Critique of Central Banking

Part II: The European experience

This article appeared in AToL on November 8, 2002

During the rise of Europe in past centuries, industrial progress was not made in a free-market system, but in a government-support system that provided investment capital through national banking. There are undeniable data showing that any nation that did not adopt a government-financed industrial policy had failed to develop as an economic or military power in the 17th, 18th and 19th centuries.

The idea of a national bank in modern times began in the Netherlands. Key to the success of the Dutch economy in the 17th century was the Amsterdam Wisselbank, which had been founded in 1609 to provide credit to the city of Amsterdam, to the province of Holland and to trade through the funding of the monopolistic Dutch East India Company. Wisselbank was also responsible for coinage and exchange. Some seven decades later, in 1683, it was further empowered to lend to private clients. All large payments had to pass through Wisselbank and it therefore was convenient for the major finance houses to bank with it. Thus not only was it in a position to oversee the Dutch financial scene, it was also able to act as a stabilizing influence. Its function was exclusively to enhance Dutch national financial interests and, in that sense, it was different from private banking, which sought profit wherever opportunities existed within the law.

By the middle of the 17th century, the notion of a national bank to provide needed liquidity to finance national economic development and expanding trade had gathered support in England. The perception of credit as the seed of wealth creation in a capitalistic system was gaining acceptance, leading to an awareness that money, if backed by the state, needed no intrinsic value to enable it to be useful in fueling and lubricating the economy. The concept of a sovereign or national debt being financed with paper money issued by fiat, backed ultimately by national wealth, to support national purposes, especially war, gradually gained recognition.

The Dutch model of national banking inspired the Bank of England, founded in 1694 by William Paterson, a Scotsman, with a capital of STG1.2 million, backed by gold, which was simultaneously advanced (to finance the war with France) to William III (1650-1702), who had been crowned with Mary by the Glorious Revolution of 1688-89, which marked the triumph of parliamentary authority over royal absolutism. The capital/loan came from a syndicate of private investors/lenders who, in return for holding government bonds, were given the privilege of operating a national bank. This was the origin of British national banking and the national debt, which had not been necessary under absolutism because the sovereign had absolute command of all wealth in the royal realm. The Bank of England managed the government's accounts and made loans to finance public spending at times of peace or war. Operating also as a commercial bank, it took deposits and issued notes.

John Law (1671-1729), Scottish economist, gambler, banker and royal adviser, was renowned for two remarkable enterprises he created in France: the Banque Generale and the Mississippi Scheme. His economic legacy rests on two major concepts: the scarcity theory of value and the Real Bills Doctrine of money.

Exiled from Britain for participating in an illegal, fatal duel, Law found himself welcome in the French court through the patronage and friendship of Philippe, the Duke of Orleans, regent of France during the minority of Louis XV. Despite being a nation of greater wealth than either Britain or the Netherlands, the state of French finances after Louis XIV's death in 1715 was so dismal, because of France's neglect in leveraging its national wealth through banking and credit, that the regent eagerly accepted Law's proposal to establish in 1716 a state-chartered bank, the Banque Generale, with the power to issue paper currency. Concurrently, Law also founded the Mississippi Company, an enterprise intended for developing the then French colony of Louisiana in North America.

Law was granted a charter to create the Banque Generale with a capital of 6 million livres, of which he raised 25 percent in cash and covered the remaining 4.5 million livres with government debt (billets d'etat) trading at only one-fourth of its face value. Law's Banque Generale was authorized to issue interest-paying bank notes payable in silver on demand. It soon had 60 million livres in notes outstanding. The Regime required regional tax payments to be in the form of Banque Generale banknotes to provide a ready market for them. Because these banknotes paid interest and were conveniently acceptable as for tax payment, they sold at a premium over their face value, removing from the state seigniorage (government revenue from the manufacturing of coins calculated as the difference between the monetary and the bullion value of the silver contained in silver coins) and delivering it to the speculative market. That was a major error, for interest payment turned the national banknotes into a debt instrument, indistinguishable from a government bond but with no fixed maturity.

