The Deutsche Mark between the Dollar and the European Monetary System

Kaufmann, Hugo M. Article The Deutsche Mark between the Dollar and the European Monetary System Kredit und Kapital Provided in Cooperation with: Duncker & Humblot, Berlin Suggested Citation: Kaufmann, Hugo M. (1985) : The Deutsche Mark between the Dollar and the European Monetary System, Kredit und Kapital, ISSN 0023-4591, Duncker & Humblot, Berlin, Vol. 18, Iss. 1, pp. 29-60, https://doi.org/10.3790/ccm.18.1.29 This Version is available at: https://hdl.handle.net/10419/293012 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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Introduction Economic interdependence among Western industrialized countries has increased during the last three decades in both the real and the monetary sectors and so has the international transmission of economic disturbances and the potential for inter-country conflicts. Among the problems of international monetary relations, the most important and interesting is the triangular interaction between the Deutschemark (DM), the United States dollar, and the European Monetary System (EMS), which officially began 13 March 1979. It is this triangular relationship which I intend to analyse to determine whether and how developments in the United States, Germany, and the other EMS partners were affecting each other. The first part deals with general and theoretical questions of exchange rates, interest rates and their interdependence. The second major section deals with the salient features of the EMS in action and its relation to the dollar, inasmuch as they pertain to our theme. The conclusion forms the third part. It is generally agreed that the European Monetary System was created to remove Western Europe's economies, especially the European Communities' (EC), from the influence of the United States, to create through the EMS a "zone of monetary stability," to foster greater convergence of EMS countries' economic performances, and to breathe new life into the stalled Common Market integration process. During the first three-and-one-half years, the expectations set for the new monetary system has hardly been fulfilled, as the United States, Germany, and the other EMS member countries have experienced greater divergence and higher rates of inflation and unemployment as well as slower growth rates. The latter two are certainly an unintended convergence. Some of the interesting questions for us are: what influence did the EMS have on Germany's monetary policy and the exchange rate of the DM - and OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 30 Hugo M. Kaufmann vice versa? What role does the DM play between the dollar and the EMS? Is Germany to the EMS what the United States is to Germany - a pace setter? Is the United States still the pace setter for Europe? ("When the U.S. sneezes, Europe catches pneumonia," was the saying after the Second World War.) What are the consequences of a strong dollar for Germany? For the other EMS countries? For the stability of the European Monetary System? II. Interdependence, Exchange Rates, and Interest Rates 1. Interdependence Though they are politically sovereign nation-states, the countries of the industrialized West have economically grown progressively more interdependent on both the real and the monetary planes. Even a cursory look at the recent economic performance of the United States, Germany, and other EC countries, as well as that of nonmembers of the EC - all countries in stagflation - makes one wonder whether Europe has attained the independence the EMS seemed to have promised its founders. True, the cross-country and trans-Atlantic stagflation which all have experienced could be accidental, with countries finding themselves at a similar stage in the economic cycle for country-specific reasons; but this is highly unlikely for the period under investigation, and it is an interpretation that has not been suggested, at least not in isolation. Alternatively, the United States and the Western European countries - the latter either singly or qua members of the EC - could experience recessions owing to outside forces impinging on the two areas, e.g., consequences of OPEC oil pricing. There is a third possibility: irrespective of the point of origin or the initial causes, the economies of the industrialized West are still linked with one another despite the creation of the EMS and despite fluctuating exchange rates and cyclical fluctuations are transmitted from one side of the Atlantic to the other and between EMS countries. These alternative possibilities are not mutually exclusive and may in fact have interacted. Country-specific causes, such as budgetary deficits, could have been compounded by influences transmitted from abroad, such as OPEC fuel pricing. It is my hypothesis that the special position of the DM, as the pivotal element between dollar and the other EMS currencies, played a crucial role in the transmission process. It is, however, not suggested that a change in, or special controls for, the Deutschemark are justified. Any pivotal currency would have become the conduit. Special controls would merely introduce distortions, with the cure being worse than the disease. Rather, it seems that OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 The DM between the Dollar and the European Monetary System 31 floating has not been free, nor does it guarantee complete insulation from outside influences. A national game any politician can play - and many delight in so doing - is to attribute domestic woes to foreign influences. Another pastime for politicians and critics of central bank independence is to point their fingers at central bankers, and make them responsible for high inflation or interest rates and/or slow growth rates, whatever the case may be. In Europe, the Deutsche Bundesbank (Germany's central bank) and the United States were made the culprit for the present malaise, and in the United States, the Federal Reserve and its chairman, Paul Volcker, had to bear the brunt of criticism. The levels and volatility of interest rates, even more than exchange rate movements, have made headlines here and abroad during this period of stagflation and are singled out as the major cause for this current protracted and most severe recession since World War II. If an Atlantic interest-rate disarmament could not be negotiated, then the EMS should "de-couple" itself from United States interest rate influences and coordinate a reduction of interest rates among EMS members. This was the French proposal at the beginning of 1982. 