Monetary Union

It is convenient to start with a discussion of monetary union and the banking system in the GDR.⁸ On July 1, 1990.

• the deutsche mark became the sole legal tender in the GDR and the Deutsche Bundesbank the sole monetary authority;⁹

• a market-based banking system was introduced in the GDR with unrestricted capital flows and freely determined interest rates;

• wages, salaries, rents, and other recurrent payments were converted into deutsche mark at a rate of M l = DM 1;

• residents of the GDR were entitled to convert marks into deutsche mark at parity in amounts of up to 2,000 marks for those under 14 years of age, up to 4,000 marks for those between 14 and 58, and up to 6,000 marks for those 59 or more years of age;

• other domestic financial assets and liabilities were convertible at a rate of M 2 = DM 1;¹⁰

• assets in marks of nonresident persons or institutions acquired before the end of 1989 could be converted at a rate of M 2 = DM 1, and those acquired after December 31, 1989 at a rate of M 3 = DM 1.

These aspects of the monetary conversion coupled with decisions on conversion rates for the other items on the balance sheet of the banking system meant that the assets of the banking system were converted into deutsche mark at an average exchange rate of about M 2 = DM 1, while the liabilities were converted at a lower rate. Clearly this would mean a substantial reduction in the net worth of the banking system.

Two measures were adopted to deal with this problem. First, a fund, which was derived from the difference between the official exchange rate and the commercial exchange rate on hard-currency trade and which was deposited with the State Bank, was written down to zero.¹¹ Second, it was decided that, after adding up all the assets and liabilities of each banking institution and converting net worth into deutsche mark at M 1 = DM 1, each institution’s assets would be increased to the extent necessary to balance the books by issuing “equalization claims”—that is, assets that pay interest at the Frankfurt interbank offer rate (FIBOR). This meant simply that the GDR Government would top up the assets of the banking system as a whole by issuing government paper (at FIBOR) to the banks. The stock of government debt and future interest obligations would thus be increased, but no increase would be shown in the government deficit as normally measured in flow terms.

Besides these “accounting” problems, there were serious questions raised about the quality of bank assets and the likely official response to the emergence of substantial nonperforming assets. Insofar as the quality of credits to the enterprise sector (about half of all assets) and housing credits (almost a fourth of all assets) was questionable, the potential for defaults on a very large scale relative to banks’ equity could not be ignored. The officials of both the FRG and the GDR envisaged a significant taking-over of enterprise debt by the Trust Fund or the Government itself. A large part of enterprise debt had been incurred for noncommercial reasons and the Government might be seen as liable for this debt. In any event, the whole of the existing stock of enterprise debt would in effect be guaranteed by the Government directly or indirectly through the Trust Fund. In the opening months of GEMSU the banks would be asked to extend working capital loans to enterprises. As it would be still too early to assess the soundness of these enterprises, these credits would in effect be guaranteed by the Trust Fund. It was intended, however, that after these transitional arrangements, the risks associated with new credits would be borne by the banks themselves.

The stock of bank credits for housing was seen as less of a problem as the collateral value of the real estate exceeded the debt. Initially, however, with rents held down, there might be difficulty in servicing these debts, and the Government envisaged substantial contributions to the servicing of housing debt in 1990–91. Subsequently, as rents were allowed to rise, the housing sector would be able to service its debt without government assistance.

In effect, since July 1, 1990 the major west German banks have played a large role in the banking system of east Germany. Some banks have entered into joint ventures with the commercial banking arm of the State Bank and have taken over the operations of many branches; others have started their own operations de nova. The banking law is identical to that of west Germany and therefore subject in effect to directives of the European Community (EC) on banking and solvency;¹² thus banks operate as universal banks and the system is open to participation by foreign institutions.

Since east German banks do not have assets of the quality required to engage in securities repurchase operations or to draw on the discount or Lombard facilities, they have been allowed transitional access to the Bundesbank’s discount window (up to quota limits) and the Lombard facility against equalization claims or “single signature paper” (i.e., banks’ own IOUs). In effect, the latter paper has been used in the opening stages because the issue of equalization claims has had to await final resolution of banks’ opening balance sheets.

