The Most Bizarre Monetary Policy DecisionOf Recent Times?

This was Wolfgang Munchau writing in the Financial Times a week ago:

The pre-announced interest rate rise that the European Central Bank is due to agree this Thursday must rank as one of the most bizarre monetary policy decisions of recent times. The economic recovery in the eurozone remains fragile, as last week’s German confidence indicators have shown. Even the ECB’s own forecast for headline inflation is relatively optimistic, while core inflation remained unchanged at 1.5 per cent in October.”

and he issued a warning:

“It is still not too late to propose ECB reform as part of the next treaty revision. For as long as EU leaders maintain the status quo, they have the central bank they deserve.

Central bank independence seems to be once more ‘a l’ordre du jour’, and the ECB may well live to find to its cost that there is one thing worse than actually playing the game, it’s playing the game and losing. Now why?

Well as I try to explain in this post, we really are locked into a very weird at wonderful economic conjuncture right now. The US economy is exhibiting relatively sound and sustainable growth. Germany, Japan and Italy are not. This is producing all manner of imbalances, and this is what the controversy is all about.

Opposition to the decision to raise rates has been pretty universal from eurozone finance ministers, and it has been pretty general from ECB independent economists too. Paul de Grauwe, also writing in the Financial Times thinks it was a simply victory for the policy hawks inside the bank. As he said:

Barely two weeks ago the European Central Bank issued its monthly bulletin containing an analysis of the perspectives for inflation in the euro area. In a nutshell the story was the following.

Yes, yearly inflation has increased to 2.5 per cent (October 2005) and this is a source of concern for a central bank that has promised to keep inflation below 2 per cent. But, as we all know, a central bank that targets the rate of inflation should be forward looking and base its interest rate decisions on the expected future rate of inflation. The remarkable thing about the analysis is that, after voicing its concern about current inflation exceeding 2 per cent, it came to the conclusion that the perspectives for future inflation were favourable.

It is worth quoting the conclusion: “The latest indicators do not point to a strengthening of underlying domestic inflationary pressures in the euro area. Wage increases, in particular, remained contained against a background of ongoing moderate economic growth and of labour market prospects that are still subdued. This assessment is broadly shared by private sector forecasters”. And, indeed, these forecasters almost all predicted and continue to predict a rate of inflation around 2 per cent for the next two years.

The sensible conclusion from this analysis was and still is that there is no reason for a central bank that cares only about inflation (let alone one that cares about other things too) to raise the interest rate. So the ECB correctly concluded two weeks ago that there was no reason for an increase. Of course, it added that vigilance was required, but do we not all have to be vigilant in a world where risks of all kinds lurk around every corner?

So what happened since the beginning of November?

Exactly, what has happened since the 1st November, well, at the risk of being a pain, I would say that the threat of a yield curve inversion in the United States has increased significantly – with the disconnect between US and eurozone growth as the driver – that is what has happened.

As the FT notes, EU politicians are trying to put a brave face on things, but this is uphill work. Perhaps the most significant among the many comments was not the observation from Dominique de Vllepin’s politically correct “My belief is that the ECB wouldn’t do anything that would compromise economic growth in the EU.” but rather Christian Noyer – Governor of the Bank of France – saying “we don’t have anything else in our pocket for now……it’s not forecast that it’s the beginning of the cycle.” (M. Trichet it will be noted is French, and this decision – and indeed even a bit more of the same – would arguably be quite appropriate for the French economy).

So the ECB ‘easing cycle’ may well be over, even before it actually got started. My own view is that this has been an extremely foolish move on the part of the Bank, and – as Munchau indicates – they are playing with fire here (as is incidentally and on the other side of the planet the Bank of Japan). If they have read the tealeaves badly (and I think they have) and if the German data fail to improve and the Italian data turn downhill again (which I think might well happen) then this may be the last time the ECB will dare to make a decision which isn’t approved of by the finance ministers first.

So was this a balanced risk? Was it wise – or even, god forbid, prudent – to try and call the shots when only a quarter point is in play. I think not. If I was going to make a risky call, one which could threaten my long term independence methinks I would want to do it for something a bit more susbtantial.

But then wishy-washyism has long been one of the defining characteristics of the ECB.

One last, almost anecdotal point, the ECB has, as the FT indicates taken this decision laregy on M3 money supply grounds, viz: “ECB fears had been reinforced by its analysis of money supply figures, which it regards as signalling long-term inflation trends – in spite of scepticism among other central banks”.

The scepticism which the FT is referring to is the recent decision of the Federal reserve to stop monitoring M3, which is the key indicator currently used by the ECB. Irony on irony I think.