2. Exchange Rates, Interest Rates, and the European Monetary System a) Exchange Rate Developments Before the Establishment of the EMS Two elements stand out for consideration in analysing the position of the Deutschemark as conduit for United States influence upon the EMS: exchange rates and interest rates - not unrelated variables, these. During the period of the Bretton Woods system with its intermittently pegged-exchange rates, conflicts between goals of internal equilibrium - price stability, a satisfactory and sustainable growth rate, and low unemployment - and external equilibrium - maintenance or attainment of balance of payments equilibrium - plagued many countries, including the United States and Germany. Under the pegged-rate system, internal disturbances were easily transmitted among open economies. Moreover, policies designed to reduce internal (external) aggravated external (internal) disequilibria. It was, thus, natural to look for an alternative international monetary system, one that would eliminate these dilemmas and would permit a country to pursue its domestic economic goals unimpeded by external, i.e., balance of payments, contraints. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 32 Hugo M. Kaufmann In the late 1960s and the 1970s, nations attempted to extricate themselves from the vagaries of the dollar standard, as the United States flooded the world money market with its currency. As long as pegging of exchange rates existed, domestic money supply - unless sterilized by monetary policy - was largely determined by inand outflows of foreign exchange. Ironically, the search for a new international monetary arrangement intensified during the 1970s - a period of generalized exchange rate floating. The overriding purpose of forming the European Monetary System was a desire to reduce exchange rate fluctuations among the members of the European Communities. Joint fluctuations against the U.S. dollar and other third currencies were considered of lesser importance. The road to some form of European monetary integration and thus, indirectly, to effective operation of the EMS, started in the late 1960s, but it was slow in coming. One of the main impediments during the negotiations was the rift between the "monetarist" and the "economist" approach to monetary integration as a process and the ultimate goal of forming an European Economic and Monetary Union. The two diametrically opposed approaches provided different theoretical analyses of the economic and political processes, with the former, the monetarist approach, being based on economic determinism and neofunctionalism; that is, begin with fixity of exchange rates, and the external contraints will force the members of the pegged-rate system to harmonize and coordinate other economic policies as well. The "economist" thought, in contrast, was that the so-called disciplining effect of a pegged-rate system cannot be relied upon and will not work, unless policy coordination and harmonization preceded the pegging of exchange rates. Then, exchange rate fluctuations would perforce become smaller and pegging feasible. In addition to these quite different analyses of the processes leading up to exchange-rate unification, based on theoretical reasoning, they also offered different philosophies regarding economic policy - interventionism vs. reliance on market forces. Of the two major initiators of the EMS, France and Germany, the former had few inhibitions about reverting to administrative interventions - which it never completely abandoned and for which it had a large and trained bureaucracy - and interference with market forces, beyond the mere smoothing of exchange rate fluctuations through interventions in exchange markets. Germany, on the other hand, generally rejected - partly for historical reasons - exchange control as a suitable weapon to achieve monetary union. From 1972 onward to the formation of the EMS in March 1979, in the absence of a formal agreement about a new international monetary system, OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 The DM between the Dollar and the European Monetary System 33 Germany, together with other Common Market countries, formed the European narrow margins arrangement, the "snake," and had, as "économie dominante," a determining and anti-inflationary influence on the members of the "snake." The countries with similar goals to Germany's, elected the "strong-currency option" by pegging their currencies to the Deutschemark - thereby creating a de facto DM currency area. For the countries belonging to and staying with the DM currency area, it meant that at times they had to pursue policies under dilemma conditions - as was to be expected under fixed or pegged exchange rates. What was the gain in joining the DM bloc? The members hoped to escape the highinflation rates of the nonmembers - especially after the first and second oil shocks. The aftermath of the second oil shock was somewhat different since the EMS had by then been established. b) Exchange Rates and the European Monetary System The final impetus uniting the Europeans of the EC - with the notable exception of England - for establishing a formal currency arrangement, the European Monetary System - came during the United States' "benign" - or was it "malign"? - neglect of the dollar exchange rate in 1978. Exchange rate pegging under the EMS rules was expected to generate a "zone of monetary stability" for the participants by setting them apart from the exchange rate developments of other currencies. By creating a European currency bloc, the EMS was to free Europe from dollar hegemony - without, however, substituting a Deutschemark hegemony in its stead. A symmetric adjustment mechanism within the EMS, through the introduction of a European Currency Unit and a Divergence Indicator - an early warning system, as it were - were supposed to assure that no currency within the system would become a key currency, and that the asymmetry of the defunct Bretton Woods system would not be reintroduced into the new peggedexchange-rate arrangement. Since the term "exchange rate stability" was not further defined, it was interpreted as referring to nominal, bilateral exchange rates. While this definition may simplify matters greatly, it leaves many questions open, for bilateral and nominal exchange rates are but one set of a multitude of exchange rates - and not the only meaningful ones. Intra-EMS real and nominal exchange rate relations are important for intra-EC or intra-EMS trade and capital movements, respectively, and for EMS performance and stability. Real exchange rate movements determine a country's competitive position, while the profitability of capital movements is related to nominal 3 Kredit und Kapital 1/1985 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 34 Hugo M. Kaufmann exchange rate changes. What counts most for a country's economic performance in the foreign trade sector, however, is its exchange rate vis-à-vis a weighted average of its important trading partners, i.e., its effective exchange rate. Exchange rate behavior is a multifaceted phenomenon: first, bilateral exchange rate developments may be significantly different from multilateral, effective exchange rate changes - nominal and real. For instance, the Organization for Economic Cooperation and Development (OECD) calculated a bilateral DM-dollar depreciation of some 15 percent between the end of 1979 and