To develop the territories of Louisiana in North America, Law was granted a charter for the Compagnie de l'Occident with a 25-year lease on French holdings in Louisiana. In return, the Compagnie was required to settle at least 6,000 French citizens and 3,000 slaves in the territories. The Compagnie was also granted a monopoly on the growing and sale of tobacco. The Compagnie acquired the Compagnie de Senegal, which operated in West Africa, as a source of slaves. It then merged with the French East India Company and the French China Company to form Compagnie des Indes, forming a virtual monopoly on French foreign trade.

Law's Banque Generale, under the new name of Banque Royale, tying it closer to the state, was added to a monopolistic combination that Law called the "System".

The Compagnie des Indes issued 200,000 shares at a per share price of 500 livres in 1716. By 1718 the share price had fallen to 250 livres. In 1719, the Banque Royale pumped up the supply of notes by 30 percent. It also acquired the right to act as the national tax collector for nine years. The Compagnie stock doubled and redoubled in price.

Based on new financial power from inflated market capitalization, Law then offered a plan to pay off the troublesome state debt, committing another fundamental error. The Banque would issue notes paying 3 percent interest to redeem the state debt. The banknotes could then be used to buy stock in Law's Compagnie de Indes. The Compagnie share price rose to 5,000 livres in August 1719 and 8,000 livres in October. Speculation in Compagnie stock went wild, much like the dot-com shares in the 1990s. Stock was being purchased on 90 percent margin. Fortunes were being made overnight by speculators, with a street beggar reportedly making 70 million livres.

John Law became an international celebrity. The pope sent an envoy to the birthday party of Law's daughter. Law converted to Catholicism and was appointed controlleur des finances by the Regime.

Compagnie des Indes shares peaked at a per share price of 20,000 livres at the end of 1719. In January 1720, two royal princes decided to cash in their shares of the Compagnie, prompting others to follow. Law had to print 1.5 million livres in paper money to meet the rising demand for cash. As controlleur des finances, he tried to stem the tide by making it illegal to hold more than 500 livres in gold or silver. He devalued banknotes relative to foreign currency to encourage exports and discourage imports. Nevertheless Compagnie des Indes stock fell to 5,000 livres. As head of both the Compagnie des Indes and the Banque Royale, Law bought up stocks and banknotes to try to raise their price, but by June 1720 he had to suspend all payments.

Law's note-issuing bank fell from being a spectacular success to total collapse after a panic bank run in 1720, plunging France and Europe into a severe economic crisis, which set the economic stage for the French Revolution. The impact of Law's banking schemes on France was so traumatic that, until recently, the term banque was largely shunned by French banks in order to avoid memories of Law's unfortunate institution. The common substitute term was credit, as in Credit Lyonnais and Credit Agricole.

In England, a similar scheme known as the South Sea Bubble also burst at the same time, but the South Sea Company and its banker, the Bank of England, was bailed out by the government through the British national debt, for which the people of Britain assumed responsibility and which was made credible by parliamentary control of finance. The failure of the French national bank was caused by its tie merely to whimsical royal credit rather than reliable national credit. The failure left France without an adequate banking system until Napoleon Bonaparte, who, to replenish the nearly empty state treasury, transformed the Bank of Current Accounts into the Banque de France on January 28, 1800, as the first French national bank.

Napoleon III, whom historians saw as the prototype of the modern dictator, was labeled the bourgeois emperor by royalists and the socialist emperor by the Saint Simonians, who were among the first in modern history to conceive a centrally planned industrial system, and who invented investment banking. Under him the Credit Mobilier was founded in 1852, established specifically for providing funds for industry and infrastructure, and followed by other banks. Despite the failure of the Credit Mobilier in 1867, these investment banks channeled savings into essential investments in transport, communication, agriculture and industry.