As is evident from this description, the separation between the State, the enterprise sector, and the banking system, while clear in principle, was not an entirely clean break in practice. After July 1, enterprises needed liquidity loans to meet current obligations while banks were not yet in a position to evaluate enterprises’ creditworthiness. To keep the enterprises afloat, therefore, the Government authorized the Trust Fund to guarantee short-term bank loans. In each of the three months through September, loans amounting to almost DM 10 billion were processed in this way. It appears that this mechanism of guaranteeing bank loans will continue during the remainder of 1990 and into the first quarter of 1991, but that the allocation of credits will be more conditional on the viability of the enterprises. To the extent that loan guarantees were granted to moribund enterprises—a not insignificant amount especially in the first phase—the net worth of the Trust Fund was diminished or, alternatively, the stock of government debt increased. It is clear that the Government wishes its involvement in the banking system to be limited to correcting past errors and easing transitional difficulties; but it is unclear how long, in practice, the transition will last.

The Enterprise System, the Trust Fund, and the Real Economy

The dismantling of the economic arm of the State left the GDR Government in a net debtor position and the banking system with a small and precarious net worth; thus, the public assets of the GDR were, by and large, taken over by the Trust Fund.¹³ The State Treaty on GEMSU envisaged the financial resources of the Trust Fund being used, first, to restructure viable enterprises; second, to help consolidate the GDR Government’s financial position; and, third, to the extent that resources remained, to compensate savers for the losses they suffered as a result of converting their savings into deutsche mark at a rate of M 2 = DM 1 rather than at M 1 = DM 1. Thus, much of the net worth of the State was to be deployed in the first instance to cover the costs of economic integration and development. The Trust Fund would have three sources of financing: (1) capital income—that is, the proceeds of privatization; (2) operating income distributed by its constituent companies; and (3) borrowing—up to DM 7 billion in 1990 and DM 10 billion in 1991.¹⁴ The borrowing was seen as essentially a transitional means of financing Trust Fund operations pending the realization of funds from privatization; these funds would then be used to amortize loans.

The pre-GFMSU discussion of the Trust Fund left many unanswered questions. The first related to the value of its assets. In the past these assets had generated a substantial part of national income and most of the GDR Government’s revenue. The great imponderable of the entire reform process was the value of these real assets and their income-generating capacity in a free and open market. This would be a major determinant of income, employment, and the duration and hardship of the transitional phase of economic integration. Most analysts were relatively pessimistic on this score; it was thought that perhaps 30 percent of GDR industry was viable in a market economy, another 40 percent could be restructured with reasonable chances of success, and 30 percent was probably beyond redemption. The most pervasive problem was an obsolescent structure of production and capital—the products were not of sufficient quality (at given production costs) to compete with those in the west, and the machinery and equipment were not up to the task of upgrading product standards. In some sectors—most importantly chemicals and energy—environmental concerns were also a major cause for pessimism; given the new environmental code, many plants would simply have to be shut down and a costly cleanup would be required.¹⁵

The second major question related to the precise mandate of the Trust Fund: was it intended that the Trust Fund behave like a private investment fund with the narrow objective of maximizing the market value of its assets on behalf of its shareholders (in effect the people of the GDR), or like an agency charged also with some social function (for example, limiting unemployment) so as to ease the transition to a market system? There were instructive examples from other countries of public sector industrial holding companies that had been used as an instrument of employment policy at substantial cost to the economy at large. In most cases it had been difficult to put the operations of such institutions under independent management and to separate pure market considerations from those of politics and social policy. In the particular case of the GDR, where a wholesale restructuring of the economy was envisaged, there was a danger that a departure from pure value-maximizing criteria might entail uneconomic cross-subsidization—that is, employing the profits of viable enterprises to keep hopeless ones afloat. It was not difficult to imagine how mismanagement might squander the net worth of the Trust Fund. Moreover, the issue of whom the managers were responsible to was clouded by the lack of clarity about the ownership of the Trust Fund. In any event, wasteful management of the Trust Fund would leave the people of the GDR, and ultimately all Germans, worse off.

The third important set of questions related to the feasibility of the Trust Fund’s task. The sheer magnitude of the operation—in effect the privatizing and restructuring of the entire industrial sector of the economy—was daunting. Where would managers be found to undertake such a task, at what pace would markets be able to absorb share sales, and, without an independent, high-quality management team, might not the Trust Fund begin to take on the appearance of an industrial planning ministry with considerable monopoly power in some segments of industry?