May 1982, whereas the DM's effective exchange rate was about the same at the beginning and the end of this period.1 Another aspect of the multifariousness of DM exchange rate movements is that the DM, like other currencies, moves against other EMS currencies and against those of nonmembers of the EMS, and these movements may be rather disparate. To complicate matters further, within the EMS itself, differences of exchange rate behavior are observable among members of the old "snake" and the "mini-snake." The Dutch guilder, e.g., in general moved with the Deutschemark; but this was not an unaltering relationship. The Belgian franc, a member of the "snake" and the "mini-snake", like the Dutch guilder and the Deutschemark, had managed to tie itself to the strong currency, even though this frequently created or aggravated domestic imbalances. Finally, the Belgian franc had to take the plunge, cut itself loose from the Deutschemark, and had to be devalued on 22 February 1982 - for the first time in thirty-three years. c) The Deutschemark as Pivotal Currency Although the technical and institutional arrangements of the EMS were designed to overcome the asymmetries experienced under the Bretton Woods system, it was unavoidable that one currency in the EMS - the Deutschemark - would become primus inter pares. Germany's and the Deutschemark's status was an outgrowth of two major elements: one was Germany's emergence in the 1950s as the main trading partner of the original EC countries and also of some non-EC countries, such as Austria and Switzerland. The other element was Germany's success in attaining inflation rates which were either very low in absolute terms or at least in relation to most of its main trading partners. Thus, Germany was to become the 1 Organization for Economic Cooperation and Development (OECD), Economic Outlook, 31 (July 1982), p. 62. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 The DM between the Dollar and the European Monetary System 35 center of gravity of a large economic area, and with it was laid the foundation and continuation of a de facto DM currency area. Next to the dollar, the DM had emerged as the second most important reserve currency and also an investment currency. It also serves as intervention currency. Over much of the Bretton Woods and post-Bretton Woods periods, the dollar and the Deutschemark have moved in opposite directions. This behavior became even more pronounced as the Deutschemark became an alternative to the dollar for investment and intervention purposes - a trend which, as long as the DM was very strong, received a mixed blessing by the Deutsche Bundesbank2 and its then President, Dr. Otmar Emminger. As the DM weakened and Germany ran large current account deficits, the Bundesbank's - and its new President, Karl-Otto PôhVs - attitude toward the DM's prominent position changed; the attractiveness of the DM as international reserve and investment currency was emphasized in an attempt to finance the current account deficits with capital imports. The Deutschemark's pivotal role transcends its influence on the EMS and affects non-EMS currencies as well. EMS rules allow formal association of non-EC countries - an avenue, which has not been pursued yet. Austria and Switzerland, both having close trade ties with the EC, however, have attached their currencies to the EMS informally. Austria seeks to maintain a constant real effective exchange rate with the DM, while Switzerland has "adopted an intervention margin around the Deutschemark, which effectively means a unilateral act of association with the EMS."3 With the emergence of the Deutschemark as a reserve and investment currency, and with the DM's emergence as the pivotal currency within the EMS, the DM was exposed more than other EMS currencies to international capital movements. DM exchange rate movements have become more sensitive to developments in Germany's and other countries' current accounts, 2 See e.g., Deutsche Bundesbank, Monatsberichte (MB), September 1979, p. 40. 3 Michael Emerson, "Experience under the EMS and Prospects for Further Progress towards EMU," in M. T. Sumner and G. Zis, eds., European Monetary Union - Progress and Prospects. New York: St. Martin's Press, 1982, p. 25. The exchange rate relationship between the Swiss franc and the Deutschemark is not unaltering, however, as the fate of the two currencies demonstrated during 1981 and 1982: until early May 1981, the Swiss franc depreciated against the dollar, as did the Deutschemark. When the discount and lombard rates were raised in Switzerland on 11 May, 1981, the Swiss franc appreciated against other European currencies - capital flowed into Switzerland, also in connection with the outcome of the French elections. Between early March and the end of June, the Swiss franc appreciated vis-à-vis the Deutschemark. Subsequently, the Swiss franc, together with EMS currencies, declined against the dollar. See e.g., Bank for International Settlements (BIS), Fiftysecond Annual Report. Basel, June 1982, p. 145. 3* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 36 Hugo M. Kaufmann interest and inflation rates, and exchange rate expectations. The relative weight of these four factors in influencing exchange rate movements has varied over time: current accounts have outweighted the other variables, only to be replaced in importance by interest rate differentials or one of the other two variables. d) The German-United States-EMS Triangular Relationship Because of the international importance of the Deutschemark, the exchange rate policy of the Federal Reserve, the U.S. central bank, was geared to, and its effectiveness was judged by, dollar-DM exchange rate movements. This special relationship was noted both when the dollar was weak in the pre-EMS era, as well as after 1979, when the dollar rebounded and the DM weakened. Similarly, if the Bundesbank intervened in foreign exchange markets to affect the DM exchange rate vis-à-vis currencies against which the DM was floating without limits (i. e., non-EMS currencies) it chose to influence the DM-dollar rate, letting cross rates determine the DM rates of the other currencies.4 When the Federal Reserve focused on the dollar-Deutschemark relationship in its exchange rate policy, European central banks had to decide for themselves whether and how they intended to react to its policy. This provided fertile soil for potential and actual policy conflicts between the Bundesbank and the Federal Reserve, on the one hand, and between the Bundesbank and EMS partner central banks. One of the more frequent conflicts occurred in 1981, when the Bundesbank reacted to the extreme Deutschemark weakness that had developed. Conflicts can easily arise when the German policy makers attach higher priority than do other EMS partners to eliminate external deficits, which had been one of the underlying causes of DM weakness. It has been correctly stated that "The durability of any monetary arrangement ... depends in part upon whether the decisions made by the Bundesbank and the FED about this key exchange-rate relationship are acceptable to partner central banks and governments."5 Avoidance of intra-EMS conflicts presupposes acceptance of German hegemony, 4 Because the dollar and the Deutschemark are much more affected than other currencies by decisions of private and official investors, the fixing of a dollar-DM exchange rate would be rather problematical. See e.g., Leonhard Gleske, „Ohne Schützenhilfe droht die Geldpolitik überfordert zu werden," Deutsche Bundesbank, Auszüge aus Presseartikeln (AP), 39; 28. April 1981, p. 82. 