In 1860, Credit Agricole was founded to supply credit for French agriculture in its transformation from feudal estates into a modern economic sector. Credit Agricole eventually developed into one of the world's largest banks, supplying financing to the largest agricultural producer in Europe. During the early 1980s, it was the largest, and in 1991 the sixth-largest. It has since merged with the Banque de Indo Suez. On December 2, 1945, the banking and credit industries were nationalized, and the state became the sole shareholder of the Banque de France and of the four principal deposit banks.

Reliance on the Bank of England was such that when its charter was renewed in 1781, it was described as "the public exchequer". By then, the Bank was acting also as the bankers' bank and it had to keep enough gold reserves to pay its notes on demand.

By 1797, war with France under Napoleon I had drained British gold reserves and the British government prohibited the Bank from paying its notes in gold. This Restriction Period lasted until 1821. The 1844 Bank Charter Act again tied the note issue to the Bank's gold reserves, requiring the Bank to keep the accounts of the note issue separate from those of its banking operations and produce a weekly summary of both accounts, called the Bank Return, which is still published weekly today. The Bank's second century thus saw two key elements of central banking emerge: 1) the concern for monetary stability, born during the inflationary excesses of the Napoleonic Wars; and 2) the institutional responsibility for financial stability, developed in the banking crises of the mid-19th century. Both elements were predicated on the controversial assumption that long term financial-stability rests on price stability, preventing the fluctuation of prices from being a tool for managing the economy.

In the 19th century, the Bank of England took on the additional role of lender of last resort, providing stability to the banking system during several financial crises. In the early 1900s, the Bank of England became the instrument of the ruling class as distinguished from the nation. It could and did lower prices and wages, increase unemployment and even set the price of gold to protect private wealth gained from the nation's global empire, which was unequally shared among its citizens, let alone colonial subjects, in the name of capital formation.

During World War I, the national debt jumped to STG7 billion. The Bank helped manage government borrowing and resist inflationary pressures. As with the wars with France a century before, the financial cost of World War I forced a break in the British currency link with gold. An attempt was made in 1925 in vain to return to the gold standard, and in 1931, in the midst of worldwide depression, the United Kingdom left the gold standard for good. Britain's gold and foreign-exchange reserves were transferred to the Treasury, while their day-to-day management was and still is handled by the Bank. The note issue became entirely fiduciary, not backed by gold. Since then, the pound sterling has been a fiat currency.

After World War II, the Bank of England was nationalized in 1946 under a Labour government with the passing of the Bank of England Act, which shifted authority on monetary policy to the British Treasury. The Bank then acted as the government's bank, providing loans through ways and means advances and arranging sovereign borrowing through the issue of gilt-edged securities. The Bank helped to implement the government's financial and monetary policy as directed by the Treasury. It also was granted wide statutory powers to supervise the banking system, including the commercial banks to which, through the discount market, it acted as lender of last resort. The Bank remained the Treasury's adviser, agent and debt manager. During and for years after the war, it administered exchange control and various borrowing restrictions on the Treasury's behalf.

The anti-depression cheap-money policies in the 1930s persisted in Britain after World War II, and during the 1960s, British monetary policy came under the influence of the Radcliffe Report, released in 1959, which concluded that monetary policy should give priority to controlling the liquidity of the monetary system, and not the quantity of money in the system. The report did not dismiss the importance of the quantity of money, but rather believed that given proper control of liquidity, the quantity of money would self adjust. In external policy, the report was supportive of fixed exchange rates as set up in the Bretton Woods regime of exchange controls, which alleviated the inherent contradiction between fixed exchange rates with full convertibility and domestic monetary-policy flexibility. The Bretton Woods regime did not consider free international movement of capital necessary or desirable and was aware of the incompatibility of fixed exchange rates and the lifting of exchange control.

As the apparatus of postwar controls gradually lifted in Britain, the need for a proactive monetary policy became more apparent, and the high inflation of the 1970s and early 1980s provided the catalyst for policy change. Monetary targets were introduced in 1976, and reinforced in the early 1980s. These proved unreliable as a sole guide to policy; nevertheless a monetarist consensus emerged: that price stability was deemed desirable in its own right and a necessary condition of sustainable growth. Inflation was singled out as the sole cause for stagnant growth and other social costs.

