May 1922 and lasted until 1939.22 Until then the Reichsbank was not accountable to the people, the government, or parliament. In August 1924, a new banking law again confirmed the Reichsbank's independence from the government-"but greatly increased the influence over the central bank of Germany's foreign creditors.,,23 The Reichsbank was independent from German democratic institutions, but dependent on the will of interests outside Germany. While the government could do nothing about
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Reichsbank policies, the central bank was under the control of the Reparations Commission, which was dominated by Wall Street bankers.24 Needless to mention, the interests of these Wall Street firms were not necessarily identical with those of the German population. During this time, the Reichsbank was far more independent than the Bundesbank. It was also not accountable for its policies. Yet what did this highly independent central bank do? It did much to undermine the fledgling Weimar democracy. First, it produced hyperinflation, which started in earnest in mid-1922 and peaked in late 1923 with consumer prices rising two-billion-fold. From the mid-1920s until 1933, the Reichsbank adopted highly restrictive policies. The first phase of credit tightening, between 1924 and 1926, was followed by an even worse credit crunch in 1931. In both periods, thousands of firms failed to obtain funding and went bankrupt. As we saw, for most of this time the power of life or death over firms was in the hands of Reichsbank president Hjalmar Schacht. He implemented extralegal credit controls over the banking sector of the type that we examined in great detail in this book. He used them to engage in the active transformation of the German economy by forcing the bankruptcies of many firms-a process he described as having a "cleansing" effect. His declared goal was to accelerate "rationalization," a process that today's central bankers refer to as "restructuring" or structural change.25 When U.S. banks pulled their deposits from German banks in the aftermath of the U.S. credit crunch that began in 1929, the Reichsbank insisted that the banks call in their loans to German industry to pay the U.S. depositors. As had always been expected, industry had invested the money in plant and equipment. The policies of the independent Reichsbank meant that firms had to close down and sell their assets at distressed sales prices. Overnight, mass unemployment was produced. Germany was thrown into the Great Depression. For those who trust that such disastrous policies will never be repeated (surely central bankers learn from past mistakes?), chapter 17 demonstrated that the central banks of Thailand, Korea, and Indonesia virtually copied the extraordinary policies of the Reichsbank in the 1920s and early 1930s-resulting in the Asian crisis of 1997 and 1998, which also brought down governments and created record high unemployment. In a further parallel to events of the 1920s, international bankers, this time represented by the International Monetary Fund, demanded deep structural changes from these Asian nations. The economic instability that doomed the Weimar Republic was due not only to the unreasonable demands of the victors of the First World War. It was at least as much the result of an unaccountable central bank that had excessive powers. Germany's first democracy had little chance: The government could try to create economic growth, but ultimately the power over the economy was in the hands of the central bank. Economists concluded that the Reichsbank had become a "second government" (Nebenregierung) that acted "dictatorially" and independently from the elected government.26 The democratically elected government was the less powerful one.
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Trust US, We're Central Bankers
Being independent from the German government did not prevent the Reichsbank from adopting the horrific policies of the 1920s and early 1930s that ultimately proved fatal for Germany and the world, as they set the stage for the arrival of a pro-growth party, the NSDAP. We must remind ourselves that arguing in favor of independent central banks is effectively to say that politicians cannot act in the national interest. Only central bankers, neutral and objective technical experts, can make decisions for the benefit of the people. No doubt this is a cynical view of democracy as a system. It was also the view taken by the NSDAP, which argued that politicians could not be trusted. It is a view that is not without dangers, for it turns technocrats into the rulers of our countries-a form of technocratic totalitarianism. The evidence suggests that this approach is naive. The highly acclaimed monetary technician Hjalmar Schacht, for one, used his skills and legal powers to actively and purposely hand Germany over to Adolf Hitler. He was rewarded for his services by being reappointed as head of the Reichsbank from 1933 to 1939.27 So can we expect the ECB to act in the interests of the people? The first difficulty is to identify just who those people are. The ECB makes monetary policy for twelve quite diverse economies. One size of policy shoe must fit all European feet.28 The even bigger problem is that there is no guarantee that the central bankers at the ECB are as all-knowing and benevolent as we would like them to be. So far there are few historical examples of societies that are successfully governed by a small group who are largely unaccountable for their actions. Given the enormous power that we have given into their hands, it should not surprise us if and when this power is misused.
Accountability Is Key
Back to the puzzle-why was the Bundesbank successful? Ultimately, people react to incentives. The incentive structure is usually defined by the institutional framework, and that is normally prescribed by the legal structure. So the Bundesbank's legal setup should give us some indication about what makes a good central bank. We notice that legally the Bundesbank was not just required to work toward price stability. In 1967, ten years after the founding of the Bundesbank, the parliament passed the Stability and Growth Act, which clearly set out the objectives of its policy as "price stability, a high level of employment, external equilibrium, steady and adequate economic growth." The law mandated the Bundesbank to produce low inflation and stable growth. This was also what the Bundesbank had in mind when it made its policies. Bundesbank president Klasen, for instance, is said to have "accorded economic growth equal priority to monetary stability.,,29 The Bundesbank is often talked about as having been the most independent central bank in the world. This is simply not true. In reality, the independence of
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the Bundesbank was clearly limited. To start with, central bank independence was not enshrined in the constitution and was thus not irrevocable. Moreover, the Bundesbank was only given "independence from government instructions." When this was formulated, the lawmakers, presumably remembering the lessons from Weimar, explicitly warned that this phrase "of course must not be interpreted to mean that the central bank become a state within the state."30 While being independent from direct instruction from the government, the Bundesbank was not independent from the parliament, which could pass laws or give instructions if it so wished. Moreover, it was not independent from other institutions of the Federal Republic but was subject to German laws and was accountable to the federal audit agency (the Bundesrechnungshof) and the decisions of German law courts. But even the independence from the government was limited, for the Bundesbank Law also said explicitly that "it is the duty of the Bundesbank ... while fulfilling its tasks to support the general economic policy of the Federal Government." And there is virtually no time period when the government's main policy aim was not to achieve decent economic growth. Despite the inability to give direct instructions to the central bank, government representatives could join the policy board meetings of the Bundesbank and expect the bank to support their policy objectives of near-full employment. As legal experts point out, if the government placed a different emphasis among the goals of the Stability and Growth Act than the Bundesbank-for instance, by pursuing economic and employment growth-then as long as price stability was not neglected, the Bundesbank was obliged to follow the policies of the government. Ignoring the goals of the Stability and Growth Act would have been illegal.31 There were other incentives embedded in the legal structure that helped make the Bundesbank successful. For instance, the Bundesbank had a decentralized structure that included in policy decisions representatives of the German states, appointed by the Bundesrat. Moreover, each regional representative was in tum advised by representatives of the various occupations, including trade unions.32 As a result, the decision-making process of the Bundesbank was usually well balanced, reflected the various parts and regions of society, had to take government policy into consideration, and was subject to legal checks and balances. This multifaceted accountability and consensus orientation produced the Bundesbank's fairly successful monetary policy. Of course, there were also mistakes. And the Bundesbank had enough power to cause serious problems for politicians. There are many instances where the government would have liked it to stimulate the economy more, but the Bundesbank refused. The downfall of three chancellors-Ludwig Erhard in 1966, Kurt Georg Kiesinger in 1969, and Helmut Schmidt in I 982-was directly or indirectly linked to tight Bundesbank policies.33 Often the government, not the Bundesbank, turned out to be right. 34 But ultimately there were political limits on the Bundesbank's ability to go it alone against the interests of the population.35 Ironically, we must therefore conclude that the success of the Bundesbank was
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due less to its independence than to its subtle dependence on the other elements of the democratic system. The legal setup made the central bank highly accountable for its policies, and it was always clear that these policies could not consist solely of producing low inflation, but instead had to reflect the goal of stable economic growth. By contrast, the Reichsbank's failure was surely due to its excessive independence without accountability and recourse. Thus, comparing the Reichsbank and the Bundesbank, we find that the reduction in central bank independence and the introduction of accountability and dependence on democratic institutions that was undertaken in the postwar period greatly enhanced the performance of monetary policy. Contrary to popular opinion, the Bundesbank's success was due to its comparative lack of independence. Thus in order to determine whether the ECB is going to be successful as far as the German and European people are concerned, it is crucial to determine whether the new central bank is similarly accountable to the people to implement the twin goals of low inflation and stable growth.
