Why Did the Great Inflation Not Happen in Germany?

Abstract

In March 1973, the Bundesbank was relieved of its obligation to intervene in the foreign exchange market with respect to the fixed parity against the U.S. dollar. The end of the Bretton Woods system and the transition to floating exchange rates in March 1973 gave the Bundesbank new scope for the control of domestic monetary conditions. While this did not mean complete freedom from exchange rate constraints, the strongest and most immediate external pressure had been removed. New opportunities opened up for monetary policy. In response, the Bundesbank pioneered the use of pre-announced annual growth targets for the money stock, the first of which was published in December 1974.2 GERMAN MONETARY POLICY UNTIL 1973 W hen I first became aware of the title of the special conference at the Federal Reserve Bank of St. Louis, “Reflections on Monetary Policy 25 Years After October 1979,” I was puzzled for a moment and spontaneously asked myself what happened in 1979. Then it came to my mind that, while the United States suffered from the Great Inflation, this was not at all the case for Germany. This contribution deals with the possible reasons for this and asks for the lessons that could be drawn from such experiences. To better understand this episode, one has to go back to the previous regime of fixed exchange rates. At the beginning of the 1970s, the Federal Republic of Germany found itself in a difficult economic situation caused, in essence, by high and rising inflation due to external pressures and fiscal and wage policies. At the same time, the possible ways for monetary policy to react to this inflationary environment were limited, as its freedom to act was constrained by the Bretton Woods system of fixed exchange rates. Consequently, from the second half of 1970, monetary growth— measured in terms of M1 or the central bank money stock—was very strong. In line with this development, bank lending to domestic non-banks was also expanding fast. At the same time, German foreign exchange reserves rose by 40.9 billion Deutsche marks over the period from 1970 to May 1971 compared with an increase of 14.9 billion Deutsche marks from January 1968 to September 1969.1 It should be noted that in various episodes the external com1 See Issing (1996b) for a more detailed discussion. 2 See Table 1 for a more detailed overview. For a fuller exposition, see also Issing (1992) and Deutsche Bundesbank (1995). It should also be noted that the practice of monetary targeting was continued until the year 1998—the end of the Deutsche mark as a currency.