5 David T. Llewellyn, "European Monetary Arrangements and the International Monetary System," Sumner and Zis, eds., European Monetary Union, op. cit., p. 142. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 The DM between the Dollar and the European Monetary System 43 Foremost among the economic reasons in Germany was the sudden and severe deterioration in its current account, which had turned negative for the first time in fourteen years. Some figures are needed to suggest the magnitude of the current account changes that took place. During the period, which lasted from 1975 through 1977, the current account surplus amounted to nearly DM 10 billion each year, and it nearly doubled thereafter in 1978, to over DM 18 billion, but declined into deficit of nearly DM 11 billion in 1979, a swing of over DM 29 billion. Germany's current account deterioration resulted from Germany's expansionary policies of 1978, which coincided with the effect of the second oil shock, and OPEC did not, nor was it expected to, increase in the near future their orders from Germany as in 1974. At about the same time, the effect of the real DM revaluation, that occurred from 1976 - 1979, had worked itself through the system, with increased import and reduced export growth, first in volume, then later in value terms. As the terms of trade effects of exchange rate changes had temporarily outweighed the corrective influence on real flows, the so-called J-curve phenomenon had masked the underlying trade developments. The Bundesbank estimates that the Deutschemark's 6V2 percent nominal appreciation in 1978 amounted to a 3V2 percent improvement in its terms of trade and had been the only reason for the increase in Germany's trade balance surplus by DM 3 billion to DM 49 billion.12 On a volume basis, i.e., with constant, 1977 prices, Germany's trade surplus would have shrunk by DM 6 billion. The weakness of the Deutschemark was not only the result of the magnitude of the swing in Germany's current account from surplus to deficit, but also the private as well as official expectation that Germany would not soon be able to reverse its current account deficit, and that for the near-term, things would get much worse before they improved - the J-curve working in the opposite direction as Germany's terms of trade deteriorated with the decline in the DM's exchange rate. Indeed the current account deficit deteriorated to nearly DM 30 billion for 1980, while for 1981, a year of anticipated international stagflation, only a moderate improvement to a possible deficit of DM 22 - 25 billion was forecast by the Federal Government.13 The actual improvement, however, was much bigger - a decrease to 12 Deutsche Bundesbank, Annual Report (AR) 1978, p. 20. The trade surplus was calculated on an f.o.b. basis for both imports and exports. If exports had been calculated on an f. o. b. and imports on a c. i. f. basis, the trade surplus would have amounted to DM41 billion. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 44 Hugo M. Kaufmann a deficit of about DM 17 billion. This improvement, in conjunction with monetary policy, helped the Deutschemark to appreciate later - at least within the European Monetary System. Other contributory elements to the DM weakness were the interest rate differentials, real and especially nominal, favoring other currencies of the European Monetary System and the dollar. Capital exports from Germany to countries with higher nominal interest rates added to DM exchange rate pressures that had developed after the deterioration in the current account. Nominal interest rate differentials within the EMS became more important than real interest rate differentials - as long as exchange rate stability within the system was reasonably assured. As long as exchange rates are not changing, the return on assets is calculable from interest rate or dividend income and exchange rate risk is negligible; furthermore, interest rate income is not reduced by devaluations. EMS countries which had inflation rates resembling those in the United States also had nominal interest rates more in harmony with those prevailing in the U. S. than those in Germany. Thus, capital was attracted to other countries in search of higher yields.14 Reinforcing the causes of DM weakness was its role as alternative international reserve and investment currency, rendering the DM more vulnerable than other EMS currencies to interest rate induced capital movements. Germany's partnership in the EMS did not shield the Deutschemark from exposure and attractiveness as alternative international reserve currency. It may have been expected that the creation of the EMS would distribute more equally among the various EMS currencies their attractiveness for serving as dollar or pound sterling substitutes in international transactions.15 Initially, the Bundesbank accepted, even welcomed, high United States interest rates as a price that had to be paid for "resolute anti-inflationary monetary policy ... in the best interest of all countries, even if ... this policy 13 „Jahresbericht 1981 der Bundesregierung. Auszüge aus den für 1981 angestrebten wirtschaftsund finanzpolitischen Zielen." Deutsche Bundesbank, AP 14; 17 February, 1981, p. 3. 14 This development provides further proof, if it were needed, that convergence of economic performance and policies among EMS member countries should not only be among the goals of the EMS but is a prerequisite for its smooth functioning, i.e., exchange rate stability. 15 This is one of the reasons why a joint dollar policy by EMS countries would not be able to forestall or reduce tensions within the EMS. See Leonhard Gleske, „Perspektiven der deutschen und der internationalen Währungsentwicklung." Deutsche Bundesbank, AP, 5; 13 January, 1981, p. 2. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 The DM between the Dollar and the European Monetary System 45 led to exceptionally high levels of interest rates and marked shifts in exchange rates with which we still have to live today."16 Nominal interest rate differentials and changes in interest rate differentials were, however, not always good predictors of capital and exchange rate movements between countries whose exchange rates were permitted to fluctuate. Even massive interventions in foreign exchange markets, both when the dollar weakened against the DM and when it strengthened, were unable to stem the trend of exchange rate movements, as long as expectations of further depreciations or appreciations prevailed. Between 1977 and the latter part of 1979, a widening interest rate differential in favor of the dollar did not prevent a steady deterioration of the dollar exchange rate vis-à-vis the DM. In the early months of 1979, however, shortly after the October 1978 announcement of U. S. anti-inflation policy, the dollar rose about five percent, despite a narrowing of the interest rate differential in favor of the United States. This was possible and lasted only as long as anti-inflation measures were believed to take hold. When the opposite became evident, the dollar resumed its decline against the Deutschemark - despite a widening of interest rate differentials in favor of the dollar. Exchange rate movements paralleling interest rate differentials movements - as they did between 1974 and 1976 and as expected on an a priori basis - came only after early 1980, when the second U. S. anti-inflation program had been instituted and the Federal Reserve had adopted a policy controlling monetary aggregates to bring inflation under control, irrespective of where interest rates would be headed in the short run. Similar was the case of Germany in 1980, when the improvement in its relative interest rate position was accompanied by an appreciation of the DM during the second quarter. The foreign exchange markets must have assessed that the DM would not stay fundamentally weak in the medium run, even though in the short run the balance of payments was expected to worsen before an improvement would set in. If the expectations for the medium run had been otherwise, the narrowing and even the reversal of interest rate differentials17 would not have aided the Deutschemark exchange rate - as it did not help the dollar during the period from 1977 through 1979. In real terms, the Deutschemark declined in the first half of 1980 by about three percent,18 a development which was welcomed as assisting the balance 16 Deutsche Bundesbank, AR 1980, p. 45. 17 During May and June, 1980, the interest rate differential was in favor of Germany. 18 On wholesale price basis. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 46 Hugo M. Kaufmann of payments adjustment process, increasing Germany's international competitiveness. But at the same time it also raised the possibility of direct and indirect importation of inflation. To lessen the latter effect, the Bundesbank intervened in the dollar market during DM weakness, and in the EMS, the DM was supported by EMS partners when it reached the lower intervention point. Because of the linkage between the dollar, the DM, and EMS currencies, less intervention in the dollar market would have caused a larger decline of the DM against the dollar and with it the need, for institutional reasons, of greater EMS support operations for the Deutschemark. Because of Germany's worsened balance of payments situation, the Bundesbank relaxed its restrictions against capital imports and, together with the Federal government, actively sought to encourage the financing of its current account deficits through capital imports. For the entire first half of 1980, capital outflows even exceeded the current account deficit, as they did during the final quarter of that year. Only during the third quarter of 1980 was Germany able to finance its current account deficit with capital imports. But that was hardly a "stable" situation, since short term capital imports of about DM 9V2 billion by far outweighed long term capital import of DM 1 billion. With renewed pressure on the DM exchange rate in October 1980, the United States authorities acquired DM as part of smoothing operations in the DM-dollar market. Required interventions were undertaken in the EMS as the DM reached the lower intervention margin, especially vis-à-vis the French franc and the Dutch guilder. These interventions accounted for the bulk of the Bundesbank's October reserve losses.19 For the entire fourth quarter of 1980, half of Germany's foreign exchange reserve losses were caused by compulsory DM interventions within the EMS. The Bundesbank availed itself of the "very short term financing facility" of the European Monetary Cooperation Fund. The decline of the DM in the fall of 1980 was the result of nominal interest rate differentials unfavorable to Germany, combined with large deficits in its current account. Thus a situation arose whereby the country with the 19 Deutsche Bundesbank, MB November 1980, p. 11. Of course, not all interventions show up as foreign exchange reserve changes. However, all DM interventions within the EMS at intervention points are reflected in the Bundesbank's ECU position. See Deutsche Bundesbank, MB December 1980, p. 40, footnote 3. The Bundesbank objected to the insinuation of having intervened in the foreign exchange market to prevent changes in the DM's exchange rate. It asserted that only 20 percent of its intervention transactions were not compulsory. See Deutsche Bundesbank, MB December 1980, p. 40. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 The DM between the Dollar and the European Monetary System 47 better price performance - Germany - and therefore lower nominal interest rates could not attract sufficient capital to finance its current account deficit and lost foreign exchange reserves to countries with much higher inflation rates, such as France, which had an inflation rate twice that of Germany, but whose current account, though also negative, was better than Germany's. Capital flows from lowto high-inflation countries could continue as long as the risk of devaluation (revaluation) of the high (low) inflation countries' currencies were judged low for the near term, because of trust of the stability of EMS currency relations. Under these conditions, nominal yield differentials crucially influenced capital flows. Whereas the DM recovered within the EMS after the reduction of interest rates in France and managed to stay above the floor between October 1980 and the beginning of February 1981, the DM decline against the dollar continued unabated: the DM had become anything but a candidate for revaluation within the EMS or appreciation against the dollar in the near term. From the end of September 1980 to the first week of February 1981, the DM tumbled 15 V2 percent against the dollar, 13 V2 percent against the pound, and 19 percent against the yen.20 On a trade-weighted average, the DM fared less badly, declining by about four percent over the same time span. This was the result of relatively stable exchange rate relations within the EMS, with whose partners Germany conducted over 40 percent of its trade. Germany's EMS membership imparted stability for Germany, at least in this instance, and against Germany's original expectations. (ii) How (not) to deal with the DM Weakness When the DM weakened, both EMS members and the Bundesbank - in conjunction with the German government - engaged in operations to keep the DM within EMS margins. They did so, despite recommendations by the Scientific Council at the Federal Economics Ministry, some economic research institutes and sectors of the economy that Germany should resolve its unemployment and balance of payments problems by devaluing the Deutschemark.21 The institutes reasoned that such an act would soon attract 20 For the period since the United States had changed its policy course (end-1979) to mid-February 1981, when the Bundesbank changed its own policy course, the DM had plunged 23 percent against the dollar, 24 and 33 percent against the pound sterling and the yen, respectively. See Deutsche Bundesbank, MB March 1981, p. 6. 