The Unaccountable ECB
With the introduction of the ECB system, the German government has lost its influence over monetary policy. With the creation of the ECB, the Bundesbank Law was also revised. In the new Bundesbank Law the German central bank not only became subject to the ECB instructions, but also is no longer required to support the general policies of the government.36 Neither is the ECB required to support the policies of the German government. It is, however, required to support the "general policy goals of the EU." The Maastricht Treaty, which defines the role of the ECB, says that the ECB has a primary mandate to maintain stable prices. It also says that "where it is possible without compromising the mandate to maintain price stability," the ECB will also support the "general economic policy of the EU," which includes among other goals "steady, non-inflationary and environmentally friendly growth" and "a high level of employment."3? This could be interpreted to mean that the ECB, like the Bundesbank, has to work for the twin goals of low inflation and stable economic growth. However, the emphasis is explicitly on price stability. Moreover, unlike in the case of the Bundesbank, there are virtually no checks and balances on the actions of the ECB. It is therefore practically impossible for anyone-for instance, a government, parliament, or even the (unelected) EU Commission-to enforce any specific goals or, for that matter, enforce anything at all. Unlike the Bundesbank, the ECB is independent not only from the government but also from parliaments, democratically elected assemblies, or other institutions within the EU. Moreover, the Maastricht Treaty, defining the ECB's status, includes the clause that no democratic institution within the EU is even allowed to attempt to influence the policies of the ECB.38 This is unprecedented among democracies. In addition, the ECB is far less transparent than the Bundesbank was. For in
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stance, the deliberations of its decision-making bodies are secret.39 It is not required to publish detailed information about its transactions (this requirement was also scrapped for the Bundesbank with the establishment of the ECB). While it has the power to obtain data from any bank or company in the EU, the ECB is not obliged to publicize that data or any specific statistics. Not surprisingly, the ECB's statutes are already being interpreted as virtually exclusively aimed at price stability. Wim Duisenberg, when he was head of the ECB's predecessor organization, the EMI, told us that he favors "a single monetary policy which strictly aims at price stability in the euro area as a whole."40
Resurrection of the Reichsbank
The ECB is far more independent than the Bundesbank has ever been. It is also much more independent than the U.S. central bank, the Federal Reserve, whose legal status is far weaker and which is directly accountable to Congress and the government.41 We find that the ECB is the least accountable central bank among advanced nations. We must conclude that there is a danger that the incentive structure of the staff at the ECB is not sufficient to guarantee optimal economic policies. This is worrying. It suggests that the lessons of German history were not interpreted correctly and the ECB was created on the wrong foundations. Instead of adopting the features that made the Bundesbank successful-accountability and interdependence with other democratic institutions-the creators of the ECB revived the corpse of the unaccountable Reichsbank. As we saw, the story line of human misery runs quite directly from Schacht to Ichimada, who had trained with the "financial wizard," and the princes at the Bank of Japan who created the recession of the 1990s. History tells us that it is dangerous to deliver vast powers without checks and accountability into the hands of a few unelected officials. "Human wisdom nurtured by history" suggests not to revive the Rt:ichsbank. But the creation of the ECB did just that.
Overstepping the Boundaries of Monetary Policy
The Reichsbank in the 1920s was engaged in policies that went beyond the boundaries of standard monetary policy. It engaged in structural policies and forced "rationalization" of industries. The experience of Germany during the Weimar republic shows that Japan is not the first country that is being coerced by an independent central bank into implementing deep structural reforms and "restructuring." Nor is it the last, as the experience of Eastern European, Latin American, and Asian countries under IMP tutelage shows. Their central banks, probably thanks to the allure of legal independence that the IMP promised, in almost all cases supported the IMP's arguments. Recessions and large-scale economic dislocation followed. Surely the ECB would not do such a thing in Europe?
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When German politicians, including the finance minister, hinted in summer 2001 that further stimulatory policies would be needed from the ECB to support growth, ECB president Wim Duisenberg and his colleagues repeated what the Financial Times describes as their "monthly mantra": calls for fiscal tightening and structural reform. During its short history, the ECB has consistently refused to create more money to stimulate the German and European economies until its conditions are met, namely, that the German and other governments implement structural changes: "Wim Duisenberg, president, and his colleagues have turned calls for fiscal discipline and structural reform into a monthly mantra. These demands have been the implicit price for an easing in monetary policy."42 These structural changes include liberalization, deregulation, and privatization-in short, the introduction ofneoliberal U.S.-style shareholder capitalism and the abolition of the well-established and successful welfare capitalism. The parallels with Japan are disturbing. What if the ECB has already decided that the postwar German-style economic system is bad and must be scrapped? It ordered the Bundesbank to shrink its credit creation by record amounts in 2002. As the amount of money circulating in the economy shrank, demand fell and the economy moved into recession. Parallel with this, the central bank stepped up its claim that the German recession is due to its outdated economic structure. Most observers would find it hard to prove otherwise. As the recession continues, more and more experts would likely agree-all they can see is a long recession. Surely that proves that the system does not work?
Slow Growth Due to the System-or Monetary Policy?
Japan built its postwar economic system on the German model of economic development, pioneered by German economists and implemented by policymakers in the first half of the twentieth century. The system has been highly successful in achieving fast growth, the rapid overall development of the economy, a sharp rise in incomes and living standards, and a surprisingly equal distribution of incomes and wealth. In Germany, Ludwig Erhard, a proponent of the concept of a "social market economy," undertook the postwar modification of this system. The aim was to combine a market economic structure with clever government guidancesimilar to what happened in Japan. There can be no doubt that the German and Japanese system of economic development has been highly successful and especially beneficial for the average citizen. It can serve as a model for developing countries. However, this is not happening. To the contrary, both Germany and Japan are being asked by the central banks, as well as the institutions of the "international community" (such as the IMP and the OECD, as well as the ECB and the U.S. Treasury), to implement deep structural reforms. The German-style system, we are told, is bad and inefficient. The entire system needs to be scrapped, together
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with the economic and social structures that it spawned. What is good for efficiency, we are told, is unmitigated U.S.-style capitalism.
