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25 Years Later: DIW Berlin's Experts analyse German and European Monetary Union

Press Release of July 2, 2015

German monetary union on July 1, 1990 was politically necessary despite painful economic consequences – Greece, similar to the GDR back in the 1980s, in urgent need of reform – the crisis of European monetary union potentially boosts integration

Precisely 25 years ago, on July 1, 1990, German monetary union came into force. On the same day, capital controls in Europe were abolished, creating the basis for European monetary union and the euro. Both German and European monetary union were and still are being heavily criticized and debated. Was the design of German monetary union flawed? Was it a mistake to adopt the euro? On the occasion of this historically important date, experts at DIW Berlin addressed these questions.

German Institute for Economic Research (DIW Berlin)

The German Institute for Economic Research (DIW Berlin) is one of the leading economic research institutions in Germany. Its core mandates are applied economic research and economic policy advice as well as provision of research infrastructure. As an independent non-profit institution, DIW Berlin is committed to serving the common good. The institute was founded in 1925 as Institut für Konjunkturforschung (Institute for economic cycle research). Since 1982, the Research Infrastructure SOEP (German Socio-Economic Panel Study), a long-term study, is affiliated to DIW Berlin. The institute has been headquartered in Berlin since its founding. As a member of the Leibniz Society, DIW Berlin is predominantly publicly funded.

The Euro – Locomotive or Coronation of Integration?

In their essay on European monetary integration, the authors, Ferdinand Fichtner and Philipp König, depict the path toward the introduction of a common currency. The essay describes how, at the beginning of the debate, there were two opposing schools of thought. One camp assumed that a common currency would act as a “locomotive” automatically resulting in deeper economic integration in Europe. The other school of thought saw the euro as a form of “coronation” at the end of the process of integration in the belief that economic structure and economic performance had to converge first.

In retrospect, it can be said that the idea of the euro as a “locomotive” dominated, although, according to the authors, “it was only in response to crisis that the necessary changes to the institutional structures of the monetary union were made.  There is much evidence to suggest that, when the monetary union was originally being created, such tension and even crisis situations were consciously tolerated because of the stimulus for deeper integration this would provide.” Fichtner and König are critical of this strategy seeing it as a “very risky political move, since it can lead to the loss of public support for the integration process, in doing so endangering the very existence of the monetary union.” According to the authors, this is exemplified by recent developments in Greece. Almost exactly 25 years after the abolishment of capital controls in Europe, economic and political tensions lead to renewed capital controls in Greece and threaten to force the country’s exit from the monetary union.

German Monetary Union – Shock Therapy

In contrast, German currency union materialized with very little preparation. It was politically unavoidable and the result of public pressure. The move was intended, inter alia, to put a brake on the massive exodus of people from East to West Germany at the time. According to DIW Berlin’s expert Karl Brenke, 1990 monetary union was also politically desirable since “given the insecure foreign policy situation, the aim was to seize the chance of reunification and push through monetary union to create an irreversible fait accompli.” However, in terms of economic development, monetary union proved to be an enormous challenge and a painful process. “With virtually no warning, East Germany’s few productive factories and businesses were exposed to free market competition; industrial production collapsed in a way unparalleled in history.” What followed was a process of system transformation through shock therapy: “Overnight, East Germany’s economy was exposed to competitive forces which, to a large extent, it was quite unable to cope with.”

Today’s Greece Needs Structural Reform Like the GDR before It

“Particularly in terms of finding a solution to the current European crisis, it is important to understand what lessons Europe can take from German monetary union,” summarizes Marcel Fratzscher, President of DIW Berlin, in his editorial. In his article, Fratzscher comes to the conclusion that, from an economic perspective, in many ways, Greece today is comparable to the GDR of 1990: both countries had or have inefficient government institutions and an economic structure incapable of competing internationally and, in both cases, the population was promised that the new currency would bring prosperity, without being adequately informed of the hardships the transformation process would involve.

And yet, in Fratzscher’s opinion, German monetary union was the right step, even with the relatively high conversion rate and incomes in East Germany which were not that low: “As a result, demand in East Germany stabilized and created an important anchor for stability.” A key difference between the situation in the GDR at the time and the current situation in Greece is the transfers from West to East Germany: “German monetary union included a fiscal union and high financial transfers from West to East Germany whereas such fiscal transfers are much lower within the euro area.” The process of transformation in Greece is therefore likely to proceed much more slowly, says Fratzscher.