Quite so. And judging by what happened in the British economy in the 1980s, Tinbergen was correct – which should not be entirely surprising since, with Ragnar Frisch, he was the first of Nobel laureates in economics in 1969.

Britain’s government abandoned its attempt to apply a more-or-less strict version of “monetarism” in the autumn of 1984 and instead adopted an exchange rate target for monetary policy intending to achieve and maintain a “competitive exchange rate” for the Pound against the DMark. This was to create an option for Britain’s eventual entry into the European Exchange Rate Mechanism (ERM), which it duly did enter in October 1990.

Sadly, interest rates were kept too low for too long because of concerns about an “uncompetitive” Pound exchange rate. The result was unsustainably high GDP growth by 1989-90 with an upsurge in inflation. As events unfolded, Britain was forced out of the ERM in September 1992 when even exceptionally high interest rates were unable to maintain the required parity of the Pound against other ERM currencies. Readers may recall that George Soros at the time was betting against the Pound staying in the ERM by selling it short – reportedly he made c. £1 billion profit on the bet.

As you say, “the proof of the pudding”.

Captain Video: “Since wages and prices are sticky, there does not seem to be any intrinsic reason that monetary policy cannot be assigned DURING RECESSIONS to bringing the unemployment rate down to the natural rate of unemployment, and, when this has been achieved, reassigning it to maintaining an inflation target. Therefore monetary policy is assigned to only one target AT A TIME.”

On that prescription, monetary policy dilemmas become acute in situations where prices are rising as well as unemployment, – situations dubbed: “Stagflation” by the punditry 30 years back. That is what happened on both sides of the Atlantic during the 1970s as the result of hikes in world oil prices in 1973/4 and 1978/9 when OPEC curbed oil production.

In those circumstances, a tighter monetary policy, with rising interest rates, was needed to curb cost-price spirals but the outcome of curbs on aggregate monetary demand is rising unemployment unless wage earners and business are willing to accept some reductions in their respective real incomes to pay for higher oil prices – and/or accept cuts in oil consumption.

If monetary policy is relaxed to ease unemployment, the likely consequences are an escalation in the cost-price spiral thereby embedding expectations of a persistently higher inflation rate, which can take years and much social pain to eradicate, as Britain came to learn in the 1980s. Pending eradication of inflationary expectations, trade unions and businesses build into wage bargaining and price setting deliberate extra margins to allow for beliefs that prices are bound to rise. Left unchecked, the result is accelerating inflation so it is better for monetary authorities to act sooner than later, a consideration which I believe has recently motivated the ECB to raise its interest rate from 2% to 2.25%.

Besides, how are businesses and consumers to judge when the monetary authories are giving policy priority to curbing inflation or to the other attributed policy objective of boosting employment. Changes in interest rates will be subject to ambiguous interpretations so monetary policy will certainly not be “consistent, coherent and predictable”, which is what is needed for monetary policy to be at its most credible and effective.

In any event, it can be seriously misleading to draw quick conclusions from simple comparisons between the respective behaviours of the US and European economies, whether explictly or otherwise. That is not because, somehow, different economic “laws” apply on either side of the Atlantic but because the structures of the US and European economies are very different.

The US economy has adapted to use of a single currency since 1794. The European economy is fragmented by different languages, customs, social security systems and residual trade barriers, especially on services, despite the single currency in Eurozone countries.

Americans tend to move more readily in search of better job prospects than do Europeans even within national boundaries.

Some European governments tend to maintain long-established traditions of intervening in their respective national economies when they don’t like what they believe will be the outcome of unbridled market forces.

For whatever reasons, most of the studies of the Eurozone economy that I have come across report substantial, persistent price disparities of many consumer products across national borders despite the single currency. The fact is that consumers are generally reluctant to engage in cross-border shopping and businesses with price-setting power tend to price products according to what local markets will bear.

As Phillippe Maystadt, then the Belgian Finance Minister and now president of the European Investment Bank, said in 1996: “The purpose of the single currency is to prevent the encroachment of Anglo-Saxon values in Europe.”

The trouble is that since the launch of the Euro in 1999, the Anglo-Saxon economies have mostly out-performed the major economies of the Eurozone.

That’s fine for economics textbooks, but the proof of the pudding is in the eating. The Fed, by not rigidly adhering to an inflation target and muddling through has done a better job of achieving relative price stability with relatively low unemployment than the European Central Bank has done in Europe. The American people would not accept a unemployment rate like Germany’s and the independence of the Fed would be imperiled if, in order to rigidly adhere to an inflation target, it raised interest rates during a recession.

quoted by Roisland and Torvik: Optimum Currency Areas Under Inflation Targeting
http://www.svt.ntnu.no/iso/Ragnar.Torvik/oer.pdf

Sadly, I have been unable to find a better online source for Eichengreen’s research.

However, on whether the Eurozone area meets the conditions for an optimal currency area, see a recent, encouraging speech in March by J-C Trichet, president of the ECB:
http://www.bis.org/review/r050314b.pdf

I recall that there is a chapter specifically about that in: Barry Eichengreen: European Monetary Unification: Theory, Practice and Analysis (MIT Press 1998: ISBN: 0262050544)

De Grauwe identifies the convergence issue as central and highlights differences in the real rate of interest. One thing puzzles me. What is the level of ‘divergence’ between the various US states and why is this considered so much less significant than that between EU states.?