It was widely accepted that the initial phase of GEMSU would see a period of “creative destruction”: many companies would be restructured, others would be liquidated, and unemployment would rise sharply. This was seen as a necessary step in the weeding out of obsolete economic structures so as to provide a solid foundation for future growth. Although the new social security system would be able to cushion some of the impact, this would be a painful period.

Within official circles there were different perceptions about how, in practice, the operations of the Trust Fund might be conducted. On the one hand, there was the conventional pyramid structure—top management would initiate most of the decisions on the basis of information culled from lower levels and from the market. In this view, the task for management was, indeed, enormous, and the feasibility of rapid restructuring and privatization had to be questioned. On the other hand, there was a more grassroots view—that is, managers of companies within the Trust Fund would themselves seek out partners for joint ventures or buy-outs; these deals would then be proposed to top management who would seek simply to ensure that shares or assets were sold at reasonable prices. In this latter view, which envisaged much greater reliance on grassroots entrepreneurship as individual companies sought to safeguard their existence, the tasks of the privatization program were spread more widely and appeared more feasible.¹⁶

In other areas of the real economy the changes expected were also radical. The services sector was underdeveloped; many parts of it would have to be built from the ground up. Public infrastructure was sorely inadequate and massive investment would be required in activities such as telecommunications. The agricultural sector in east Germany would have to adapt to the Common Agricultural Policy of the EC to ensure common producer prices; transitional adjustment mechanisms would be adopted. In signing the State Treaty, the Government of the GDR undertook to make available sufficient land to provide adequate facilities for foreign investors in industry, trade, and services.¹⁷

In the first three months of GEMSU all of the doubts raised in the pre-GEMSU discussion of the Trust Fund proved to be well-founded:

• First, estimates of the proportion of GDR enterprises that would be viable in a market economy were revised downward.

• Second, while registered unemployment had risen to 445,000 (5 percent of the labor force) by September, the number of short-time workers (in most cases disguised unemployment) had reached nearly 1¾ million. Together, unemployed and short-time workers constituted almost one fourth of the labor force.

• Third, output declined sharply: in August industrial production was only one half of its level 12 months earlier. At the same time, extravagant wage demands were acceded to—a 60 percent increase in construction and a 25 percent increase in metal, electro-technical and chemicals industries—perhaps in the expectation of a government bailout.

• Fourth, liquidation of uneconomic firms and privatization and restructuring of others did not take off. The Trust Fund—notably, for example, in the mining and chemicals industries—has been loath to take responsibility for a course of action that would entail a massive reduction in the workforce of any single large enterprise.

• Fifth, besides the difficulty of pricing east German companies, investment and takeovers from the west were slowed down by the need, in each case, to allocate responsibility between the Trust Fund and the would-be investor in four critical areas: (1) property rights—who would be responsible for settling claims by previous owners; (2) clearing up the environment—who would bear the cost; (3) shedding surplus labor—new owners would be bound by costly restraints on large-scale dismissals in the German labor law; and (4) old company debt—who would pay this. Also, investors were concerned about the adequacy of supporting infrastructure for production and distribution.

• Finally, the Trust Fund became enmeshed in the shortterm financial problems of its enterprises; the debate about guarantees for short-term bank loans diverted attention from longer-term objectives.

The task facing the Trust Fund involves liquidating or restructuring and privatizing some 8,000 enterprises with 4 million employees, a substantial debt burden, tight liquidity constraints, and, in some areas, dire environmental problems. All in all, such an undertaking looks even more daunting now than it did before GEMSU.

The Government and the Social Security System

The State Treaty required that the structure of public sector budgets in the GDR be adapted to conform with that in the FRG. Starting in the second half of 1990, the government budget would exclude the social security system (which would be budgeted for separately as in the FRG), business enterprises (which would become independent legal entities under the Trust Fund), and the railways and postal service (which would be constituted as separate entities with their own budgets). The social security system of the GDR would be adopted by and large from that of the FRG. Within the framework of general budgetary aid from the FRG to the GDR, it was envisaged that some start-up financial assistance would be given to the new unemployment and pension insurance schemes of the GDR.