No Serious Debate
This may well be a worthwhile undertaking. I would, however, like to take issue on several grounds. First, the question of whether an entire economic (and hence also social) system should be changed affects such large parts of society that in a democracy a wide-ranging public debate and far-reaching policy discussions are normally preconditions. This debate should follow the standard procedures of the democratic decision-making process and should include a discussion of the advantages and disadvantages of the German-style economic system, comparing them to the costs and benefits of U.S.-style capitalism. Let us not forget that Ludwig Erhard and the intellectuals around him, as well as their colleagues in Japan, were fully aware of the features of U.S.-style free market capitalism. Yet they purposely chose a different system. They must have had some good reasons. The fact is, U.S.-style capitalism has major disadvantages that will not be popular in European countries. Among these are income and wealth disparities so wide that they otherwise exist only in developing countries, greater educational inequality, far larger social instability, and far higher crime rates-in other words, a society that European thinkers in the past have considered but rejected as inequitable and socially unjust. Nevertheless, whether German citizens wish to adopt this system or not is ultimately a choice that they should make for themselves. After a suitable public debate, the voters and their representatives should make a considered decision. This, however, is not happening. It seems that such decisions are nowadays made behind closed doors by central bankers. Second, it is not clear that the adoption of U.S.-style deregulation and U.K.style privatization is the only solution for Germany. The German system has many worthwhile features that could be preserved, as does Japan. Would it not be better to renovate what is outdated, while leaving the structure in place? That, certainly, is more in line with European tradition. Third, the reasons why Germany and Japan's economic systems are being criticized are suspect. There is little evidence to suggest that changing their economic structures radically and introducing U.S.-style capitalism will lead to higher economic growth. If Germany's economic structure is indeed the cause of low growth, why did Germany experience much higher growth in the early 1990s and 1980s, before the structural reform policies implemented over the past five years or so? Ifthe German-style economic structure is so inefficient, how come it produced 8 percent real GDP growth in the 1950s? Moreover, ifthe U.S.-style economic system will lead to an economic recovery, how come the United States itself moved into recession in late 2001, or ten years earlier? Clearly, the U.S. system also has business cycles. This proves that another factor besides the eco
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nomic structure explains economic growth. That factor is money. And money is controlled by the central banks.
Misuse of Central Banking Power
Those in favor of central bank independence argue that central bankers should be put above politicians and governments because they are objective and not political. But the history of central banking is littered with examples of central banks overstepping their powers and engaging in highly political decisions. The founding fathers of the United States of America were well aware of the power of banks and banking dynasties. They therefore categorically resisted the establishment of a central bank. Thomas Jefferson was a vehement opponent of central banks. The u.s. Constitution therefore enshrines the right of the government to issue money. It leaves no role for a central bank. This is why for a large part of its existence the United States did not have a central bank. Money was issued by the government or by banks in a system of free, competitive banking. America did not fare badly without a central bank: It was the fastest-growing emerging market at the time and by 1900 had just about overtaken Britain, the world's number one economic power. The Federal Reserve was founded only in 1913 and remains half privately owned. A reluctant Congress was finally persuaded to agree to its establishment based on the argument that the central bank could step in and bailout banks when a banking crisis occurs. But when such a banking crisis did arrive in the 1930s (triggered by the Fed's very own policies of excessive credit creation), the Fed failed to act. Hundreds of thousands of farmers lost their land and livelihoods. The Great Depression changed the face of America. Yet the Fed has never been held accountable for its policies.
Lessons from Japan
Given the enormous dangers, many ordinary citizens have protested against the creation of the ECB and the scrapping of the mark. Several German politicians refused to become Mitliiufer (those who "go with the flow") and dared to speak up against the growing tide of high-level political support for the euro. Oskar Lafontaine, for instance, argued that the ECB needed more democratic checks and balances on its policies. Implementing such checks does not mean that money should be debauched and inflation allowed. To the contrary, the only guarantor of stable money is accountability of a central bank that has been given suitable policy goals. The lessons of the Reichsbank and of the Bank of Japan are also the lessons oftheECB. Like the Reichsbank during the Weimar Republic, the Bank of Japan has been the true government of Japan. The threat remains that the ECB is following closely in the footsteps of these dictatorial central banks.
THE REVNAL OF THE REICHSBANK 247
Global Rule of the Princes
Unfortunately, the situation is not significantly different in the United States. No one disputes the power of the Fed to move markets and the economy. Yet this power is used without many actual democratic checks and balances. Whenever Fed chairman Alan Greenspan gives an account of his policies and actions to Congress, he says little of interest (and is even commended for it by the press). Nobody monitors and imposes limits on the amount of credit the Fed is creating. Thus Greenspan, through his interest rate policies, has publicly given the impression that he wanted to slow the economy most of the time from the mid1990s onward, such as with his famous 1996 speech on "irrational exuberance." The fact is, however, that he has continued to increase the credit creation of the Fed during this time.43 This was exactly the reverse of the policy taken by the Bank of Japan in the 1990s. While the BoJ publicly wanted to demonstrate that it was doing all it could to reflate the economy by lowering interest rates, the truth of its policy intentions was revealed by its quantitative policy: It failed to reflate for most of the 1990s. Likewise, Greenspan has expressed surprise at the strength of the U.S. economy. But whenever he raised rates, he accelerated his printing of money. The Fed has moved the economy through its quantity policies while focusing its public statements strictly on interest rates in the same way as Japan.
The Yoke ofthe Princes
The current power of central banks is difficult to reconcile with democracy. As long as central bankers continue to exert unchecked control over the quantity of credit and its allocation, they are the undisputed rulers of the economy. If they have such powers, they are likely to use them. This probably means the continuation of the boom-and-bust cycles engineered by central banks in the pursuit of their goals. And these goals may be quite different from what we may naively assume. As long as there is no meaningful accountability, people's lives are but puppets in their credit game. To strengthen democracy, policymakers will have to consider changing the laws again, to make central banks accountable to parliaments for their policies-and this means their quantitative policies. Alternatively, we should heed the conclusion Milton Friedman came to after decades of research and experience dealing with the Federal Reserve: "The only two alternatives that do seem to me feasible over the longer run are either to make the Federal Reserve a bureau in the Treasury under the secretary of the Treasury, or to put the Federal Reserve under direct congressional control. Either involves terminating the so-called independence of the system. But either would establish a strong incentive for the Fed to produce a stabler monetary environment than we have had."44
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Short of changing the laws and making central banks directly part of the government again, an interim measure should be the establishment of government-imposed nominal GDP growth targets that central banks are required to meet within predetermined error margins and within a given time frame-under threat of meaningful sanctions. I believe that many of the business cycles and major recessions that we have witnessed since the creation of central banks would have been avoided with such an incentive structure. Otherwise, the rule of the princes will continue unabated, and to the detriment of democracy and our well-being.