Milton Friedman asserted that inflation is everywhere a monetary phenomenon; and without appropriate monetary measures, inflation could not be properly brought under control. Inflation was seen as not merely being destructive of wealth, but also as causing unemployment in the long run. Thus a theoretical justification was found to fight inflation with unemployment. Lay off workers now before inflation does it for you later, economists would tell management. The outcome of this approach was a new phenomenon known as stagflation, in which inflation and unemployment rose together, as producers raised prices to compensate for falling revenue from declining sales volume, diluting the purchasing power of money, at the same time laying off workers to cut costs to compensate for a declining profit margin. Unemployment then led to reduced consumer spending, forcing companies to lay off more workers and raise prices to compensate for lost sales in a downward spiral.

During the 1970s, the Bank of England played a key role during several banking crises of stagflation in Britain and again in the 1980s when monetary policy again became a central part of British government policy. The Bank of England did not become a central bank until May 1997 when the government gave the Bank responsibility for setting interest rates to meet the government's stated inflation target, a good decade after the Big Bang. That was the term given to the financial deregulation on October 27, 1989, of the London-based security market. The Big Bang was comparable to May Day in 1975 in the United States, which ushered in an era of discount brokerage and diversification into a wide range of financial services using computer technology and advanced communication systems, marking a major step toward a single world financial market.

The Exchange Rate Mechanism (ERM) was a fixed-exchange-rate regime established by the then European Community designed to keep the member countries' exchange rates within specific bands in relation to one another. The purpose of the ERM was to stabilize exchange rates, control inflation rates (through the link with the strong and stable deutschmark) and nurture intra-Europe trade. It was also designed to enhance European world trade in competition with the US, creating a so-called "United States of Europe" and as a stepping stone to a single-currency regime - the euro.

Britain joined the ERM in October 1990 at a fixed central parity of 2.95 deutschmarks to the pound, an over-valued rate intended to put pressure upon the British economy to reduce inflation rather than institutionalizing international competitiveness. British pride might have played a role in insisting on a strong pound. This chosen rate, or any fixed rate required by ERM membership, proved misguided, because it tried to benefit from the effect of a single currency for separate economies without the reality of a single currency within an integrated economy.

During the 23 months of ERM membership, from October 1990 to September 1992, Britain suffered its worst recession in six decades, with the gross domestic product (GDP) shrinking by 3.86 percent, unemployment rose by 1.2 million to 2.85 million. The total price of ERM fixed exchange rate for the United Kingdom had been estimated to be as high as 13.3 percent of 1992 GDP. The number of residential mortgages with negative equity tripled, reaching a peak of 1.25 million, and company insolvency rose above 25,000 a year.

The British government of John Major sought to balance political and macroeconomic considerations, only to fail in its effort to "support the unsupportable" to prevent a devaluation of a freely traded pound by market forces. If the UK had not lost some STG8.2 billion defending the pound's unsustainable exchange rate, it could have avoided budget deficits, tax hikes, cuts in public spending, and the unpopular value-added tax on fuel. Spending on the National Health Service could have been more than doubled for 12 months.

Withdrawing from the ERM released the UK economy from persistent deflation and provided the foundation for the non-inflationary growth subsequently experienced. It enabled monetary policy to be freed from the sole task of maintaining the exchange rate, thus contributing to economic expansion by a combination of rational monetary measures. While ERM countries were compelled to maintain relatively high real interest rates to prevent their currencies from falling outside the permitted bands, Britain enjoyed the freedom to benefit from lower rates. Hong Kong has been facing the same problems in the past five years and will not recover from economic crisis until its currency peg to the US dollar is lifted. Waiting for an improved economy before depegging is like waiting for death to cure an infection.