In order to limit deficits and foster market mechanisms, the territorial authorities in the GDR would cut subsidies on goods (including food and agriculture generally), gradually reduce subsidies on housing, transportation, and energy, and undertake a substantial reduction in expenditure on personnel. All elements of expenditure would be scrutinized to determine their legal basis and the real need for them. The income tax laws of the FRG would be adopted,¹⁸ property and indirect taxes would be the same as in the FRG, and the GDR would adopt the customs laws, border taxes, and duties of the EC.

The institutional arrangements envisaged in the State Treaty did not anticipate full political unification by October; as a result, fiscal policy prescriptions for the GDR as a separate state were spelled out for 1990 and 1991. Quantitative limits were set on borrowing by the GDR Government on its own account and on borrowing by the Trust Fund. The size of transfers from the FRG to the GDR, for general budgetary support and social security assistance, was specified. Moreover, all decisions on public debt, borrowing, and equalization claims in the GDR were made subject to agreement between the GDR and the FRG.

Fiscal Policy

In midyear, the territorial authorities in the FRG envisaged expenditure equivalent to 30½ percent of GNP in 1990 and a deficit of DM 53 billion (2.2 percent of GNP). This represented a doubling of the 1989 deficit; it reflected an acceleration in expenditures (to 6 percent, double the medium-term target rate) and a sizable tax cut (1 percent of GNP net of subsidy reductions), offset by the positive influence of faster-than-expected growth. In 1991 the deficit was projected to be virtually unchanged.

In the GDR borrowing by the territorial authorities was not to exceed DM 10 billion in 1990 (effectively the second half of the year) and DM 14 billion in 1991. Besides these figures, the total amount of government financing included the borrowing of the Fonds Deutsche Einheit (German Unity Fund)¹⁹—DM 20 billion in 1990 and DM 31 billion in 1991—and potential borrowing by the Trust Fund—DM 7 billion in 1990 and DM 10 billion in 1991.

On July 22, the parliament in the GDR passed a budget for the second half of 1990 which was consistent with the financing constraints laid out in the State Treaty on GEMSU. By September, however, it had become clear that budget financing requirements would be a great deal larger than initially envisaged.

First, the social insurance funds would require substantial additional financing. Payment of unemployment benefits would be far above budget, both because of higher unemployment—the budget had assumed an unemployment level of 270,000 with an additional 160,000 short-time workers²⁰—and because of higher benefit levels owing to wage increases. The costs of medical services had risen more quickly than anticipated—doctors’ fees had increased and more expensive drugs from the FRG had replaced local products—so that the medical insurance system would require additional financing. Also, there were likely to be some delays and shortfalls in social security receipts because of administrative difficulties, problems faced by illiquid enterprises in remitting payroll taxes, and lower employment.

Second, difficulties had also arisen in the budget of the Central Government itself. Receipts had been adversely influenced by some of the same factors affecting the social insurance funds. On the expenditure side it appeared that the principal overruns would be in transfers and subsidies. Energy and transportation subsidies would be larger owing to greater consumption than anticipated in the budget and higher oil prices. Subsidies to support exports to the CMEA countries might also be significantly larger than budgeted²¹ and the difficulties in the agricultural sector might result in increased budgetary support. Also, an across-the-board expenditure cut (of DM 3½ billion) contained in the budget estimates seemed unlikely to be fully realized.

Although the fiscal situation in the GDR was turning out much weaker than budgeted, it was decided not to produce a revised budget as, with political unification, the central government functions in the GDR would be absorbed into their FRG counterparts. Instead, at the end of September, the FRG introduced a third supplementary federal budget that provided DM 26 billion in additional borrowing, of which DM 24 billion was related to the GDR. Similarly, although the State Treaty provided a framework for fiscal policy in the GDR in 1991 (in the form of a borrowing limit for the GDR Government and specified transfers from the FRG to the GDR), there would not now be any separate budget for east Germany in 1991. The magnitude of the fiscal imbalance in the country as a whole and the extent of the revisions in the budgetary outlook are summarized in Table 1.

Table 1.

Germany: Borrowing Requirement of the Public Sector¹

(In billions of deutsche mark)

Source: IMF staff current services estimates—that is with unchanged tax rates and expenditure programs.