In many countries today ... monetary policy making is entrusted to an independent central bank. This reflects the human wisdom that has been nurtured by history. -Yasushi Mieno, governor of the Bank of Japanl
The Fed, the European Central Bank and the Bank of Japan together set monetary policy for a zone that accounts for 80 per cent of the world's industrialized economic activity .... Rarely, if ever, can so much power have been wielded by such a small number of institutions sitting outside the direct democratic process. -Goldman Sachs economic research2
Greenspan is part of a trend that's been sweeping the globe in recent years: Central bankers are running the world nowadays. An unelected economist, he's been holding America's economic reins .... In Europe, 12 countries have adopted a single currency and effectively forfeited economic sovereignty to the European Central Bank. -William Pesek Jr., columnist, Bloomberg News]
Recession-But Nothing We Can Do
Commentators seem to agree that today central bankers are in charge. In his article entitled "When Central Bankers Run the World," Bloomberg financial columnist William Pesek wonders why "there's been minimal backlash against this new world economic order, save the occasional protest at meetings of the World Trade Organisation or IMF." He suggests it is because of "voters and politicians alike finding comfort in knowing that a tested economic policy maker is at the controls.,,4 In
232
THE REVIVAL OF THE REICHSBANK 233
other words, we are happy with the rule of the central bankers, because we believe this will ensure lasting economic growth and prosperity. It is a comforting belief. When the German economy started to slow down visibly in 2001, German politicians, including finance minister Hans Eichel, increasingly felt the need to implement stimulatory policies.5 However, just like their Japanese colleagues in 1999, they found that there was little they could do. Normally, three types of policy tools are available to governments in order to influence and stimulate an economy: regulatory policy, fiscal policy, and monetary policy. Since Germany, like many countries today, is committed to deregulation, privatization, and liberalization, there was no leeway for new regulatory intervention. Due to fiscal tightening imposed by the European stability and growth pact, stimulatory fiscal policy also had to be ruled out. This leaves us with monetary policy, which is the most powerful policy tool to influence an economy. However, politicians had no power over it. The ECB is independent from any government. Thus the government had been left without any serious macroeconomic policy tool. Even if the Bundesbank, Germany's central bank, felt that it needed to act to stimulate the German economy, there was nothing it could do. Once one of the most powerful central banks in the world, the Bundesbank has been transformed into the Frankfurt branch office of the European Central Bank. The ECB decides German monetary policy, whether German politicians or Bundesbank staff like it or not.
The End of the D-Mark
On January 1, 2002, new paper money and coins were introduced in most of Europe. What still seemed an unlikely scenario to many observers as recently as the mid-1990s happened without major obstacles or upsets: Twelve European countries gave up their national currencies. With the introduction of fixed exchange rates in January 1999, their governments and national central banks had already relinquished all control over monetary policy to the new power center of Europe: the European Central Bank.6 Most astonishing to outside observers was the fact that Europe's largest economy, Germany, had given up its deutsche mark. The strong attachment the Germans had developed to their mark during the postwar era had bordered on the religious. Many economists attributed the postwar German economic miracle to the stability of the mark and to the reliability of its guardian, the Bundesbank. With the demise of the deutsche mark, the history of the Bundesbank also came to an end. British observers called it "a puzzle": "The DM became the key currency of the EMS [European Monetary System] and one of the world's major currencies; by the 1980s it was second to the U.S. dollar in terms of the proportion of world trade that was invoiced in it. That so much was achieved in such a relatively short time makes the history of the currency remarkable. What is perhaps even more remarkable is its future. That a currency which achieved so much, and which was for that
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reason so popular with the citizens of the country that used it is to disappear into EMU [European Monetary Union] in 2002 is, at the least, surprising .... One could not but be surprised that a currency at once a cause and a symbol of Germany's recovery should be abandoned in a democracy."7
The Primacy of Politics
Economists knew all the while that there was no good economic rationale for abandoning the mark. Many of the economists at the large German banks, for instance, wanted to issue warnings about the costs and dangers to Germany of the introduction of the euro. However, the boards of their banks did not allow them to publish such research. To the contrary, only positive analyses were allowed to be published.s There can be little doubt that the reasons for the creation of the euro were not to be found in the realm of economics.9 Monetary integration had been used as a tool to accelerate the unification of Europe and push toward the establishment of a fully fledged "United States of Europe."lO Despite the public information campaigns and the occasional muffling of intellectual opponents of the euro, grassroots resistance to the single currency remained strong in many major European countries, including Germany and France. Opposition is probably still strongest in the United Kingdom, whose population is aware of the inevitable loss of sovereignty and control over its destiny if it gives up its own money. Referenda held in Denmark and Sweden were uncomfortable for politicians, because the population turned out to have a different opinion than they did. Thus they will be asked to vote again and, if necessary, again after that. It would also have been difficult for any referendum in Germany to achieve a majority in favor of the abolition of the mark and the adoption of the euro. That is why no such referendum was ever held. Instead, politicians used taxpayers' money to fund expensive publicity campaigns to make the euro popular.
Power in the Hands of a Few
The area where the euro is used includes a population of about 290 million, with a GDP of more than €7 trillion. This closely rivals the United States, with a population of about 280 million and a GDP of about €8 trillion. The handful of decision makers at the European Central Bank control the amount and ultimately also the allocation of money circulating in the twelve countries in this region. I I This is no small matter. History has shown that the power to create and allocate money easily rivals, and usually dominates, military might. Yet the often dismal performance of politicians has convinced many observers that it may be preferable to hand power over to objective technical experts, such as the central bankers. There are several problems with this argument. First, even technical experts are humans. As such, they are as prone to errors and acts of selfishness as anyone else. What they need is the right incen
THE REVIVAL OF THE REICHSBANK 235
tive structure to limit these tendencies. This means meaningful accountability for their policies. Second, are central bankers really always objective? In the words of the chair of the economic and monetary committee of the European Parliament, the German Christa Randzio-Plath, "monetary policy is never neutral. It affects growth and employment."12 That is why, before the establishment of the ECB, RandzioPlath was pushing for greater transparency and accountability of this institutionin vain, as it turns out. Especially given Europe's-and Germany's-disastrous experiments with unaccountable and opaque control regimes in the twentieth century, it is astonishing to find that yet another experiment with centralized control is being attempted. How was it possible that such enormous power over such a vast region has been handed to such a small number of people?
