The Euro, the new European currency

German translation, Spanish translation

By Josef Hund of IWB Radolfzell e.V., GERMANY, 1997

Contribution to the EDUVINET "European Monetary Union" subject

(English translation of the German original by Hermann Seidel, GERMANY, Hilary McEwan, UNITED KINGDOM, Elaine Hampson, UNITED KINGDOM, 1999)

Table of contents

1. What is Money

1.1 The notion of money

1.2 The functions of money

1.3 Kinds of money

2. Historical Perspective

2.1 Currency reform of 1923

2.2 Currency reform of 1948

3. Currency systems and value of money

3.1 An internal perspective of the Federal Bank of Germany (Deutsche Bundesbank) and a critical evaluation of its work

3.2 Complementation of agreed political-economic aims for a central bank

4. Maastricht citeria: Agreement on objectives for the preparartion of monetary union

4.1 An attempt to explain the criteria from the experience of unsuccessful anti-cyclic policies to influence economic fluctuation

4.2 The criteria

4.3 Evaluation of the entry levels for inclusion

4.4 Evaluation of the agreements after founding the monetary union

4.5 How independent is the European Central Bank?

4.6 Cost benefits

4.7 Process of exchange

5. Conclusion

1. What is Money?

1.1 The notion of money

Economic understanding
"Money is an individual's entitlement to a share of the national product, recorded in a general promise of value." (Schmoelders)

Legal understanding
"The means of payment within a legal framework prescribed by the state." (Knapp)

The common person's understanding
The means of payment for which anyone can purchase goods within an economy.

1.2 The functions of money

  1. Money as a unit of calculation which attributes a single and exact value to goods. Example:
    1 kg of butter= 10 DM or = 30 FF or = 800 Ptas.
  2. Money as a means of exchange in order to purchase goods from a person without having to give other goods to this person.
  3. Money as a means of storage which enables transfer of purchasing power to the future, e.g. saving now to buy a house in the future
  4. Money as an available reserve which is necessary because income is only paid at set periodic intervals whereas expenses have to be met daily and often unexpectedly
  5. Money as a means of transfer of loans and of removing debt which enables temporary transfer of purchasing power from the creditor to the debitor, e.g. taking a loan to finance a car.

1.3 Kinds of money

  1. (XXX1)
    One example is bartering animals, e.g. sheep, camels or horses. Other examples are imperishable and rare goods, such as sea-shells, pearls and precious metals, all of which are also easily transportable.
  2. (XXX2)
    Bars or rods of precious metal which are cut, their value being represented by their weight.
  3. Coinage
    Pieces of metal minted into coins with which the sovereign gurantees the purity, weight and value.
  4. Notes
    Amounts of precious metals were deposited in banks and a receipt was issued. These receipts were used as bank notes to pay for goods as a substitute for the precious metals.
  5. Bank deposit money
    Money in the form of credit in Giro accounts with the banks which is exchanged in the act of payment from bank to bank.

2. Historical Perspective

With the foundation of the German Reich in 1871, legislation concerning coins and notes became the responsibility of the Reich government. On 1st January 1876, the Reichsbank established business as a successor to the Prussian Bank. Until 1945 it was the German Central Bank.
The Minting Act of 9.7.1873 proclaimed the gold standard and ordered the withdrawal of all money that had not been issued in the Reich currency.
A government act of 30.4.1874 limited the circulation of paper money to 120 million Reichsmark (RM) in notes. The banking law of that time prescribed that one third of the circulating bank notes had to be guaranteed by a combination of gold and German exchangable money including bank notes. The remainder was guaranteed by good bills of exchange, valid for three months at the most. The remaining two thirds might only be exceeded to a very slight margin when the national economy was in need of money. This notion of a guarantee was based on the idea that bills of exchange had to be based on the real economic value of goods that had been created and must be financed during the turnover of the goods. Bills of exchange are promises of payment in the future for goods received, which are either going to be processed or offered directly to the consumer.
The exchange rate between the Reichsmark and gold was fixed at 1,392 RM for 500g of gold. At today's rates we would have a rate of about 10,000 DM for half a kilo of gold, which is seven times the price of 1874. At the beginning of the First World War the Reichsbank's duty to redeem bank notes with gold was abolished. Since the currency's guarantee through gold to one third turned out to be existing only formally, it also was abolished by an amendment in 1921 of the Banking Law.

