T-Bill Substitute.

The Bundesbank objects to Germany issuing short-term debt. For a host of reasons, Bubba is wrong.

The fight between the Bundesbank and the German Ministry of Finance over managing the countrys federal debt might sound too technical for many. But the outcome of that fight may well determine whether or not the embattled euro will live up to the hopes of its promoters. Their hope? For the euro to become a reserve currency, so that others outside Europe will use it as a convenient store of value.

Currently, the German Finance Ministry and the Bundesbank together issue Germany's federal debt. The Bundesbank, however, wants to avoid issuing short-term debt. As a result, the market for German short-term government debt is tiny. Europe's largest economy, which provides about one-third of EMU GDP, accounts for only 3.6 percent of all EMU government domestic short-term debt. It's no wonder the European market is only half the size of the U.S. market.

In its reluctance to issue short-term debt, Germany is unusual in Europe and among industrialized countries. Some 10 percent of French government debt is of less than one-year maturity, which is five times greater than Germany's level of 2 percent. Italy has issued 17 percent of its debt in short maturities, the United States 21 percent, and Canada 32 percent. It certainly appears that many other industrialized countries have found short-term issues to be a useful instrument for debt management.

But more important, a short-term debt market is critical for the use of the euro as a reserve currency. All around the world, central bank currency managers and corporate treasurers need to be able to park their money in a safe, liquid, and convenient place for short periods of time. Currently, the U.S. treasury bill market serves this purpose admirably. The EMU countries simply lack a similarly broad, liquid, and safe short-term market. As a result, those investors who want such financial instruments at their disposal have to buy dollars, strengthening that currency's international role at the expense of the euro.

The determination of German Finance Minister Hans Eichel to reform German debt management will go a long way to help create such a short-term market. The center of his proposal is the establishment of an independent public agency to take over all aspects of debt management. The new agency would almost certainly issue more short-term debt, and do so in a predictable manner. The result would be a larger and more liquid market in short-term European government debt. Such a market would be competitive with the U.S. treasury bill market.

The Bundesbank has always worded that issuing short-term government debt is too much like printing money. In the past, therefore, it has avoided creating a short-term market precisely because it was afraid this market would inflate the liquidity of the German economy, and ultimately spark inflation. But why should the Bundesbank continue believing this since the U.S. experience has pointed in the opposite direction for so many years? After all, it's hard to argue that the large and liquid U.S. treasury bill market contributes to U.S. inflation. The Bundesbank has not made the case that Europe is different.

And what are the prospects for early change? On past experience, progress in Germany, particularly in the area of institutional reform, moves like a snail. But with the arrival of EMU, both the Bundesbank structure and financial market supervision as a whole are under official review. As public attention increasingly focuses on the ECB, the Bundesbank's previously sacrosanct status is beginning to fray at the edges; it has been stripped of its role as guardian of the currency. The German public is growing accustomed to the fact that the ECB, not the Bundesbank, holds the monetary reins. As the role of the Bundesbank and the nine regional central banks is placed under the spotlight, the public mood is unlikely to be adverse to fundamental change, incorporating the broad spectrum of financial supervision as well. Finance Minister Eichel has the opportunity to tailor an agreement on a total overhaul as early as the second half of this year, to be implemented in 2001 and 2002, once euro notes and coins are in place.

The truth is that now is the perfect time for Europe to set up a market competitive with U.S. T-bills. Current projections indicate that due to rising budget surpluses, the U.S. federal government will have bought back all of its obligations -- long-term and short-term -- in the next fourteen years. We have already seen the long end of the U.S. treasury market experience turbulence because of the uncertainties of the unprecedented buy-backs. In this atmosphere, investors around the world are already discussing possible replacements for the T-bill market. And what better replacement than the short-term debt of the member governments of the euro zone, a region with an economy about the same size as that of the United States?

There is another good reason for Germany to create a highly liquid market in short-term debt: It saves taxpayers' money. If German short-term debt were able to attain benchmark status by becoming the dominant, most liquid short-term debt issued in Europe, the government would get a discount in the markets on the interest it has to pay on that debt. That's because international investors demand a premium on other securities that don't offer them the same kind of liquidity.

Europe has made a good start by creating a currency that can play a major role in world finance. The European Central Bank has begun to establish its reputation, and Europeans are warming up to the project. But the euro must become widely accepted outside Europe as well. This will happen. But it would be accelerated in no small degree by the creation of a broad, liquid market in European short-term government debt.

Klaus Friedrich is Chief Economist for Dresdner Bank Group