For the Sake of Low Inflation
The European Commission, an unelected group whose raison d' etre is to build a United States of Europe with all the trappings of a unified state, had an interest in weakening individual governments and the influence of the democratic parliaments of Europe. What better way than creating an independent European Central Bank? What is not so easy to see is why Europe's parliamentarians should have agreed to their own castration, which the creation of central bank independence entailed. They agreed because they believed that economic theory as well as historical reality had proven this to be the best solution. Just as in Japan's case, the creation of the strongly independent ECB was justified with the argument that this was the "human wisdom nurtured by history," to use Mieno's words--especially the history of the Bundesbank. Indeed, the German experience with the Bundesbank has been largely positive. But as we see from this book, that is the exception in the relatively short history of central banks. The experience with the Bundesbank's predecessor and with the central banks of other countries has not been as happy. This raises three questions: What made the Bundesbank so successful? Is the same ingredient for success also to be found with the ECB (and the Bank of Japan and other central banks)? What, indeed, is the definition of "successful" monetary policy? Inflation is usually considered the main policy mistake that central banks or governments can commit. Pundits have boiled the message down to the formula that central bank policy is successful if there is little inflation. Indeed, during much of the postwar era, German inflation has been modest by international comparison. The same commentators usually argue that the main ingredient of the Bundesbank's success of low inflation was its independence. This view has become accepted wisdom, so much so that we hardly ever ask whether there is any real evidence for it. 13 Several influential academic studies have offered such evidence, showing statistically that the degree of independence of a central bank is
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correlated with lower inflation. The less influence governments can exert over central banks, the more stable the currency, they say. It turns out that the scientific evidence for central bank independence that was relied upon in the Maastricht Treaty derives from a single study that was commissioned by none other than the European Commission itself-an interested party. Published in 1992 under the name "One Market, One Money," the study purported to demonstrate that central bank independence leads to low inflation. 14
Phony Findings
How reliable are the findings of this study? A closer look reveals that there is no such scientific evidence. The study arbitrarily selects a number of countries, then arbitrarily determines the degree of independence of their central banks and then finds that this is correlated with the past inflation performance of the country concerned. There were no tests to determine whether the results vary if one uses a different time period for the average inflation than the one chosen by the authors. There were no tests to demonstrate whether a different selection of countries, other than the seventeen picked by the study, would yield a different result. IS Most damning, however, is the methodology employed to determine the degree of central bank independence of the countries that were examined. Since there is no official index of central bank independence, the authors set out to create one. James Forder, an independent economist at Oxford University, has examined whether the researchers carefully followed their own definitions of independence and hence were at least internally consistent in their argument-the most basic and necessary (but not sufficient) requirement for scientific research.16 His findings are shattering. He uncovered a string of manipulations of the data by the original authors, which happen to produce the desired answer that a high degree of independence is associated with low inflation. Correcting for these apparent "mistakes," Forder finds that some of the data points from the countries most crucial for obtaining the result suddenly differ. After his correction, no more statistically significant correlation could be detected between independence and inflation. Forder's conclusion: The data and method used by the economists commissioned by the European Commission do not provide evidence of any relationship between central bank independence and inflation. The European Commission used this flawed study as the main argument for the introduction of the Maastricht Treaty of 1992, which signed Europe up for rule by the ECB under a single currency.17 We must conclude that statistically no robust link exists between central bank independence and low inflation.
Not by Low Inflation Alone
But we saw that inflation is not the only example of central bank policy mistakes. Japan's inflation rate has been lower than the German one for the past decades.
THE REVNAL OF THE REICHSBANK 237
Hence by the traditional definition of the success of monetary policy, the Bank of Japan beat even the highly respected Bundesbank at its game. Japanese consumer price inflation averaged 1.5 percent in the last twenty years, compared to 2.5 percent in Germany. Consumer price inflation even turned negative in the late 1990s, averaging 0.8 percent during the decade (compared to 2.3 percent in Germany). Yet we all know that Japanese monetary policy cannot be called a success over the last decades. This proves the point that low inflation must not remain the only way to measure a central bank's achievements. There are many other serious problems that central banks can create, such as recessions. In this case, inflation may be low, but the economy may suffer from large-scale unemployment induced purely by monetary policy. Central banks can also create deflation, which increases the real debt burden of borrowers, such as homeowners with mortgages. This is what happened in Japan and several Asian and Scandinavian countries. Again, by the measuring rod of low inflation, the central banks would have been doing a good job. But in reality they were not doing their job at all. Central banks can also cause excessive speculative booms through their policies. That is the story of the United States, the Scandinavian countries, Japan, and most of Asia, where asset booms were accompanied by stable consumer price inflation. Once again, if measured solely by low inflation, central bankers seemed to be doing their job. But asset inflation stored up enormous trouble for the future, ultimately causing the bankruptcies of a large part of the corporate sector and pushing the economy into recession and high unemployment.
Independence Does Not Guarantee Good Policies
There is no evidence that the central bank policies leading to asset inflation and th8n deflationary recessions in the above countries were determined by other actors, such as governments. Instead, they were made by central banks that were largely independent from government interference concerning their crucial credit quantity policies. This shows that central bank independence alone does not guarantee economic success of monetary policy. The Swedish Riksbank, for instance, independently created a credit boom in the 1980s and a credit crunch in the 1990s. The U.S. central bank leadership was not influenced by political pressure when it increased credit creation steadily throughout the 1990s, thus creating a vast asset bubble. The central banks of Thailand and Korea independently encouraged their banks to lend excessively to the real estate sector and independently set policies that encouraged their entire corporate sectors to borrow from abroad, thus placing a precarious time bomb at the heart of their economies. IS After this they took excessively tight policies, creating deep recessions. 19 This happened against the will of the respective governments. Most of all, the Bank of Japan acted independently when it forced the Japanese banks to create the 1980s asset bubble and then independently prolonged the subse
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quent ten-year recession of the 1990s, which brought down the once mighty Japanese economy. By comparison, the Bundesbank did a reasonably good job also by our broader definition of success, as unemployment, while rising especially in the mid-1980s and late 1990s, remained significantly below that of other European countries.20 Economic growth was fairly high throughout the postwar era, clocking up over 6 percent in real terms in the 1950s and 1960s, and averaging 2.7 percent in the 1970s, the 1980s, and again the 1990s. This is among the best of all industrialized countries. Moreover, there has neither been a deflationary credit crunch nor a nationwide asset bubble based on excessive speculation in financial investments in Germany-as happened in so many other countries the world over. We learn two things. First, the measure of monetary policy success must be more than inflation, namely, the combination of low inflation with stable and positive economic growth. As we saw in chapter 4, growth is largely determined by the central banks, because only the creation of new purchasing power enables new growth. Central banks can manipulate their own credit creation as well as that of the private-sector banks. Increased credit creation pushes up nominal GDP. The link to inflation is simple: Growth will remain without inflation until the economy reaches the maximum potential growth rate. Credit creation beyond that may produce inflation if the newly created money is used for unproductive purposes. But whenever growth remains below the maximum potential growth rate, creating additional credit does not necessarily produce inflation. Second, the main reason for the high esteem that is accorded to the Bundesbank by the German population is its growth orientation. If the German central bank had pushed Germany into ten years of deflation, very few commentators would have considered its policies a success despite the absence of inflation. So the crucial question is this: Did the Bundesbank achieve its policy combination of low inflation and high growth thanks to independence from the government?