The appropriate exchange rate of currencies at any particular time is that which enables their economies to combine full employment of productive resources, including labor, with a simultaneous balance-of-payment equilibrium. An excessively high exchange rate causes trade deficits and domestic unemployment, while a low one generates an excessive buildup of foreign-currency reserves and stimulates domestic inflationary pressures that lead to a bubble economy. Thus every nation must retain the ability to adjust the external values of its currency in this unregulated global financial market and an international financial architecture based on dollar hegemony. To be fixated on a fixed exchange rate within rigid limits is to court economic disaster in the current international finance architecture.

The ERM was a transitional regime whose problems were finally removed once the EU moved toward a single currency in the form of the euro. Still, the anti-inflation bias of the European Central Bank continues to create conflict with monetary policy needs of national economies within euroland.

In a fast-changing economic environment of unregulated globalized markets, the value of the exchange rate that facilitates full employment and a foreign trade balance will frequently fluctuate. Speculative volatility must be countered and the exchange rate managed by the national bank to prevent disruption in the domestic economy and in external trade. However, this does not imply fixed, unchangeable bands as under the ERM. The optimum strategy for cooperation between national central banks on exchange rates requires a combination of maximum short-term stability with maximum long-term flexibility, the opposite of the effects of fixed exchange rates.

Since, under ERM, Britain's interest rate was pegged to that of Germany through the fixed exchange rate, reduction in interest rates was not available to deal with increasing unemployment and declining growth in the UK. The fact that Britain had no control over interest rates, coupled with the questionable independence of the Bundesbank, Germany's central bank, was an important factor in the final decision to withdraw the pound from the ERM fixed-exchange-rate regime.

The reunification of Germany cracked open the structural flaw in the Exchange Rate Mechanism because massive capital injection from West to East Germany had produced inflationary pressure in the newly unified in German economy, leading to preemptive increases of interest rates by the Bundesbank. At the same time other economies in Europe, especially that of Britain, were in recession and not prepared for interest-rate hikes dictated by Germany. This interest-rate disparity magnified the overvaluation of the pound in the early 1990s.

Along with the European Currency Unit (ECU, the forerunner of the euro), the ERM was one of the foundation stones of economic and monetary union in Europe. It gave currencies a central exchange rate against the ECU, which in turn gave them central cross-rates against one another. It was hoped that the mechanism would help stabilize exchange rates, encourage trade within Europe and control inflation. The ERM gave national currencies an upper and lower limit on either side of this central rate within which they could fluctuate.

In 1992, the ERM was torn apart when a number of currencies could not keep within these limits without collapsing their economies. On Wednesday, September 16, a culmination of factors led Britain to pull out of the ERM and to let the pound float according to market forces. Black Wednesday became the day on which George Soros, hedge-fund titan, broke the Bank of England, pocketing US$1 billion of profit in one day and more than $2 billion eventually. The British pound was forced to leave the ERM after the Bank of England spent $40 billion in an unsuccessful effort to defend the currency's fixed value against speculative attack. The Italian lira also left and the Spanish peseta was devaluated.

In order to curb German inflation, an increase in German interest rates was necessary, but if the Bundesbank were completely independent of German political-economic interests as a dominant regional central bank, it would not have adopted this policy, as there were cries from all over Europe for a decrease in interest rates. By adopting tight monetary policies in response to domestic inflationary pressures that followed German reunification in 1990, German short-term interest rates, which had been rising since 1988, continued to rise, reaching nearly 10 percent by the summer of 1992. So, at a time when Britain needed a counter-cyclical reduction in interest rates, the Bundesbank sent the interest rate upwards, plunging Britain deeper into recession through the ERM.

This was the fundamental problem with the ERM - fixed exchange rates conflicted with the interest-rate levels needed by different economic conditions in separate member economies. The British interest rate pegged to that set by the Bundesbank was crippling the British economy because the UK was in a recession and required low interest rates.

In 1997, the British government announced its intention to transfer full operational responsibility for monetary policy to the Bank of England. The Bank thus joined the ranks of the world's "independent" central banks. However, debt management on behalf of the government was transferred to Her Majesty's Treasury, and the Bank's regulatory functions passed to the new Financial Services Authority.