21 The other, more extreme, recommendations were to ignore external aspects of economic policy entirely and to conduct economic policy with a view to internal issues only - or even to drop out of the EMS arrangement, at least for the time being. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 48 Hugo M. Kaufmann capital in expectation of an improvement in the DM exchange rate. Correctly, the Federal Government and the Bundesbank rejected their recommendation and the reasoning behind it: first, the social costs involved in changing price relations between tradeables and non-tradeables in a devaluation which proves to be "unnecessary" could be avoided. A devaluation was considered unnecessary because of the substantially better price performance in Germany than in other major trading partners, which would soon be reflected in an improved balance of payments position for Germany. Secondly, such a temporary devaluation as the proponents of the exchange rate change envisioned, was unnecessary since the European Monetary System, as a "zone of monetary stability" was designed to assist countries in temporary difficulties with very short term financing facility and medium term assistance to avoid exchange rate changes if currencies are not fundamentally underor overvalued. Furthermore, the "stable but adjustable" exchange rate system was meant to impart internal price stability, warding off the possibility of imported inflation through higher foreign prices, calculated in domestic currency.22 The Bundesbank estimated that two-thirds of the 11 percent increase in import prices - calculated in DM - between September 1980 and April 1981, was caused by the DM depreciation, primarily the depreciation against the dollar.23 Here, too, the dollar-DM relationship is important, since one-third of all German imports are calculated in dollars.24 This kind of imported inflation has the potential to set in motion a vicious circle of increasing prices, followed by depreciating currency, which in turn will lead to another round of price increases and depreciation, etc. For Germany, being price-stability-conscious, a devaluation of the Deutschemark would have to be accompanied by deflationary policies in order to prevent a vicious circle from being set in motion - not exactly conducive to the promotion of full employment. Another reason why a devaluation of the DM would not have been advisable or, for that matter, easily accepted by the other EMS partners, who are involved in exchange rate change deliberations, was that Germany, like Bel22 The Bundesbank even emphasized the value of the EMS in this particular instance for helping Germany in its fight against inflation by making a devaluation of the Deutschemark unnecessary. See Deutsche Bundesbank, AR 1981, p. 79. 23 Deutsche Bundesbank, MB June 1981, p. 6. In its September 1981 MB, p. 6, the Bundesbank estimates that three-fourth of the price increase of imports can be explained by the DM decline against the dollar. 24 Deutsche Bundesbank, MB, June 1981, p. 31. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 The DM between the Dollar and the European Monetary System 49 gium, when it devalued its franc in 1982, would have been suspected of attempting to engage in "competitive devaluation." This suspicion would have been more applicable in the case of Germany than in other instances, since Germany's price behavior in the EMS was better than other countries', so that, even with a constant nominal DM exchange rate, Germany's real exchange rate was depreciating and its international competitiveness improving. But to erase any suspicion that one devaluation might be insufficient and might, therefore, have to be repeated, a substantial devaluation would be called for which, as we have seen, would have been neither desirable nor acceptable. The importance of an overvalued currency in the fight against inflation was amply demonstrated not only in Germany's case after the first oil shock; it was also experienced by Japan and Switzerland - both countries which managed to reduce their inflation rates rapidly without great sacrifice in terms of reduced gross national output. One may recall that Germany and some other countries were, therefore, accused of having engaged in a deliberate exchange-rate-appreciation policy during the mid-seventies. Since not all countries can engage in a successful currency-overvaluation policy - if, indeed they did - a source of potential conflict between countries in external economic policy is given. This external dilemma is added to the internal one - which may exist in any case - such as the conflict between monetary and exchange rate policy. It is not suggested, on the other hand, that overvaluation (undervaluation) per se is desirable to fight inflation (underemployment), since in the longer run the costs of exchange rates, which are far out of line, may outweigh the benefits, by transmitting the wrong signals to the economies. Finally, and certainly not the least important, consideration was that, in the light of the prominent position of the DM as a reserve and investment currency, the proposal to devalue the DM to encourage capital inflow seemed almost perverse. If anything, a devaluation would have led to a capital flight out of Germany and from the DM. The basis of DM reserve currency status was the expected stability of the currency's national and international purchasing power. The demand for the DM as an investment vehicle was, at least partly, encouraged by its tendency to appreciate vis-à-vis other currencies, with total return on investment consisting of interest rate yield plus capital (i.e., also currency) appreciation. To regain international confidence after a devaluation would have been difficult and not attainable in the short run. A foretaste of what could have resulted from a DM devaluation could be seen in the increased capital flow out of the Federal Republic of Germany 4 Kredit und Kapital 1/1985 OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 50 Hugo M. Kaufmann when the DM came under heavy selling pressure during the first month and a half of 1981. Instead of the proposed devaluation, Germany temporarily tried to finance its current account deficits through capital imports, which proved very difficult under the given circumstances: the comparatively low interest rates in Germany and the absence of any reasonable expectations