The Reichsbank Was Also Independent
Many economists who argue that the Bundesbank's success was due simply to legal independence from the government forget that even the Bundesbank's prewar predecessor, the Reichsbank, was legally independent from the government. This independence existed to a great extent de facto since its foundation in 1875, because the central bank was largely privately owned and accountable to the shareholders.21 Independence was explicitly written into law in May 1922 and lasted until 1939.22 Until then the Reichsbank was not accountable to the people, the government, or parliament. In August 1924, a new banking law again confirmed the Reichsbank's independence from the government-"but greatly increased the influence over the central bank of Germany's foreign creditors.,,23 The Reichsbank was independent from German democratic institutions, but dependent on the will of interests outside Germany. While the government could do nothing about
THE REVIVAL OF THE REICHSBANK 239
Reichsbank policies, the central bank was under the control of the Reparations Commission, which was dominated by Wall Street bankers.24 Needless to mention, the interests of these Wall Street firms were not necessarily identical with those of the German population. During this time, the Reichsbank was far more independent than the Bundesbank. It was also not accountable for its policies. Yet what did this highly independent central bank do? It did much to undermine the fledgling Weimar democracy. First, it produced hyperinflation, which started in earnest in mid-1922 and peaked in late 1923 with consumer prices rising two-billion-fold. From the mid-1920s until 1933, the Reichsbank adopted highly restrictive policies. The first phase of credit tightening, between 1924 and 1926, was followed by an even worse credit crunch in 1931. In both periods, thousands of firms failed to obtain funding and went bankrupt. As we saw, for most of this time the power of life or death over firms was in the hands of Reichsbank president Hjalmar Schacht. He implemented extralegal credit controls over the banking sector of the type that we examined in great detail in this book. He used them to engage in the active transformation of the German economy by forcing the bankruptcies of many firms-a process he described as having a "cleansing" effect. His declared goal was to accelerate "rationalization," a process that today's central bankers refer to as "restructuring" or structural change.25 When U.S. banks pulled their deposits from German banks in the aftermath of the U.S. credit crunch that began in 1929, the Reichsbank insisted that the banks call in their loans to German industry to pay the U.S. depositors. As had always been expected, industry had invested the money in plant and equipment. The policies of the independent Reichsbank meant that firms had to close down and sell their assets at distressed sales prices. Overnight, mass unemployment was produced. Germany was thrown into the Great Depression. For those who trust that such disastrous policies will never be repeated (surely central bankers learn from past mistakes?), chapter 17 demonstrated that the central banks of Thailand, Korea, and Indonesia virtually copied the extraordinary policies of the Reichsbank in the 1920s and early 1930s-resulting in the Asian crisis of 1997 and 1998, which also brought down governments and created record high unemployment. In a further parallel to events of the 1920s, international bankers, this time represented by the International Monetary Fund, demanded deep structural changes from these Asian nations. The economic instability that doomed the Weimar Republic was due not only to the unreasonable demands of the victors of the First World War. It was at least as much the result of an unaccountable central bank that had excessive powers. Germany's first democracy had little chance: The government could try to create economic growth, but ultimately the power over the economy was in the hands of the central bank. Economists concluded that the Reichsbank had become a "second government" (Nebenregierung) that acted "dictatorially" and independently from the elected government.26 The democratically elected government was the less powerful one.
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Trust US, We're Central Bankers
Being independent from the German government did not prevent the Reichsbank from adopting the horrific policies of the 1920s and early 1930s that ultimately proved fatal for Germany and the world, as they set the stage for the arrival of a pro-growth party, the NSDAP. We must remind ourselves that arguing in favor of independent central banks is effectively to say that politicians cannot act in the national interest. Only central bankers, neutral and objective technical experts, can make decisions for the benefit of the people. No doubt this is a cynical view of democracy as a system. It was also the view taken by the NSDAP, which argued that politicians could not be trusted. It is a view that is not without dangers, for it turns technocrats into the rulers of our countries-a form of technocratic totalitarianism. The evidence suggests that this approach is naive. The highly acclaimed monetary technician Hjalmar Schacht, for one, used his skills and legal powers to actively and purposely hand Germany over to Adolf Hitler. He was rewarded for his services by being reappointed as head of the Reichsbank from 1933 to 1939.27 So can we expect the ECB to act in the interests of the people? The first difficulty is to identify just who those people are. The ECB makes monetary policy for twelve quite diverse economies. One size of policy shoe must fit all European feet.28 The even bigger problem is that there is no guarantee that the central bankers at the ECB are as all-knowing and benevolent as we would like them to be. So far there are few historical examples of societies that are successfully governed by a small group who are largely unaccountable for their actions. Given the enormous power that we have given into their hands, it should not surprise us if and when this power is misused.
Accountability Is Key
Back to the puzzle-why was the Bundesbank successful? Ultimately, people react to incentives. The incentive structure is usually defined by the institutional framework, and that is normally prescribed by the legal structure. So the Bundesbank's legal setup should give us some indication about what makes a good central bank. We notice that legally the Bundesbank was not just required to work toward price stability. In 1967, ten years after the founding of the Bundesbank, the parliament passed the Stability and Growth Act, which clearly set out the objectives of its policy as "price stability, a high level of employment, external equilibrium, steady and adequate economic growth." The law mandated the Bundesbank to produce low inflation and stable growth. This was also what the Bundesbank had in mind when it made its policies. Bundesbank president Klasen, for instance, is said to have "accorded economic growth equal priority to monetary stability.,,29 The Bundesbank is often talked about as having been the most independent central bank in the world. This is simply not true. In reality, the independence of
THE REVIVAL OF THE REICHSBANK 241
the Bundesbank was clearly limited. To start with, central bank independence was not enshrined in the constitution and was thus not irrevocable. Moreover, the Bundesbank was only given "independence from government instructions." When this was formulated, the lawmakers, presumably remembering the lessons from Weimar, explicitly warned that this phrase "of course must not be interpreted to mean that the central bank become a state within the state."30 While being independent from direct instruction from the government, the Bundesbank was not independent from the parliament, which could pass laws or give instructions if it so wished. Moreover, it was not independent from other institutions of the Federal Republic but was subject to German laws and was accountable to the federal audit agency (the Bundesrechnungshof) and the decisions of German law courts. But even the independence from the government was limited, for the Bundesbank Law also said explicitly that "it is the duty of the Bundesbank ... while fulfilling its tasks to support the general economic policy of the Federal Government." And there is virtually no time period when the government's main policy aim was not to achieve decent economic growth. Despite the inability to give direct instructions to the central bank, government representatives could join the policy board meetings of the Bundesbank and expect the bank to support their policy objectives of near-full employment. As legal experts point out, if the government placed a different emphasis among the goals of the Stability and Growth Act than the Bundesbank-for instance, by pursuing economic and employment growth-then as long as price stability was not neglected, the Bundesbank was obliged to follow the policies of the government. Ignoring the goals of the Stability and Growth Act would have been illegal.31 There were other incentives embedded in the legal structure that helped make the Bundesbank successful. For instance, the Bundesbank had a decentralized structure that included in policy decisions representatives of the German states, appointed by the Bundesrat. Moreover, each regional representative was in tum advised by representatives of the various occupations, including trade unions.32 As a result, the decision-making process of the Bundesbank was usually well balanced, reflected the various parts and regions of society, had to take government policy into consideration, and was subject to legal checks and balances. This multifaceted accountability and consensus orientation produced the Bundesbank's fairly successful monetary policy. Of course, there were also mistakes. And the Bundesbank had enough power to cause serious problems for politicians. There are many instances where the government would have liked it to stimulate the economy more, but the Bundesbank refused. The downfall of three chancellors-Ludwig Erhard in 1966, Kurt Georg Kiesinger in 1969, and Helmut Schmidt in I 982-was directly or indirectly linked to tight Bundesbank policies.33 Often the government, not the Bundesbank, turned out to be right. 34 But ultimately there were political limits on the Bundesbank's ability to go it alone against the interests of the population.35 Ironically, we must therefore conclude that the success of the Bundesbank was
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due less to its independence than to its subtle dependence on the other elements of the democratic system. The legal setup made the central bank highly accountable for its policies, and it was always clear that these policies could not consist solely of producing low inflation, but instead had to reflect the goal of stable economic growth. By contrast, the Reichsbank's failure was surely due to its excessive independence without accountability and recourse. Thus, comparing the Reichsbank and the Bundesbank, we find that the reduction in central bank independence and the introduction of accountability and dependence on democratic institutions that was undertaken in the postwar period greatly enhanced the performance of monetary policy. Contrary to popular opinion, the Bundesbank's success was due to its comparative lack of independence. Thus in order to determine whether the ECB is going to be successful as far as the German and European people are concerned, it is crucial to determine whether the new central bank is similarly accountable to the people to implement the twin goals of low inflation and stable growth.