Many economists have pointed out that, at the end of the day, a quarter point change, even if it’s a quarter point in the wrong direction, isn’t a make or break issue. Quite right. Let’s not get things out of perspective. This won’t be disastrous, except, of course, just possibly, for the ECB itself. As Dave Altig says “the ECB has played its hand“, fine, but let’s just hope that this time next year it is is still in a position to be able to deal the cards.

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About Edward Hugh

Edward 'the bonobo is a Catalan economist of British extraction. After being born, brought-up and educated in the United Kingdom, Edward subsequently settled in Barcelona where he has now lived for over 15 years. As a consequence Edward considers himself to be "Catalan by adoption". He has also to some extent been "adopted by Catalonia", since throughout the current economic crisis he has been a constant voice on TV, radio and in the press arguing in favor of the need for some kind of internal devaluation if Spain wants to stay inside the Euro. By inclination he is a macro economist, but his obsession with trying to understand the economic impact of demographic changes has often taken him far from home, off and away from the more tranquil and placid pastures of the dismal science, into the bracken and thicket of demography, anthropology, biology, sociology and systems theory. All of which has lead him to ask himself whether Thomas Wolfe was not in fact right when he asserted that the fact of the matter is "you can never go home again".

26 thoughts on “The Most Bizarre Monetary Policy DecisionOf Recent Times?

  1. We can, I believe, discount the possibility that the governors of the ECB are functionally illiterate so they will have doubtless read recent OECD reports suggesting that Eurozone recovery is still fragile so a hike in the ECB’s rediscount rate would be premature – along with similar views of EU finance ministers and the punditry.

    Why then, oh why, did the ECB go ahead and raise its interest rate from 2% to 2.25% ?

    Perversity apart, another possibility, I suppose, is that the ECB has succumbed to collective insanity but I can’t really say I find that plausible.

    Surely the ECB does have a point or two in commenting: (a) that at current Eurozone inflation rates, the 2% rate is a negative rate of real interest, hardly an encouraging signal to the world suggesting that all is well in the Eurozone, especially when the US Fed has been hiking its interest rate and (b) the current Eurozone inflation rate is still above the ECB’s target rate of 2%.

    Some national economies in the Eurozone – such as Spain – have a problem constraining inflation at prevailing interest rates. Is there not also (c) the looming problem of asset price bubbles – notably with house prices – developing in some Eurozone economies?

    Could it also be that the ECB wants to maintain pressure on governments in the major Eurozone economies to press ahead with market liberalisation measures?

  2. “that at current Eurozone inflation rates”

    This begs the whole issue doesn’t it bob, what does this harmonised rate actually mean? It actually applies to virtually no-one (maybe France?).

    “Some national economies in the Eurozone – such as Spain”

    Of course this – the impact of negative interest rates on asset prices in Spain – is a huge problem (Ireland too).

    “Could it also be that the ECB wants to maintain pressure on governments in the major Eurozone economies to press ahead with market liberalisation measures?”

    Yes, I’m sure this is true, but this way of doing things punishes Germany – which has been quite reforming and has a government seriously about to do more – rather than getting at the big culprits.

  3. Edward : “This begs the whole issue doesn’t it bob, what does this harmonised rate actually mean? It actually applies to virtually no-one (maybe France?).”

    The Harmonised Consumer Price Index purports to show what is happening to average prices across all Eurozone countries – separate Harmonised Indices cover EU15 and all EU25 countries.

    Of course, there are often arguments about how “truly” representative any price index, anywhere, is and the EU’s harmonised indices are no exception. But the really substantive issue in this context concerns the divergence of national inflation rates around the average for the Eurozone, or worse still, if some Eurozone countries are experiencing (possibly rising) inflation while others have broadly static or declining prices.

    Since the ECB’s rediscount rate must necessarily prevail across the whole monetary union of the Eurozone, a fundamental question is whether all the Eurozone countries have sufficiently similar rates of inflation to be able to cope with the loss of national monetary autonomy in a monetary union without experiencing unacceptable rates of inflation (or deflation) and unemployment. This boils down to questioning whether the Eurozone economies were sufficiently similar to justify the launch of European monetary union in 1999. As I’ve mentioned before a few times, in February 1998, more than 150 German academic economists felt impelled to write to the Financial Times calling for “for an ‘orderly postponement’ of economic and monetary union because economic conditions in Europe are ‘most unsuitable’ for the project to start. . . ”

    However, in additon to that, issues about the components of a stabilising monetary policy for the Eurozone compound. The ECB itself chose to adopt inflation targeting as its primary policy objective and set the target as maintaining the Eurozone’s Harmonised Price Index at less than an annual rate of 2%.

    The ECB wasn’t and isn’t obliged to adopt inflation targeting as its primary policy objective – indeed, by several press accounts, the ECB was at one time pressed to adopt monetary targets after the (hugely successful) fashion of the German Bundesbank instead of an inflation target.