Germany has a vital banking tradition that dates back to the great Fugger money-lending network in the 15th and 16th centuries, and before that the limited banking practices required by the Hanseatic League (Hansa) of northern Germany in the 14th century. Germany's first commercial bank was established in Hamburg in 1619. The Giro bank lasted until its takeover by the state-run Reichsbank in 1875.

By the early 1800s Frankfurt am Main was a banking center under the House of Rothschild. The Rothschilds, in fact, took their name from the red (roth) shield (Schild) on the front of their Frankfurt home during the first years of the Jewish family's history. Their banking dynasty soon extended beyond Frankfurt to London, Naples, Paris, and Vienna.

On January 18, 1871, Otto von Bismarck proclaimed in Versailles the German Empire. Between 1870 and 1872 several other important German banks evolved, some of which are still around in one form or another, despite political interruptions associated with Germany being the vanquished in two world wars.

Until the 1870s, the financial regulation of German overseas trade had been almost exclusively in the hands of London banks. The historical structure of independent principalities under the Holy Roman Empire presented an obstacle to German unification and by implication the emergence of a German national bank. The establishment in 1870 of the Deutsche Bank at Berlin was a turning point. The Deutsche Bank's charter identified the purpose of the corporation as "to do a general banking business, particularly to further and facilitate commercial relations between Germany, the other European countries, and oversea markets".

The founders of the Deutsche Bank had recognized that there existed in the organization of the German banking and credit system a gap that had to be filled in order to render German foreign trade independent of the English intermediary, and to secure for German commerce a firm position in the international market. It was rather difficult to carry out this program during the early years because Germany at that time had no gold standard and bills of exchange made out in various kinds of Germanic currency were neither known nor liked in the international market. The introduction of the gold standard in Germany in 1873 did away with these difficulties, and by establishing branches at the central points of German overseas trade (Bremen and Hamburg) and by opening an agency in London, the Deutsche Bank succeeded in vigorously furthering its nationalist program.

Later the other Berlin joint-stock banks, especially the Disconto Gesellschaft and the Dresdner Bank, followed the example of the Deutsche Bank, and during the past decade particularly the Berlin joint-stock banks have shown great energy in extending the sphere of their interests abroad. The German banks suffered the largest loss in the 1997 financial crisis in Asia, partly because, being latecomers, they fell victim the classical buy-high-sell-low syndrome.

The central bank of Germany is the Deutsche Bundesbank, with its head office in Frankfurt. It is a federal corporation under public law, and also performs supervisory functions in the same way as the Federal Banking Supervisory Office. Its powers of authority are governed by a special law, the Bundesbank Act. Until December 31, 1998, the Bundesbank had the exclusive right to issue banknotes and coins and had been assigned the task of maintaining the stability of the national currency by regulating the money supply and the amount of credit available to the economy. This exclusive right was transferred to the European Central Bank on January 1, 1999, with the start of the common currency, the euro.

After the adoption last April 22 of the Law on Integrated Financial Services Supervision (Gesetz uber die integrierte Finanzaufsicht - FinDAG), the German Financial Supervisory Authority (Bundesanstalt fur Finanzdienstleistungsaufsicht -BAFin) was established on May 1. The functions of the former offices for banking supervision (Bundesaufsichtsamt fur das Kreditwesen - BAKred), insurance supervision (Bundesaufsichtsamt fur das Versicherungswesen - BAV) and securities supervision (Bundesaufsichtsamt fur den Wertpapierhandel - BAWe) have been combined in a single state regulator that supervises banks, financial services institutions and insurance undertakings across the entire financial market and comprises all the key functions of consumer protection and solvency supervision. The new German Financial Supervisory Authority is intended to make a valuable contribution to the stability of Germany as a financial center and improve its competitiveness.

The BAFin is a federal institution governed by public law that belongs to the portfolio of the Federal Ministry of Finance and, as such, has a legal personality. Its two offices are in Bonn and Frankfurt/Main. The BAFin supervises about 2,700 banks, 800 financial services institutions and more than 700 insurance undertakings.