2.1 The Currency reform of 1923

The immediate burdens due to the war and the subsequent costs such as reparations resulted in an immense increase in the amount of paper money and necessarily led to a currency conversion.

One billion (or one million millions) RM were exchanged for one Rentenmark
1,000,000,000,000 RM for 1 Rentenmark.

Assets in money became worthless and thus the old age pension money saved by a great number of persons was gone.

4,20 Rentenmark had to be paid for 1 US dollar
20,76 dollars had to be paid for a troy ounce of gold (= 31.1035 g)

The price for 1.000 g of gold was fixed at 2.790 Rentenmark
(compare the gold price of 1874: 2.784 RM for 1.000 g)

The exchange rate between Mark and dollar was fixed via the gold price.

1 troy ounce of gold= 31.1035 g of gold = 20,67 US $

1.50476 g of gold 1 US $ = 4,20 M

0.35828 g of gold =

1,00 Mark

999,594 g of gold =

2790 Mark

Due to the crisis in the Great Depression the gold price increased, a fact leading to an adjustment in 1934. The rate was newly fixed at

1 troy ounce of gold= 31.1035 g of gold =35.00 US $

This meant a devaluation of the German currency by 40.943%.

2.2 The Currency reform of 1948

Development of debts:

1933 11,7 Billion Reichsmark
1939 41,0 Billion Reichsmark
1945 ca. 390 bis 440 Billion Reichsmark

A freeze of prices, rigourously ordered and carried out by the German government as from 1936 was maintained also by the allied military governments in post-war Germany.This was leading to a hidden inflation or, simply put, one did not get any goods anymore for one's money. A time of bartering began, a flourishing "black market". There existed a surplus of money after the war, contrasted by a low rate of production. A reason for this was that the production plants had on the one hand been destroyed and on the other hand been dismantled and taken away by the victorious powers. The currency reform was basically carried out as follows:

Obligations were exchanged at a ratio of 10 RM : 1 Deutsche Mark (DM)

Wages, and salaries, pensions, income from renting or leasing at a ratio of 1 RM : 1 DM

A sum of 40 DM in June and again 20 DM in August was paid in cash per capita.

The hidden reserves of the past and a re-evaluation in DM produced an exchange rate of 100 RM : 98.1 DM in the conversion of RM into DM, of share capital of companies. This meant that for share-holders the going rate in the new currency remained almost identical. This meant also that company capital was assessed almost equally high so that share-holders could hardly complain about losses.

Thus the common person had lost nearly all their savings again and consequently the self-contributed security for old age twice within 25 years.

The Currency Conversion to EURO = A Currency Reform?

Will the new currency change towards the Euro be comparable to the currency reforms of the past?

3. Currency system and value of money

3.1 An internal perspective of the German Federal Bank and a critical evaluation

The Federal Republic's currency has no gold guarantee but is a manipulated currency instead. This does not mean manipulated arbitrarily, but oriented towards certain objectives.
These objectives have been laid down in the government act concerning the Federal Bank.
The main task of the Federal Bank is to supply economy with sufficient money to avoid inflationary as well as deflationary developments in the value of money. For that the Federal Bank should be able to estimate economic dvelopment as precisely as possible so as to provide a sufficient quantity of money for the goods produced. A growth in the national product must be reflected by a growth in the same scale, of the amount of money provided.

These correlations are expressed in Fisher's circulation equation:

Price level = amount of money x speed of circulation / volume of trade.

When both the amount of money and the volume of trade are growing at the same percentage, the level of prices will remain cinstant unless the speed of circulation undergoes a change.

However, from this simple correlation various peoblems may arise:

  1. Which amount of money constitutes the purchasing power? At times of low interest rates, holders of money assets tend to higher liquidity, i.e. cash money or credit with daily settlement.
  2. Inflationary price tendencies increase the circulation speed of money because money loses value quickly which in turn increases the amount of money available for purchasing power.
  3. In the case of reserve currencies, part of the cash money is transferred abroad and there may play the role of a substitute means of payment. This amount is indeed included in statistics, though it does not provide purchasing power on the interior market; thus it has no influence on inflation.
  4. In modern banking money is not created exclusively by the Federal Bank. Cash inflow from abroad e.g. creates a multiple process of creating money through the domestic banks involved. Its overall effect is all the bigger the lower any prescribed or voluntary restrictive bahaviour concerning the spending of money in banks or private households is.