    At various times, the ECB has also been pressed to fudge the inflation target by taking separate account of other indices as well – such as the Eurozone’s average unemployment rate or its real GDP growth or the gap between potential and actual output or the exchange rate between the Euro and the US Dollar. The obvious question is what is to happen if actual movements in many targeted indices increase the extent of the ECB’s policy dilemmas as to whether to raise, lower or maintain interest rates at any time?

    The prevailing professional paradigm for monetary policy is that to be most effective, monetary policy should aim to be coherent, consistent and predictable. That certainly won’t be the case if the ECB attempts to target a spread of indices thereby compounding the possibility of policy dilemmas.

    From recent press reports, what seems to have finally tipped the ECB into raising interest rates was data showing strong recent growth in the basic monetary supply of the Eurozone when the (average) Harmonised Price Index is still running at or above the ECB’s target of 2%. Evidently, the ECB’s worry is that the growth in the Eurozone’s monetary supply could finance an upsurge in inflation downstream unless reined back.

    I am prepared to be convinced about that and it is difficult to believe that the Eurozone economy is so fragile that it will be tipped over the edge into stagnation or worse by a hike in interest rates from 2% to 2.25%.

  4. There’s an article on monetary policy ‘Bratwurst and Sushi’ supporting the ECB decision (and cautioning against Japanese moves in the same direction) in the current Economist. Unfortunately, it’s premium content online. It does suggest that despite Trichet’s nationality, it is German concerns that are being addressed. I hope Edward will dissect it for us.

  5. In an article dated 14 July, The Economist was saying (subscription only):

    “Real interest rates in the euro area have been negative or near zero for most of the past two years, their lowest for more than 25 years. This suggests that policy is fairly loose, as does the growth in the M3 measure of money supply, which has exceeded the ECB’s desired range for four years running. The Fed may think that money no longer matters, but the ECB worries that this overhang of liquidity will eventually stimulate inflation or asset-price bubbles.”

    The article of 2 December, after the ECB’s decision to raise interest rate from 2% to 2.25%, is supportive rather than critical: “If euro-zone inflation stays well above target, the ECB will probably have to act again, no matter how much this upsets currency markets or politicians.”

    It goes on to remark that the Eurozone is hardly “an optimal currency area” as the business cycles of its constituent national economies are not aligned.

    In all, I find little if anything to disagree with in the analysis, which I only read after writing what I posted above.

    Cheers for The Economist.

  6. For what it’s worth, Dutch central bank governor Wellink yesterday pointed to house prices, telling Dutch television the strong price increases in the Netherlands were an ‘extreme situation’ that gave rise to the ‘wrong economic decisions’. ‘We would like to gradually make an end to this situation,’ he said.

  7. @ Bob

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

    Yep, this is what I mean in saying that your original point ‘begs the question’.

    “I am prepared to be convinced about that and it is difficult to believe that the Eurozone economy is so fragile that it will be tipped over the edge into stagnation or worse by a hike in interest rates from 2% to 2.25%”

    Two points here. Firstly I agree that 0.25% change is not earth shattering, the point is mopre the potential damage that can be done to the credibity of the central bank, and confidence in the economic recovery itself if your ‘easing cycle’ consists only in one measly quarter point. That may suggest the economiy is more fragile than it actually is.

    Secondly, the fact that the ECB always seems to be behind the curve. The US Fed has just ditched M· for the very good reason that it is not a reliable indicator, and *not* one on which you can base policy decisions.

    @ Nick

    I though the Dutch housing boom was over, 18 months or so ago, that they had had a ‘soft landing’, but (like the UK) subsequently economic growth had been slower.

    On housing generally, it is Spain and Ireland that have the problem, and which need country specific remedies, Germany certainly does not, and I don’t think Italy does. France could be an area of future concern. Probably if I was French I’d be in favour of a Fed-type ‘measured pace’. But then, we have the eurozone, and you can’t think like this. I don’t agree with the Economist, Germany and Japan’s problems are similar, and Germany needs ‘extra loose’ monetary conditions as far ahead as the eye can see.

    Italy is cuaght in the middle, the ‘risk premium’ charged to the italian government should be going up, but the private sector in Italy needs cheap money to restructure.

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

    Spain’s Economy minister is so proud of running zero deficit, he’s even willing to lower taxes. But he is doing nothing to adress high inflation rates or the runaway housing bubble.

  9. “But he is doing nothing to adress high inflation rates or the runaway housing bubble.”

    Yes Marina, I think you got the point. Solbes isn’t doing anything because effectively he can’t. That’s the eurozone system. You could add the huge balance of payments deficit to the list of things he can’t do anything about if you want :).

  10. Edward: “The US Fed has just ditched M· for the very good reason that it is not a reliable indicator, and *not* one on which you can base policy decisions.”