¹Including the Unity Fund and the Trust Fund, but excluding the social security system.

²For the GDR the figures refer only to the second half of the year.

³The revised figures for the Trust Fund reflect the limit set in the Unity Treaty.

Table 1.

Germany: Borrowing Requirement of the Public Sector¹

(In billions of deutsche mark)

		19902				1991
		Original (June)		Revised (Sept.)		Original (June)		Revised (Sept.)
Borrowing by the FRG Government		53	}	94		53½	}	145
Borrowing by the GDR Government		10				14
Borrowing by the Unity Fund		20		20		31		31
Borrowing by the Trust Fund3		7		12		10		13
	Total	90		126		108½		189
	Total in percent of all-German GNP	3½		4¾		3¾		6½

Source: IMF staff current services estimates—that is with unchanged tax rates and expenditure programs.

¹Including the Unity Fund and the Trust Fund, but excluding the social security system.

²For the GDR the figures refer only to the second half of the year.

³The revised figures for the Trust Fund reflect the limit set in the Unity Treaty.

View Table

Table 1.

Germany: Borrowing Requirement of the Public Sector¹

(In billions of deutsche mark)

		19902				1991
		Original (June)		Revised (Sept.)		Original (June)		Revised (Sept.)
Borrowing by the FRG Government		53	}	94		53½	}	145
Borrowing by the GDR Government		10				14
Borrowing by the Unity Fund		20		20		31		31
Borrowing by the Trust Fund3		7		12		10		13
	Total	90		126		108½		189
	Total in percent of all-German GNP	3½		4¾		3¾		6½

Source: IMF staff current services estimates—that is with unchanged tax rates and expenditure programs.

¹Including the Unity Fund and the Trust Fund, but excluding the social security system.

²For the GDR the figures refer only to the second half of the year.

³The revised figures for the Trust Fund reflect the limit set in the Unity Treaty.

There are a number of caveats with respect to these estimates.

First, the figures in the table are current services estimates—that is, they make no allowance for any discretionary changes in expenditure or taxation. It is not unlikely, however, that the authorities will introduce significant expenditure cuts, thereby reducing the overall deficit.

Second, the figures exclude the capital infusion to the banking system by the GDR Government—perhaps some DM 26 billion in 1990—which, while not in the budget as conventionally measured, will add to the (still relatively modest) outstanding stock of government debt.

Third, the operations of the Trust Fund will influence the financial position of the public sector. Successful privatization will produce capital receipts and viable enterprises that are not privatized will produce income. On the other hand, there are bound to be additional Trust Fund liabilities to the banks related to guarantees of short-term bank borrowing by enterprises. To the extent that enterprises with such loan guarantees are liquidated, the Trust Fund will have to assume the liabilities. In principle, it would seem that the vast physical assets of the Trust Fund should be capable of earning substantial income—historically enterprise profits were the principal source of government revenue—but recent developments do not augur well for the earnings of the Trust Fund and call into question the net worth of the Fund.

Fourth, it is not inconceivable that part of the large stock of old debt of GDR enterprises and some of the old housing debt might be assumed by the Government. This, of course, would increase the stock of government debt and future debt service would raise budget expenditures.

However one analyzes these projections, it is clear that the first 18 months of economic integration will witness a sizable increase in government borrowing in the deutsche mark area. The question arises therefore as to how this should best be financed. The Government has indicated an aversion to increasing taxes to finance unification. While one might be loath to endorse a pledge of no new taxes, decisions on the appropriate method of financing would depend upon the duration and composition of the additional demands for public resources. An argument against tax increases would be strengthened to the extent that:

• The large deficits are likely to be temporary—that is, they are projected to decline quickly after peaking in 1991.

• The deficits are linked to public investment—that is, expenditures aimed at increasing the potential output of the economy—rather than to current expenditures aimed simply at easing the transition.

• There is room for a substantial restructuring of expenditures in west Germany. For example, the Government estimates the cost of its support for the inner-German border areas and West Berlin at about DM 40 billion in 1990.²²

• Strict limitations on the scope for new taxation, combined with a rigorous antipathy for deficits, will help to contain subsidies. Ideally, subsidies in east Germany should be limited to self-correcting transitory support (e.g., unemployment benefits); subsidization of employment or investment will quickly be reflected in factor prices, embedded in investment decisions, and thus entrenched.

