[A-List] Henry Liu on central banking 2

["Michael Keaney" <michael.keaney@xxxxxx>]

BANKING BUNKUM
Part 2: The European experience
By Henry C K Liu
Asia Times, 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.

The Deutsche and Dresdner merger changed the playing field not just in
Germany but also throughout Europe. The merger 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
followed the takeover of Mannesmann by Vodafone - the first hostile takeover
in Germany - and both 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.