The Unaccountable ECB
With the introduction of the ECB system, the German government has lost its influence over monetary policy. With the creation of the ECB, the Bundesbank Law was also revised. In the new Bundesbank Law the German central bank not only became subject to the ECB instructions, but also is no longer required to support the general policies of the government.36 Neither is the ECB required to support the policies of the German government. It is, however, required to support the "general policy goals of the EU." The Maastricht Treaty, which defines the role of the ECB, says that the ECB has a primary mandate to maintain stable prices. It also says that "where it is possible without compromising the mandate to maintain price stability," the ECB will also support the "general economic policy of the EU," which includes among other goals "steady, non-inflationary and environmentally friendly growth" and "a high level of employment."3? This could be interpreted to mean that the ECB, like the Bundesbank, has to work for the twin goals of low inflation and stable economic growth. However, the emphasis is explicitly on price stability. Moreover, unlike in the case of the Bundesbank, there are virtually no checks and balances on the actions of the ECB. It is therefore practically impossible for anyone-for instance, a government, parliament, or even the (unelected) EU Commission-to enforce any specific goals or, for that matter, enforce anything at all. Unlike the Bundesbank, the ECB is independent not only from the government but also from parliaments, democratically elected assemblies, or other institutions within the EU. Moreover, the Maastricht Treaty, defining the ECB's status, includes the clause that no democratic institution within the EU is even allowed to attempt to influence the policies of the ECB.38 This is unprecedented among democracies. In addition, the ECB is far less transparent than the Bundesbank was. For in
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stance, the deliberations of its decision-making bodies are secret.39 It is not required to publish detailed information about its transactions (this requirement was also scrapped for the Bundesbank with the establishment of the ECB). While it has the power to obtain data from any bank or company in the EU, the ECB is not obliged to publicize that data or any specific statistics. Not surprisingly, the ECB's statutes are already being interpreted as virtually exclusively aimed at price stability. Wim Duisenberg, when he was head of the ECB's predecessor organization, the EMI, told us that he favors "a single monetary policy which strictly aims at price stability in the euro area as a whole."40
Resurrection of the Reichsbank
The ECB is far more independent than the Bundesbank has ever been. It is also much more independent than the U.S. central bank, the Federal Reserve, whose legal status is far weaker and which is directly accountable to Congress and the government.41 We find that the ECB is the least accountable central bank among advanced nations. We must conclude that there is a danger that the incentive structure of the staff at the ECB is not sufficient to guarantee optimal economic policies. This is worrying. It suggests that the lessons of German history were not interpreted correctly and the ECB was created on the wrong foundations. Instead of adopting the features that made the Bundesbank successful-accountability and interdependence with other democratic institutions-the creators of the ECB revived the corpse of the unaccountable Reichsbank. As we saw, the story line of human misery runs quite directly from Schacht to Ichimada, who had trained with the "financial wizard," and the princes at the Bank of Japan who created the recession of the 1990s. History tells us that it is dangerous to deliver vast powers without checks and accountability into the hands of a few unelected officials. "Human wisdom nurtured by history" suggests not to revive the Rt:ichsbank. But the creation of the ECB did just that.
Overstepping the Boundaries of Monetary Policy
The Reichsbank in the 1920s was engaged in policies that went beyond the boundaries of standard monetary policy. It engaged in structural policies and forced "rationalization" of industries. The experience of Germany during the Weimar republic shows that Japan is not the first country that is being coerced by an independent central bank into implementing deep structural reforms and "restructuring." Nor is it the last, as the experience of Eastern European, Latin American, and Asian countries under IMP tutelage shows. Their central banks, probably thanks to the allure of legal independence that the IMP promised, in almost all cases supported the IMP's arguments. Recessions and large-scale economic dislocation followed. Surely the ECB would not do such a thing in Europe?
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When German politicians, including the finance minister, hinted in summer 2001 that further stimulatory policies would be needed from the ECB to support growth, ECB president Wim Duisenberg and his colleagues repeated what the Financial Times describes as their "monthly mantra": calls for fiscal tightening and structural reform. During its short history, the ECB has consistently refused to create more money to stimulate the German and European economies until its conditions are met, namely, that the German and other governments implement structural changes: "Wim Duisenberg, president, and his colleagues have turned calls for fiscal discipline and structural reform into a monthly mantra. These demands have been the implicit price for an easing in monetary policy."42 These structural changes include liberalization, deregulation, and privatization-in short, the introduction ofneoliberal U.S.-style shareholder capitalism and the abolition of the well-established and successful welfare capitalism. The parallels with Japan are disturbing. What if the ECB has already decided that the postwar German-style economic system is bad and must be scrapped? It ordered the Bundesbank to shrink its credit creation by record amounts in 2002. As the amount of money circulating in the economy shrank, demand fell and the economy moved into recession. Parallel with this, the central bank stepped up its claim that the German recession is due to its outdated economic structure. Most observers would find it hard to prove otherwise. As the recession continues, more and more experts would likely agree-all they can see is a long recession. Surely that proves that the system does not work?
Slow Growth Due to the System-or Monetary Policy?
Japan built its postwar economic system on the German model of economic development, pioneered by German economists and implemented by policymakers in the first half of the twentieth century. The system has been highly successful in achieving fast growth, the rapid overall development of the economy, a sharp rise in incomes and living standards, and a surprisingly equal distribution of incomes and wealth. In Germany, Ludwig Erhard, a proponent of the concept of a "social market economy," undertook the postwar modification of this system. The aim was to combine a market economic structure with clever government guidancesimilar to what happened in Japan. There can be no doubt that the German and Japanese system of economic development has been highly successful and especially beneficial for the average citizen. It can serve as a model for developing countries. However, this is not happening. To the contrary, both Germany and Japan are being asked by the central banks, as well as the institutions of the "international community" (such as the IMP and the OECD, as well as the ECB and the U.S. Treasury), to implement deep structural reforms. The German-style system, we are told, is bad and inefficient. The entire system needs to be scrapped, together
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with the economic and social structures that it spawned. What is good for efficiency, we are told, is unmitigated U.S.-style capitalism.