The unemployment rate and per capita personal income divergences between Connecticut and Oregon, say, are considerable, and do not always move in step over time. Does the price index not also vary accordingly? Are there also big interstate discrepancies in the buoyancy and perhaps even the direction of the housing market? I’m no economist, so please excuse my ignorance. I assume that to some of you, this is basic knowledge that you can dispense without research.

Is it just a question of the relative mobility of labour, capital and goods within the US as opposed to within the EU? Or have I missed something glaringly obvious?

The European Central Bank (ECB) was set up with the freedom to choose its own policy targets. It elected to choose an explicit inflation target: maintaining the average Harmonised Consumer Price index for the Eurozone at an annual rate of 2% or less.

Gordon Brown, Britain’s Chancellor of the Exchequer or treasury minister since May 1997, has famously criticised that target on at least three grounds:

Firstly, the ECB’s target is asymmetric; the Bank of England’s corresponding inflation target was (originally) to maintain the annual inflation rate as measured by Britain’s Retail Price Index (excluding mortgage interest) within half a per cent of 2.5%. The target was later reset to 2%, as measured by the EU’s harmonised price index. Secondly, the voting numbers and names of the Bank of England’s Monetary Policy Committee when it makes interest setting decisions are minuted and published. Transparency reigns. By contrast, deliberations of the ECB are confidential and no voting numbers or names are published. Thirdly, the particular remit to the BoE to maintain a specific inflation target was approved by Parliament and could, in principle, be changed by Parliament: indeed, the particular price index to be applied was changed, somewhat to the chagrin of the BoE, which was then forced to recalibrate its economic models – and such models are essential tools for assessing where the inflation rate is moving and the likely downstream effects of changing interest rates.

The US’s Federal Reserve Bank does not have a specific inflation target from the US Congress. Rather, the empowering legislation requires the Fed to maintain price stability but also to have regard for employment and other good things – I need to dig out the fine print again.

Basically, that is a fudge. Not only are there implicit political issues about the Fed being asked to balance price stability against unemployment rates but the Fed is being asked to do too much with the policy instrument it has: the ability to set and enforce short-term interest rates.

At least since Tinbergen in the early 1950s, we have known that to avoid confusion and muddle, one and only one policy target should be associated with each policy instrument.

If that principle is violated – as it was by the British government during the 1980s – we generate the confusion of sometimes using interest rates to restrain inflation and at other times to boost demand to reduce unemployment or ensure a “more competitive” exchange rate to boost exports and cut imports. Any change in the official interest rate of the central bank is therefore open to a variety of interpretations according to the current whim. Monetary policy is therefore not “consistent, coherent and predictable”.

Happily, Ben Bernanke, the new chariman of the Board of Governors of the Fed is well aware of all this and more, for he is a leading exponent of the case for inflation targeting by central banks compared with other potential candidates for the role of policy targets, an issue which came up in the course of the recent nomination hearings in the US Senate.

What remains problematic is the extent to which central banks should address asset price bubbles, if at all. The fundamental difficulty here is being able to diagnose the presence of such a bubble and then in deciding what to do about it. The challenge is in being able to at least arrest the bubble from growing further or, preferably to let it down gently, but without massively widening a gap between potential and actual output.

One way or another, central banks cannot avoid making judgements of the effectiveness of the transmission mechanisms of monetary policy and the extent of price flexibility in the economy when making decisions about interest rates. That is built in if central banks are charged to curb inflation.

In any case, in Europe, we are well used to vesting in unelected institutions the right to make political judgements – eg the right to introduce European legislation is vested in the EU Commission. It is our way of avoiding of what can be highly charged decisions in order to maintain amity in Europe.

I think all I can do here is direct you back through some of my posts in the archive gcs.

Mattew, the issue is really this one:

“This boils down to questioning whether the Eurozone economies were sufficiently similar to justify the launch of European monetary union in 1999″

I don’t think they were, and I think we are now getting the consequences. Paul de Grauwe, who is in fact a big partisan of the euro, yet writes for the FT, has this interesting presentation:

http://www.econ.kuleuven.ac.be/eng/ew/PDF%2050%20jaar%20CES/De%20Grauwe.pdf

Here you can see a pretty impartial review of the pro’s and con’s of EMU.

“FT still doing strong at ECB-bashing, I see”.

I think this turns everything into some sort of football match, and I don’t think that approach is helpful. I am a European, I would dearly like to see a European central bank which did a better job than the Fed, unfortunately that isn’t the case. I don’t think it is simply down to personalities, I think the ECB has a structural problem.

And on top of everything else, I think demography matters, and much of present day European demography is asymmetric (France and Germany eg).

“why is a modest hike ‘the most bizarre monetary policy decision of recent times’??”

Well it’s not for the size of the hike that’s for sure, except maybe becuase if that’s all the powder you have in the keg it may be better not to let people know this.

Basically it is bizarre for the way the decision was taken and announced, and for the fact that the two main arguments given (inflation threat and M3 growth) don’t seem to hold water.

Mario Monte tries to rescue the case, and I give him credit for doing better than most:

http://more.fistfulofeuros.net/archives/002147.php