• It is possible to extrapolate from the historical (econometric) evidence for the FRG, which shows that some 60 percent of any increase in public saving from higher taxes would be offset in the short run by a drop in private saving.

• The external current account remains in surplus so that German saving continues to help finance investment abroad.

Clearly the case against taxation involves a great many conditions. There is a danger that the sequence of developments will influence the composition of public expenditure. Large public works programs that are necessary in their own right would also help to absorb unemployed labor; but initiating such programs will require many decisions at the state and local government levels and it may take some time before this decision-making apparatus is put in place. Without such programs concerns about prolonged unemployment might elicit costly and wasteful subsidies that subsequently prove difficult to remove. Moreover, a dearth of supporting public infrastructure will discourage private investment. The case against new taxation is critically contingent on the composition of government expenditure, as well as on the magnitude of financing required.

It is not difficult to envisage changes in the structure of taxation that would yield short-run revenue gains and would nevertheless be consistent with the medium-term thrust of German tax policy toward a more efficient system. There is scope for raising indirect taxes in a way that would be compatible with the process of harmonization within the EC. The benefits of such action would have to be weighed against the unfavorable temporary impact on prices.

Monetary Policy

In 1989 the restrictive stance of monetary policy was supported by a sizable reduction in the government deficit; nevertheless, real growth proved robust and interest rates rose. In 1990, even without the effects of GEMSU, fiscal policy would have eased, wage costs would have increased more rapidly, and capacity utilization rates would have risen—thus the task of containing inflation would have become more difficult. Given the added effects of GEMSU, the environment for monetary policy will be even more demanding.

In the FRG, the 18 months before GEMSU had seen pre-emptive monetary policy actions that had helped sustain the favorable economic performance. Growth of the monetary aggregates had been brought back into line with that of potential real output and an inflation rate of about 2 percent. There was some concern about the pace of growth of residents’ holdings of short-term bank bonds and Euromarket deposits—although these assets are less liquid than those included in M3—which would probably have argued for holding the growth of M3 (for FRG residents) to the lower end of the target range of 4–6 percent. In the second half of 1990, the Bundesbank intended to continue to maintain separate data for the FRG and the GDR as constituted before unification, and to target M3 in the (old) FRG.²³

The currency conversion part of GEMSU was accomplished without disruption. The consolidated balance sheet of the banking system in the GDR for the end of June was not available for some time after the currency unification, and it was therefore not possible to quantify the effects of the currency conversion on the balance sheets of the banks or on the money supply with great precision. Equalization claims to compensate GDR banks for the asymmetric nature of the currency conversion would only be issued after the final resolution of opening balances.²⁴ In the interim, the Bundesbank conducted its money market operations in the GDR primarily against single signature paper issued by the banks (i.e., bank IOUs). Given the favorable interest rate charged on discount operations, the initial discount quota (DM 25 billion) granted to the banks in the GDR was quickly utilized. Some banks also had recourse to the Lombard facility. Additional liquidity to the GDR financial markets came from fiscal transfers to the GDR and from FRG banks. Deutsche mark currency outstanding (including currency held by banks) at the end of July 1990 was 10½ percent higher than 12 months earlier.

The Bundesbank recognized that monetary union would exacerbate the difficulties facing monetary policy at both a technical level and a more fundamental level. At a technical level, monetary control would be made more difficult. With a free flow of people and capital between east and west Germany and the same banks operating in both, it would become increasingly difficult to segregate the monetary statistics. In the transition, with monetary targeting only in the west, the money supply in the east would be determined by demand. Financial flows would, therefore, accommodate sharp increases in certain prices and wages. These might be seen largely as an unwinding of relative price distortions. The eventual shift from targeting money in west Germany to targeting money in the whole deutsche mark area would involve venturing into unknown territory, since there was no history on which to base estimates of money demand in east Germany. The relative size of east Germany, however, was such that even fairly large errors in calculating money demand would not be that significant in the whole deutsche mark area.