Despite these problematic fields the Federal Bank is still pursuing a concept of various defined quantities of money. This is to say that it wants to ensure a stable value of money by controlling certain quantities of money. For this purpose the Federal Bank establishes e.g. the quantity M3 (M = Menge = quantity) under which name all cash, demand deposits, time deposits and ordinary savings accounts are summed up. This clearly defined quantity of money is to grow within a certain conceded range in accordance with the national product. Exceeding this range, as a rule causes restrictive measures by the Federal Bank. This way of acting may be criticized in so far as a shift in capital investment at short notice will result in an increase of quantity M3 though the overall available purchasing power in the economy has not changed at all.
Large industrial countries, such as the USA or France therefore turned away from this concept and have in recent years been pursuing a different one resting on interest rates. It has been realized that real interest rates of 2,5 - 3% have been the rule over the last decades. A higher interest rate will encourage saving and will slow down growth, one that is lower will boost consumption and consequently growth since the interest on savings as a premium for postponed consumption is too small.
An inflation rate of 1.5% and a real interest rate of 2.5% should result in a long-term capital interest rate of about 4%. Interest rates with a face value of 5.5 or 6% will stall growth.
The Federal Bank's way of measuring the inflation rate does not take into account that a considerable part of this rate is caused by increases in fees, taxes or tariffs on part of the state and not through actions of free participants of the markets. Moreover, quality improvement in products will not be considered as long as there is no corrective factor for, say, an increase in value by applying better or more economical technologies, which will not be recognized by statistics in the end. The non-existence of such factors might in various European countries already have led to a deflation in the manufacturing sector unnoticedly for some time, which may have resulted in job losses because consumers have been reluctant to buy goods.

3.2 Complementation of agreed political-economic aims for a central bank

Questions arising:

  1. Are the Federal Bank's aims defined too narrowly as a consequence?
  2. Should the aims not be complemented by the aims of full employment and steady growth?
  3. Should the questions of prolonging the time in office and eventually the pensions of the responsible persons in the Federal Bank or later the European Central Bank be inevitably linked to reaching such aims? New Zealand is setting a successful example in this.

Such questions are being discussed quite rightly by the future partners in the European Monetary Union.

What are arguments for defining the tasks of the European Central Bank narrowly as "safeguarding stability of currency value"?

  1. The task is formulated unmistakably and success can be measured to a large extent.
  2. Shared responsibility for achieving political-economic aims is clearly limited to eight years for the politically elected governments as well as competent experts, called into the board of the Central Bank.

What is an argument for the independence of the European Central Bank?

Currency experts must be able to pursue medium- and long-term strategies during their term unbiased and independent of day-to-day politics or election times so as to create and maintain confidence in a currency.

What are arguments for complementing political-economic responsibility of the European Central Bank?

Political-economic decisions in favour of employment in newly created branches of economy (caused e.g. by major structural changes) must not be counteracted by a policy exclusively oriented at stability of money. Misuse on part of the politicians can only be avoided by clear guidelines for interior policy. A negative example were the demonstrations in the streets, of German miners who in this way successfully fought for subsidies for coal mining for another eight years. Such a policy of racketing coud have devastating consequences in the different nations of Europe. A foretaste of such tensions was given by French and Spanish fishermen in the Bay of Biscay.

4. Maastricht citeria: Agreement on objectives for the preparartion of monetary union

4.1 An attempt to explain the criteria from the experience of unsuccessful anti-cyclic policies to influence economic fluctuation

During the 1970s industrial nations have tried to overcome their structural problems and those of economic fluctuation with devaluation or deficit spending. Devaluations gave new impetus to employment but also resulted in an increase of prices for imported goods, while anti-cyclic government financing through loans put a strain on capital markets. While during a recession the negative effects were negligible and the positive aspect of providing employment were dominating, the repayment of the loans, as it is prescribed in the German stability laws for times of a boom, was not duely respected. Thus government borrowing raised interest rates rapidly and consequently new investment in such a country became less profitable. Increasing unemployment with all ensuing costs and reduced profit margins caused decreasing tax revenue. In order to balance this development, contributions to the social security systems were raised and the progressively rising rate of taxation washed an ever-growing real part of income into public budgets after every pay rise due to inflation.On a local level the rates of assessment for taxation were continuously raised in a similar way.
The loss of interior value as well as of currency value abroad along with a steep rise of unemployment were signalling the dead end street into which the industrial nations were moving because of wrongly applied policies to influence economic fluctuations. This is the background against which the clearly defined criteria for joining a European Monetary Union can be explained.

