A looming European recession?


Potential Monetary Crisis. While the Federal Reserve struggles to steer between inflation and recession, a crisis in monetary policy is looming in Europe. For a decade, Europe's economies have maintained stable exchange rates under the European Monetary System (EMS); a year ago, this system appeared to be a way station on an inexorable march to monetary union. Yet now, in the wake of the recent German elections, the EMS faces a challenge in which German reunification may lead to Euro-recession.

To understand why a continental downturn may be in the offing, it is important to realize that the success of the EMS is based on a white lie. In principle, it is an agreement among equals. In practice, one member is dominant. By tacit accord, Germany has become Europe's monetary boss: The Bundesbank sets policy and other European countries follow its lead. Germany's dominance is not the result of sheer economic power. It is the biggest economy in Europe, but even after unification it will produce only about 30 percent of European GNP. By comparison, the U.S. accounts for almost 40 percent of the industrial world's output -- yet the U.S. no longer dictates global monetary policy. In fact, German influence is based on a reputation for monetary virtue as much as power: During the 1980s, Europe found that pegging its currencies to the mark aided its inflation-fighting credibility because of the Bundesbank's commitment to price stability. It was this combination of factors -- Europe's biggest country also being its most anti-inflationary in an era of determined disinflation -- that made the EMS such a success.

Germany vs. Its Neightbors. While a system based on German leadership did well in the 1980s, it was bound to run into trouble. Under the EMS, the Bundesbank in effect sets monetary policy for Europe; yet only Germany has a direct say in these policies. It is as if the Federal Reserve Bank of San Francisco controlled the U.S. money supply but was answerable only to California. That's fine as long as what is good for California is good for America and vice versa, but what if there's a conflict of interest?

The conflict of interest is now upon us. Reunification creates huge needs for new spending within the enlarged Germany. The International Monetary Fund forecasts that West Germany will go from a small budget surplus in 1989 to a deficit of 3.5 percent of GNP in 1991. True to form, the Bundesbank is restricting credit to offset any inflationary effects of this fiscal expansion. German interest rates have surged since the fall of the Berlin Wall last year, rising above U.S. rates for the first time in memory and driving the mark to record highs against the dollar.

This may be acceptable from Germany's point of view. But other European countries do not share in the fiscal expansion from reunification; if they go along with Germany's monetary contraction, as they must to sustain the EMS, they are threatened with recession. France's interest rates have risen as much as Germany's, and the franc has risen as much against the dollar as the mark has. It is as if, faced with a boom in California, Alan Greenspan were to focus on preventing any rise in the West Coast cost of living. By raising interest rates enough to stabilize California prices, he would plunge the rest of the U.S. into a recession. Greenspan, who answers to a national constituency, would not do this, but the Bundesbank's Karl-Otto Pohl, who runs Europe's money but answers only to Germany, would and will.

Another analogy: What would have happened if the Ronald Reagan-Paul Volcker policy cocktail of the early 1980s -- fiscal deficits coupled with tight money -- had been served up under the pre-1973 dollar standard, in which other countries pegged their currencies to ours? Everyone else would have been obliged to match our high interest rates, without the stimulus from our deficits. The result would have been a global recession -- everywhere except in the U.S.

Reaganomics Redux. So the question is whether the macroeconomics of German reunification -- a mix of budget deficits and high interest rates that is oddly reminiscent of early Reaganomics -- will destroy the EMS. A breakup of the EMS would hurt European unity, undoing much of the momentum from the agreement to unify markets in 1992. Yet the choices seem stark. Either Germany must concede that the Bundesbank answers to Europe, not merely to Germany, or the rest of Europe must endure a recession imposed by the tight monetary policy of a booming Germany.

Increasing Rates:

Germany's tight monetary policy has pushed up interest rates in Europe, which are are now higher than those in the U.S.

Yields on government bonds Germany France U.S.:


J 6.90 8.69 8.28

J 6.72 8.57 8.02

A 6.95 8.39 8.11

S 7.19 8.61 8.19

O 7.37 8.88 8.01

N 7.68 9.06 7.87

D 7.60 9.14 7.84


J 8.07 9.52 8.21

F 8.92 9.95 8.47

M 8.73 9.97 8.59

A 9.03 9.65 8.79

M 8.96 9.62 8.76

J 8.86 9.76 8.48

J 8.72 9.61 8.47

A 8.98 10.17 8.75

S 8.79 10.52 8.89

O 8.83 10.08 8.70

N 8.73 9.92 8.38


Rising European interest rates have bolstered the mark and franc against the dollar

Currency units per dollar:

German French

mark franc


J 1.98 6.72

J 1.89 6.42

A 1.93 6.50

S 1.95 6.59

O 1.87 6.33

N 1.83 6.22

D 1.74 5.95


J 1.69 5.76

F 1.68 5.69

M 1.70 5.76

A 1.69 5.67

M 1.66 5.60

J 1.68 5.66

J 1.64 5.50

A 1.57 5.27

S 1.57 5.26

O 1.52 5.10

N 1.48 4.99


Reunification has stimulated the German economy, boosting growth above its neighbor:

Percentage change in real GDP:

Germany France

1986 2.3 pct. 2.3 pct.

1987 1.7 pct. 2.4 pct.

1988 3.6 pct. 3.8 pct.

1989 4.0 pct. 3.7 pct.

1990 3.9 pct. 3.1 pct.

Note: GDP figures for 1990 are estimates.

Originally published, 12.17.90