The Deutsche Bundesbank, the central bank of the Federal Republic of Germany, is an integral part of the European System of Central Banks (ESCB). The Bundesbank participates in the fulfillment of the ESCB's tasks with the primary objective of maintaining the stability of the euro, and it ensures the orderly execution of domestic and foreign payments. It was established in 1957 as the sole successor to the two-tier central bank system that comprised the Bank Deutscher Lander and the Land Central Banks. At the time, the Land Central Banks were legally independent bodies. Together, the institutions in the central bank system bore responsibility for the German currency from June 20, 1948, when the deutschmark was introduced, until the Deutsche Bundesbank was founded.

As a result of the Bundesbank's becoming part of the European System of Central Banks (ESCB), the need to restructure became increasingly evident. The Bundesbank's organizational structure has now been changed by means of the Seventh Act Amending the Bundesbank Act, which came into effect on April 30. The Bundesbank's decision-making body, the executive board, normally convenes in Frankfurt. It comprises the president, the vice president and six other members. Its mandate is to govern and manage the Bundesbank.

The board will draw up an organizational statute to establish how responsibilities are shared out among the board members and to determine the tasks that may be delegated to the regional offices. The members of the board are all appointed by the president of the federal republic. The president, the vice president and two other members are nominated by the German federal government, while the other four members are nominated by the Bundesrat in agreement with the federal government.

Until recently, the five largest German banks are Deutsche Bank, Dresdner Bank, Westdeutsche Landesbank, Commerzbank and the Bayerische Vereinsbank. In 1994 Frankfurt won the heated contest to house the European Monetary Institute (EMI), the precursor to the current European Central Bank (ECB), which began operations in Frankfurt in January 1999 with the introduction of the euro. Until the ECB began operation in 1999, Germany's Bundesbank, known as the Buba to the financially literate, was Europe's most influential central bank. For all practical purposes, the Bundesbank was to Europe what the US Federal Reserve Bank is to the United States; indeed, the Fed served as a model for the postwar German central bank.

A proposed Deutsche and Dresdner merger would have changed the playing field not just in Germany but also throughout Europe. The merger proposal was driven by two factors. First, banks fear e-commerce will cut into already dwindling retail profits. Second, the two banks want to get bigger so they can compete with US banks globally in the more profitable investment banking market. The bank merger proposal followed the takeover of Mannesmann by Vodafone - the first hostile takeover in Germany - and such deals signal the changing face of German corporate culture. The collapse of the Internet and telecom bubbles has cast doubt on the validity of these mergers.

Germany's complex systems of cross-shareholdings between major companies appears to be unraveling, increasing the chance that some of it could fall into foreign hands. The move marks a shift from retail banking, which has proved to be an unprofitable headache for many German banks. Deutsche Bank had planned to invest up to 1 billion euros every year in Internet ventures before the bubble burst. In 1998, Deutsche Bank bought Bankers Trust of the United States for $10 billion, with highly mixed results to date.

Before the stewardship of Paul Volcker, since the New Deal after the 1930 Great Depression, the historic bias in the US Federal Reserve Board had given a higher priority to jobs and growth than to price stability. The ECB, which has inherited the German obsession with inflation born out of the country's hyperinflation experience of the past century, is still fixated on its anti-inflation bias. Most neo-liberal economists identify Germany, the growth engine of euroland, as the root cause of the eurozone's weakness, saddled with three interlinked problems of inflationary pressures from unification, an uncompetitive conversion exchange rate with the euro, and a policy inertia against structural reforms. Yet neo-liberal reform requires the wholesale abandonment of the historical and cultural essence of German economic structure.

The ECB is working at cross purposes against its member governments, which need relief from its strict deficit rules in economic downturns. The ECB's determination to demonstrate its independence from eurozone political reality is preventing it from being a constructive force in economic recovery.

The classic error of central banks doing too little too late now infects all three key central banks in the West: the Fed, the ECB, and the Bank of England.

Next: The US Experience