4.2 The criteria

  1. Inflation: no more than 1.5% above the average inflation of the three most stable nations.
  2. Budget deficit: no more than 3% of the national product in the budget year in question
  3. Total of national debts: no more than 60% of the national product
  4. Long-term interest rate: no more than 2% above the average rate of the three most stable nations
  5. Participation in the European Monetary System for the last two years before establishing the Monetary Union

While the criteria for inflation and long-term interest rates represent a maximum deviation from an average of other EU members, the criteria concerning debt are oriented at the development of domestic economy and national product.

4.3 Evaluation of the entry levels for inclusion

An aim is to make these framework rates of the invidual economies reach desirable rates of stability. However, data about projects financed give no answer to the question whether a particular object of financing makes sense or not for an economy. A country which finances the building of motorways via tax revenues and, partly, government borrowing, and a country which has private enterprises finance such investment in the infrastructure, which eventually make the users pay dearly over the next few decades, have to be assessed differently. The debts arising from expanding a system of vocational training have got a different quality than those coming from concert halls or museums. In my opinion, employees correctly criticize that the criteria of stability are one-sided, as long as the aim of stability of employment, i.e. a high rate of employment, has not been included, since this endangers social stability in a society.
Furthermore, it was not clearly stated which tasks and which economic activities of a state are to be included in, or excluded from, the overall calculation. This having been neglected, the countries which want to be included try to shift debts into special funds with balancing tricks, or to outsource or privatize hitherto government responsibilities. It is not economic deliberations that lie behind such decisions but the arbitrarily fixed figures for joining or not.
In the two-year test phase with a narrow range of fluctuation in the EMU, the political-economic decisions must be increasingly harmonized among participating countries, which in turn will result in a convergence of their economic development.

4.4 Evaluation of the arguments after founding the monetary union

There is no automatic mechanism of sanctions to discipline budget management of the participating countries, but sanctions that have been agreed on today may be cancelled by a majority vote.

4.5 How independent is the European Central Bank?

The Central Bank will have the only responsibility for financial policy from the first day of monetary union onward. Its foremost task is to pursue the aim of price stability and it may support the general economic policy of the union only as long as this foremost task is not impaired. Its leading personalities will be experts who will be independent of political directives during their term of office. Representatives of the Federal Bank of Germany feel that the German strategy of money quantities ought to be considered to ensure a stable currency. However, to unite countries with diverging inflation rates will always create an average rate of inflation. The more stable currencies will become softer.

4.6 Cost benefits

Tourists who no longer have to exchange money expensively will notice this as the most evident occasion of saving money. The savings of trade and industry, though, will be far more important, because transaction costs will disappear, faster payments can be enforced, and insecure calculations because of currency fluctuation will come to an end. Furthermore, the costs for business with the aim of safeguarding currency value will no longer be necessary. All this is of enormous importance, as Germany is trading 60% of her exports with European partners, a figure which may be similar for other European countries.

4.7. Process of exchange

All money assets will be converted or exchanged at equal exchange rates within a determined period of time. This process can be compared to a long-term investment of money in a different currency, e.g. the U.S. dollar. As soon as the investing persons also live in the area for which the currency applies, they will realize that they have kept up their purchasing power and will monthly receive a comparable purchasing power as before along with their earnings.

5. Conclusion

Introducing the Euro means introducing a new kind of money alright, but it can in no way be compared to the German "currency reforms" of 1923 and 1948, which were in fact bankruptcies rather that reforms, in the course of which a certain bankruptcy quota was handed out. No economic thinking person would feel a conversion of a DM account into a Swiss Franc account to be a bankruptcy, but a change into another stable currency, something that many European citizens are dreaming of, be it for different reasons. Unfortunately, the positive expression "currency reform" was misused in the past as a cover-up of an oath of disclosure, so that the common person in Germany mistrusts our politicians' talk of "the Euro, the new European currency."

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