No Serious Debate
This may well be a worthwhile undertaking. I would, however, like to take issue on several grounds. First, the question of whether an entire economic (and hence also social) system should be changed affects such large parts of society that in a democracy a wide-ranging public debate and far-reaching policy discussions are normally preconditions. This debate should follow the standard procedures of the democratic decision-making process and should include a discussion of the advantages and disadvantages of the German-style economic system, comparing them to the costs and benefits of U.S.-style capitalism. Let us not forget that Ludwig Erhard and the intellectuals around him, as well as their colleagues in Japan, were fully aware of the features of U.S.-style free market capitalism. Yet they purposely chose a different system. They must have had some good reasons. The fact is, U.S.-style capitalism has major disadvantages that will not be popular in European countries. Among these are income and wealth disparities so wide that they otherwise exist only in developing countries, greater educational inequality, far larger social instability, and far higher crime rates-in other words, a society that European thinkers in the past have considered but rejected as inequitable and socially unjust. Nevertheless, whether German citizens wish to adopt this system or not is ultimately a choice that they should make for themselves. After a suitable public debate, the voters and their representatives should make a considered decision. This, however, is not happening. It seems that such decisions are nowadays made behind closed doors by central bankers. Second, it is not clear that the adoption of U.S.-style deregulation and U.K.style privatization is the only solution for Germany. The German system has many worthwhile features that could be preserved, as does Japan. Would it not be better to renovate what is outdated, while leaving the structure in place? That, certainly, is more in line with European tradition. Third, the reasons why Germany and Japan's economic systems are being criticized are suspect. There is little evidence to suggest that changing their economic structures radically and introducing U.S.-style capitalism will lead to higher economic growth. If Germany's economic structure is indeed the cause of low growth, why did Germany experience much higher growth in the early 1990s and 1980s, before the structural reform policies implemented over the past five years or so? Ifthe German-style economic structure is so inefficient, how come it produced 8 percent real GDP growth in the 1950s? Moreover, ifthe U.S.-style economic system will lead to an economic recovery, how come the United States itself moved into recession in late 2001, or ten years earlier? Clearly, the U.S. system also has business cycles. This proves that another factor besides the eco
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nomic structure explains economic growth. That factor is money. And money is controlled by the central banks.
Misuse of Central Banking Power
Those in favor of central bank independence argue that central bankers should be put above politicians and governments because they are objective and not political. But the history of central banking is littered with examples of central banks overstepping their powers and engaging in highly political decisions. The founding fathers of the United States of America were well aware of the power of banks and banking dynasties. They therefore categorically resisted the establishment of a central bank. Thomas Jefferson was a vehement opponent of central banks. The u.s. Constitution therefore enshrines the right of the government to issue money. It leaves no role for a central bank. This is why for a large part of its existence the United States did not have a central bank. Money was issued by the government or by banks in a system of free, competitive banking. America did not fare badly without a central bank: It was the fastest-growing emerging market at the time and by 1900 had just about overtaken Britain, the world's number one economic power. The Federal Reserve was founded only in 1913 and remains half privately owned. A reluctant Congress was finally persuaded to agree to its establishment based on the argument that the central bank could step in and bailout banks when a banking crisis occurs. But when such a banking crisis did arrive in the 1930s (triggered by the Fed's very own policies of excessive credit creation), the Fed failed to act. Hundreds of thousands of farmers lost their land and livelihoods. The Great Depression changed the face of America. Yet the Fed has never been held accountable for its policies.
Lessons from Japan
Given the enormous dangers, many ordinary citizens have protested against the creation of the ECB and the scrapping of the mark. Several German politicians refused to become Mitliiufer (those who "go with the flow") and dared to speak up against the growing tide of high-level political support for the euro. Oskar Lafontaine, for instance, argued that the ECB needed more democratic checks and balances on its policies. Implementing such checks does not mean that money should be debauched and inflation allowed. To the contrary, the only guarantor of stable money is accountability of a central bank that has been given suitable policy goals. The lessons of the Reichsbank and of the Bank of Japan are also the lessons oftheECB. Like the Reichsbank during the Weimar Republic, the Bank of Japan has been the true government of Japan. The threat remains that the ECB is following closely in the footsteps of these dictatorial central banks.
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Global Rule of the Princes
Unfortunately, the situation is not significantly different in the United States. No one disputes the power of the Fed to move markets and the economy. Yet this power is used without many actual democratic checks and balances. Whenever Fed chairman Alan Greenspan gives an account of his policies and actions to Congress, he says little of interest (and is even commended for it by the press). Nobody monitors and imposes limits on the amount of credit the Fed is creating. Thus Greenspan, through his interest rate policies, has publicly given the impression that he wanted to slow the economy most of the time from the mid1990s onward, such as with his famous 1996 speech on "irrational exuberance." The fact is, however, that he has continued to increase the credit creation of the Fed during this time.43 This was exactly the reverse of the policy taken by the Bank of Japan in the 1990s. While the BoJ publicly wanted to demonstrate that it was doing all it could to reflate the economy by lowering interest rates, the truth of its policy intentions was revealed by its quantitative policy: It failed to reflate for most of the 1990s. Likewise, Greenspan has expressed surprise at the strength of the U.S. economy. But whenever he raised rates, he accelerated his printing of money. The Fed has moved the economy through its quantity policies while focusing its public statements strictly on interest rates in the same way as Japan.
The Yoke ofthe Princes
The current power of central banks is difficult to reconcile with democracy. As long as central bankers continue to exert unchecked control over the quantity of credit and its allocation, they are the undisputed rulers of the economy. If they have such powers, they are likely to use them. This probably means the continuation of the boom-and-bust cycles engineered by central banks in the pursuit of their goals. And these goals may be quite different from what we may naively assume. As long as there is no meaningful accountability, people's lives are but puppets in their credit game. To strengthen democracy, policymakers will have to consider changing the laws again, to make central banks accountable to parliaments for their policies-and this means their quantitative policies. Alternatively, we should heed the conclusion Milton Friedman came to after decades of research and experience dealing with the Federal Reserve: "The only two alternatives that do seem to me feasible over the longer run are either to make the Federal Reserve a bureau in the Treasury under the secretary of the Treasury, or to put the Federal Reserve under direct congressional control. Either involves terminating the so-called independence of the system. But either would establish a strong incentive for the Fed to produce a stabler monetary environment than we have had."44
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Short of changing the laws and making central banks directly part of the government again, an interim measure should be the establishment of government-imposed nominal GDP growth targets that central banks are required to meet within predetermined error margins and within a given time frame-under threat of meaningful sanctions. I believe that many of the business cycles and major recessions that we have witnessed since the creation of central banks would have been avoided with such an incentive structure. Otherwise, the rule of the princes will continue unabated, and to the detriment of democracy and our well-being.
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