that the DM might be revalued in the near future, made DM investments unattractive, while at the same time it encouraged DM borrowings. Consequently, even without a danger of a DM devaluation, German interest rates had to be raised to decrease the unfavorable interest rate differential. It is, thus, highly questionable whether, after a devaluation of the DM a reversal of capital flows would have materialised, without a further increase in Germany's interest rates. After a devaluation, especially if it would have been judged insufficient for short-run reversal, a DM appreciation could have been achieved only with increasing German interest rates or increasing interest rate differentials in favor of Germany. Because upward pressure on exchange rates combined with declining interest rates or interest rate differentials favorable to the country with the appreciating currency, is an indication of a shift of asset preference in favor of the appreciating currency.25 The imbalance in current and capital accounts, combined with unfavorable interest rate differentials, put heavy pressure on the DM exchange rate, Bundesbank foreign exchange reserves, and, ultimately, on Bundesbank monetary policy. In its effort to avoid what it considered an unnecessary DM devaluation and to fulfill its obligations of staying within the permissible EMS exchange rate margins, the Bundesbank intervened in the foreign exchange markets and was assisted in its undertaking by other central banks. There are two kinds of interventions by the Bundesbank: those within the EMS, which are required by EMS regulations, and those against the U. S. dollar, which are not compulsory. The Bundesbank seemed not to have pursued a dollar policy in order to establish a predetermined dollarDM exchange rate, since this could have been accomplished only if the Bundesbank had accepted the liquidity effects of such a policy in the German economy.26 25 See also Edwin M. Truman and Jeffrey R. Shafer, "International Portfolio Disturbances and Domestic Monetary Policy," in The International Monetary System under Flexible Exchange Rates - Global, Regional, and National. Essays in Honor of Robert Triffin. Richard N. Cooper et al., eds. Cambridge, MA: Ballinger Publishing Company, 1982, p. 142. 26 Leonhard Gleske, Member of the Directorate of the Deutsche Bundesbank, „Ohne Schützenhilfe droht die Geldpolitik überfordert zu werden." Deutsche Bundesbank, AP 39; 28 April 1981, p. 2. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 The DM between the Dollar and the European Monetary System 51 To reduce dollar fluctuations against the EMS and to reduce the upward pressure on interest rates in the European Community and notably in lowinflation Germany during 1980 and until February 1981, there was EMS intervention in the dollar market, particularly between November 1979 and April 1980, and again between December 1980 and June 1981.27 The EMS central banks were initially assisted in their endeavor by the Federal Reserve, which also intervened until the end of 1980. Early in 1981, the U. S. had decided no longer to take an active part in part in foreign exchange market interventions - only to correct disorderly markets.28 The policy of at times heavy interventions in foreign exchange markets, introduced under the Carter Administration in 1978, when the dollar was extremely weak, was thus discontinued under the Reagan Administration. With this decision, the burden of foreign exchange market intervention was shifted into the European and other non-U.S. central banks. The decision by the U.S. no longer to intervene in the foreign exchange market may itself have contributed to the strength of the dollar - not in isolation, to be sure, but in conjunction with confidence in U.S. anti-inflation policy - because a certain "psychological barrier to exaggerated movements in the dollar rate was removed."29 The absence of U.S. foreign exchange market intervention also contributed to the magnitude of daily fluctuations and to the pronounced short-term fluctuations of exchange rates which interacted with longer term trends, whereas the shorter term movements of exchange rates responded to constantly changing interest rate differentials. 27 Commission of the European Communities, Annual Economic Review 1981 - 1982. SEC (81) 1532/2, Brussels, 14 October 1981, pp. 5.2 - 5.3. Such EMS central bank joint intervention must be harmonized and may at times be awkward and lead to conflicts, especially when central banks have different notions about the "correct" or "desirable" dollar price of their currencies or ECU movement against the dollar. 28 According to a Treasury spokesman, U. S. authorities desisted from market interventions since January 1981 - "except for a relatively small amount" at the time of the assassination attempt on President Reagan. See Federal Reserve Bank of Chicago, International Letter, No. 447, May 8, 1981, p. 2. After the June 1982 realignment, foreign exchange markets were in turmoil, and to reduce pressure on the dollar and to restore orderly conditions in the foreign exchange markets, the Federal Reserve bought $ 21 million worth of DM and $ 9 million worth of yen on 14 June. The New York Times, 16 September 1982. And between August and October 1982, the Federal Reserve had intervened four times to stem the rise of the dollar. The Wall Street Journal, 10 December 1982. The U.S. announced in December that it would discontinue its policy of non-intervention in the foreign exchange markets. 29 Deutsche Bundesbank, AR 1981, p. 69. 4* OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 52 Hugo M. Kaufmann (iii) Turnaround for the DM - EMS versus Dollar Movements Finally, early in 1981, the situation of the DM had become so precarious vis-à-vis the dollar and EMS currencies, that in mid-February 1981, the Bundesbank became convinced that a signal had to be given regarding Bundesbank intentions to assist Germany in reducing and ultimately eliminating its external disequilibrium, even if it meant initially aggravating its internal disequilibrium with respect to economic growth and employment. Accelerating inflation in Germany gave the final justification for the Bundesbank's new policy moves. Interest rates were raised, and the regular lombard rate, which at that time stood at nine percent was replaced, for the time being, by a special lombard rate, initially set at 12 percent, but to be determined daily as conditions required. Of this stipulation, however, the Bundesbank made no use.30 The period from the beginning of 1981 to October 1982 can conveniently be divided into three major phases which were, in turn, superimposed upon minor phases.31 In 1981 alone, the dollar-Deutschemark relationship underwent four episodes of dollar appreciation of at least six percent and at most 26 percent. These episodes of appreciation were followed by periods of dollar decline against the DM of at least five percent and at most 15 percent. The market seems to have regarded interventions to smooth dollar