Introduction

Until a short time ago it was generally believed that the most pressing economic problems of the 1990s would be linked to the persistent international trade and budget imbalances between the US on the one hand and Europe and the Pacific Basin on the other, and to the failure of the Latin American economies to reduce their debt burden. The fall of the Berlin Wall made an uncertain future international environment even more complicated as the already indebted Eastern European economies sought the ways and means to economic progress that would match the rapidity of their political liberalization. Yet the prospect of reunification of East and West Germany was initially greeted by an outbreak of optimism and euphoria in German and international capital markets. However, after this early optimism, German bond markets began to weaken at the beginning of 1990, and led to a stock market reversal which created a mood of widespread pessimism over the economic implications of German unification.

This chapter identifies the basis of such a rapid change in market opinion concerning the impact of German economic and monetary unification in the mistaken application of monetarist analysis grounded in a fundamental misunderstanding of the reasons which led the Bundesbank to oppose the West German government's proposal to achieve monetary unification by converting the East German mark (EM) at parity with the West German Deutsche Mark (DM).