The appropriate amount of liquidity to provide to east Germany was difficult to determine: that there was enormous potential for rapid growth from a very low base was obvious, but far from obvious were the bottlenecks that might emerge and the rate of growth that could be sustained without inciting sharp upward pressures on prices of nontraded goods. It would also be difficult to infer monetary conditions from interest rates: to the extent that returns on fixed capital investment in east Germany had risen, higher real interest rates might not dampen activity. But interest arbitrage would equalize rates over the whole deutsche mark area and (albeit less perfectly) in the ERM, and there was no clear consensus on an appropriate rise for the whole area. In these circumstances, the Bundesbank acknowledged that it would have to infer monetary conditions from a wide variety of indicators—not just the path of the monetary aggregates and interest rates, but also developments in exchange rates, wages, prices, demand, and output—and would err, if at all, on the side of restrictiveness. The credibility of the Bundesbank’s aversion to inflation was seen as an important asset that ought not to be put at risk and, from this standpoint, a strong deutsche mark was seen as a key ingredient of monetary policy in the period following GEMSU.

In the area of bank supervision and oversight there were also incipient problems. Much of the stock of state enterprise debt held by banks was of doubtful quality; however, it was not unlikely that these debts would be assumed or guaranteed by the Trust Fund or the Government. In the period following GEMSU banks faced considerable difficulty in finding criteria on which to base lending decisions to Trust Fund enterprises; it was near impossible to gauge the creditworthiness of the enterprises. Short-term bank loans to enterprises were guaranteed by the Trust Fund; this relieved the banks of the need to scrutinize the financial positions and prospects of enterprises. As (at least) some enterprises proved nonviable, the guarantees would be activated and the banks’ positions would have to be covered by the Trust Fund or, ultimately, the Government. This mechanism produced a soft budget constraint for enterprises that allowed a prolongation of illusions about the feasibility of uneconomic decisions on wages, prices, and products. It divorced certain decisions on credit from the relevant underlying economic calculations.

At the broad level of macroeconomic policy, GEMSU sparked concerns about the effect of the policy mix on the environment for monetary policy. If private investment in the GDR proceeded at the pace needed to successfully integrate the two economies and the budget turned out to be as expansionary as feared, the burden of containing inflation would fall disproportionately on monetary policy. It was difficult to tell whether this would mean higher interest rates—longer-term rates had jumped upon the announcement of currency union perhaps in anticipation of these resource demands—but even if high interest rates were warranted they would undoubtedly be unpopular. It was broadly accepted, however, that, without underutilized resources, successful integration of the GDR would have to entail some crowding out—if not by an interest rate mechanism, then via prices, taxes, or the exchange rate. The policy mix chosen would in any event have implications for exchange rate developments.

The Exchange Rate

Most scenarios envisage GEMSU eliciting more rapid growth and a more expansionary fiscal policy with continued monetary stringency. Such conditions would be consistent with higher real interest rates and some real appreciation of the deutsche mark. The appreciation would help to spread the additional demand from GEMSU to other countries and to reduce Germany’s current account surplus. At the start of GEMSU, it was difficult to tell whether these changes had been fully anticipated by market participants and were, therefore, already reflected in market rates. Some argued that they had not been fully anticipated so that a further appreciation was likely, while others thought that the market might have overshot its equilibrium so that some depreciation of the deutsche mark was possible.

The FRG authorities were skeptical of this latter position. They did not believe that an effective depreciation of the deutsche mark was warranted and were firmly of the view that a strong deutsche mark would be necessary to reduce the current account surplus, channel resources to the GDR, and contain the inflationary effect of GEMSU while spreading the beneficial real effects to the rest of the world. In particular, they did not envisage a depreciation of the deutsche mark against the U.S. dollar; this, they thought, would be contrary to the objective of narrowing current account imbalances. Events since the beginning of July 1990 have vindicated this view. Between June 30 and the end of September, the deutsche mark appreciated by 7 percent against the U.S. dollar and by almost 1 percent in effective terms.

Within the ERM, the deutsche mark was initially close to the lower intervention limit²⁵ so that, in principle, some appreciation would have been possible without any change in central parities. Among certain participants there would be strong resistance to any change in central parities—in particular, France and the Benelux countries saw fixed central parities with the deutsche mark as essential to their macroeconomic policy stance.