fluctuations as less convincing, in the absence of Federal Reserve transactions.32 The two year span from 1981 through 1982 was also the period in which exchange rates within the EMS were altered four times, of which three were multilateral realignments. So it contrasts sharply with the period between 30 November 1979 and 9 March 1981, during which no exchange rate changes had to be undertaken - a period which, not surprisingly coincided with Deutschemark weakness within the EMS and against the U. S. dollar. The first major phase in 1981 lasted till early August, with the DM - and the Swiss franc - depreciating against the dollar. But during this phase, 30 Deutsche Bundesbank, MB July 1981, p. 6. The availability and cost of special lombard credit were to be determined daily, "notably in the light of exchange market developments." Cf. OECD, Economic Outlook 29 (July 1981), p. 27., footnote 3. Yet, the disarray in financial markets caused by this special lombard facility forced the Bundesbank to keep the rate constant. See The Wall Street Journal, 9 October, 1981. To prevent the new policy measures and the balance of payments deficit from creating a liquidity crisis in Germany's banking system, the Bundesbank added reserves, overcompensating by DM 5 billion the DM 40 billion liquidity reducing effect of the balance of payments deficit. Deutsche Bundesbank, MB March 1981, p. 8. 31 Bank for International Settlements, Fifty-second Annual Report, 1982, pp. 142 - 147. 32 Deutsche Bundesbank, AR 1981, pp. 73 - 74. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 The DM between the Dollar and the European Monetary System 59 aggregates, letting nominal interest rates find their market-determined levels, other countries, especially those of the European Monetary System, notably Germany, were forced to shift their emphasis somewhat to interest rate developments, despite their avowed goal of attaining a present monetary growth target. Zusammenfassung Die Deutsche Mark zwischen Dollar und Europäischem Währungssystem Die Wirtschaftsverflechtung der westlichen Länder hat zugenommen und ebenso die internationale Übertragung wirtschaftlicher Störungen. Dies wiederum hat die Suche nach alternativen internationalen Wirtschaftsstrukturen belebt, die einzelnen Ländern oder Ländergruppen eine bessere Kontrolle über ihre Zukunft ermöglichen würden. Die Einführung des Europäischen Währungssystems (EWS) war ein solcher Versuch, der im März 1979 begann. Die miteinander verkoppelten Ziele des EWS bestanden darin, zum einen den Mitgliedern der Europäischen Wirtschaftsgemeinschaft wieder eine größere wirtschaftliche Unabhängigkeit gegenüber den Vereinigten Staaten zu verschaffen und zum anderen die festgestellten Nachteile der flexiblen Wechselkurse durch die Gründung einer „Zone monetärer Stabilität" zu vermindern. Keines der beiden Ziele wurde erreicht. Die bloße Bildung eines Währungsblocks konnte die Abkoppelung Europas von der Geldpolitik der Vereinigten Staaten nicht bewirken. Die D-Mark und Deutschlands wirtschaftliche Entwicklung bilden ein wichtiges Bindeglied in der laufenden Transmission der Wirkungen amerikanischer Geldpolitik auf die Mitgliedsländer der Europäischen Wirtschaftsgemeinschaft. Diese enge Verbindung vom US-Dollar über die D-Mark zum EWS wird in diesem Aufsatz untersucht. Da sie mal stärker, mal schwächer ist, versuche ich, die Frage zu beantworten, welche Bedingungen geeignet wären, eine gewisse europäische Abkoppelung von den Vereinigten Staaten z.B. in bezug auf die Zinsbewegungen zu erreichen sowie eine größere Stabilität innerhalb des EWS. Summary The Deutsche Mark between The Dollar and the European Monetary System Economic interdependence among Western countries has increased and so has the international transmission of economic disturbances. This in turn has promoted the search for alternative international economic structures that would give countries or a group of countries greater control over their destiny. One such attempt was the creation of the European Monetary System (EMS) which became operable in March 1979. The twin goals of the EMS were to return to the members of the European Economic Community greater economic policy independence from the United States and reduce OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22 60 Hugo M. Kaufmann the perceived disadvantages of the flexible exchange rate arrangement, by creating a "zone of monetary stability". Neither goal was achieved. A European decoupling from United States monetary policy was not attainable by merely creating a currency bloc. The Deutschemark and Germany's economic performance are important links in the transmission process of the effects of United States monetary policy upon members of the European Economic Community. It is this link from the U.S. dollar to the EMS via the Deutschemark, which this article investigates. Since this link is stronger at times, weaker at other times, I attempted to answer the question of which conditions are propitious for some European decoupling, say, of interest rate movements from those in the United States, and for greater stability in the EMS. Résumé Le marc allemand entre le dollar et le système monétaire européen L'interdépendance économique entre les pays occidentaux a augmenté et, partant, la transmission internationale de perturbations économiques. Ceci, à son tour, a poussé à rechercher des structures économiques internationales alternatives qui donneraient à des pays ou à un groupe de pays un plus grand contrôle de leur destin. La création du système monétaire européen, qui est entré en vigueur en mars 1979, compte parmi une de ces tentatives. Le système monétaire européen visait, d'une part, à rendre aux membres de la Communauté Economique Européenne une plus grande indépendance économique par rapport aux Etats-Unis et, d'autre part, à réduire les désavantages perçus du système des taux de change flexibles, en créant une «zone de stabilité monétaire». Aucun des deux objectifs n'a été réalisé. Une indépendance de l'Europe vis-à-vis de la politique monétaire des Etats-Unis ne pouvait pas être réalisée simplement en créant un bloc monétaire. Le marc allemand et la performance économique de l'Allemagne sont un lien important dans le processus de transmission des effets de la politique monétaire des Etats-Unis sur les membres de la Communauté Economique Européenne. C'est précisément ce lien du dollar américain avec le système monétaire européen par le truchement du marc allemand que cet article examine. Ce lien étant plus fort à certains moments et plus faible à d'autres, j'essaie de répondre à la question suivante: quelles sont les conditions favorables pour une certaine indépendance européenne, par exemple, des mouvements des taux d'intérêts par rapport à ceux des Etats-Unis et pour une plus grande stabilité au sein du système monétaire européen. OPEN ACCESS | Licensed under CC BY 4.0 | https://creativecommons.org/about/cclicenses/ DOI https://doi.org/10.3790/ccm.18.1.29 | Generated on 2023-01-16 12:51:22