Smad proteins transmit TGFbeta signals from the cell surface to the nucleus. Here we analyze Smad2 mutant embryos created using ES cell technology. Smad2 function is not required for mesoderm production per se, but, rather unexpectedly, in the absence of Smad2 the entire epiblast adopts a mesodermal fate giving rise to a normal yolk sac and fetal blood cells. In contrast, Smad2 mutants entirely lack tissues of the embryonic germ layers. Smad2 signals serve to restrict the site of primitive streak formation and establish anterior-posterior identity within the epiblast. Chimera experiments demonstrate these essential activities are contributed by the extraembryonic tissues. Thus, the extraembryonic tissues play critical roles in establishing the body plan during early mouse development.