    Absolutely – but then I’m not a monetarist fetishist. As I recall well, the IMF officially wrote-off strict monetarism back in 1996 with this:

    “…instability of monetary demand, especially in the context of supply shocks and declines in potential output growth, complicated the task of monetary authorities. As a result, during the 1980s most central banks – with some notable exceptions – either abandoned or downplayed the role of monetary targets”.
    IMF World Economic Outlook, October 1996, page 106.

    But nostalgia for the great historic success of the Bundesbank in controlling inflation with the DMark has lingered on in the ECB which, like the Bundesbank, is also based in Frankfurt. That mattered when it came to staffing up the ECB and the old Bundesbank was much focused on maintaining monetary targets.

    All that said, I don’t really believe we can or should completely ignor such evidence of money supply data as is available – whether in the form of M· data, if it is collected, or changes in the volume of short term financial credit. The reasoning is straight forward: an upsurge inflation or asset price bubbles will be that much harder to control in a highly liquid economy.

    As I understand it, a basic prevailing problem with the effectiveness of Eurozone monetary policy is that the transmission mechanism from a change in interest rates by the ECB through to a resulting change in Eurozone aggregate monetary demand is much weaker than the equivalent transmission mechanism in Britain from a change in interest rates set by the Bank of England (BoE) through to a change in demand. That is largely because variable interest mortgages for home purchase are such an important component of household indebtedness in Britain compared with major Eurozone economies, whether relative to national monetary GDP or national household debt.

    The efect is that a change in interest rates set by the BoE has an almost immediate impact on the disposable monthly income of households buying houses on mortgage – perhaps about a half of all home owners in Britain. Changing interest rates in Britain is a more powerful lever compared with the Eurozone – but even then the BoE reckons it takes at least two years downstream for the full effects on domestic demand to work through.

    Those who follow this and the implications carefully, came to recognise that this was and is a powerful motive for Britain to remain outside the Eurozone and one likely to apply for decades pending convergence of home purchase financing institutions. Current commentary by major mortgage lenders in Britain has suggested that average house prices are rising again here and that is when the BoE has recently cut its interest rate to 4.5%. What do you suppose would be happening to house prices here had Britain joined the Euro and central bank interest rates were 2% or 2.25%?

  11. This paper by ECB officials, amongst others, on: The role of money in monetary policy making, may be of interest.

    From the abstract:

    “It is argued that money can act as a useful information variable in a world in which a number of indicators are imperfectly observed. In this context, the paper discusses the role of a reference value or benchmark for money growth in episodes of heightened financial uncertainty. A reference value for money growth can also act as an anchor for expectations and policy decisions to prevent divergent dynamics, such as the spiralling of the economy into a liquidity trap, which can occur
    under simple interest rate rules for policy conduct.”

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

    some observations:

    1) FT (and many of the commentators in the above) focus solely on changes of the interest rate. (As if the level does not matter).

    2) Because of higher inflation, the real interest rate is lower than, say, a year ago.

    Given 1), FT can only like 2) if euro zone indicators have worsened during last year.


    3) most indicators for the real economy are better than last year.

    So tell me, why is a modest hike ‘the most bizarre monetary policy decision of recent times’??

  13. mister ed…if you will sir

    what is your view of the E zone so far ???

    are its national parties
    all better off
    if its a mixed bag
    how badly mixed ????

    would u want a mulligan ????

  14. After stirring the Eurozone entrails and reading the tea leaves, the OECD was recently impelled to draw rather bleak conclusions:

    “The eurozone is facing decades of decline with long-run growth dropping to just 1pc a year unless it embarks on root and branch reforms, according to a report yesterday by the Organisation for Economic Cooperation and Development. . .”

  15. If the United States had an unemployment rate as high as Germany’s and the Fed raised interest rates, the Fed would lose its independence P.D.Q.

  16. If the ECB is using tight monetary policy to try to force governments to move ahead with liberalization, this constutes an unacceptable misuse of monetary policy to promote a partisan political agenda. Such meddling by unelected officials in the politcal affairs of countries is a total violation of democratic principles and cannot be tolerated.

  17. “what is your view of the E zone so far ???”

    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:

    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:

  18. Captain Video, you have stepped into very deep issues, perhaps unwittingly.

    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.

  19. The US rate hikes were probably put in place to help out the bond auction and monetize the debt, while foreign interest in US paper is flagging a bit. This encouraged Fed Gov Fisher to make a statement about the subject. The Fed is probably divided on the issue, but the rate hike wars have begun, the US vs ECB, to compete for these investment dollars. The opposite is occuring in Asia, where the currencies will probably go lower to make their products more competitive. As these worlds pull farther apart the risk is that something will snap. The American consumer is indefatigable, and can only be stopped from buying when new products fail to make it to the shelf. This plan should address the concern that particularily in China, where margins are thin, that production might be cut back. There is more than a hint of desperation in the Fed move, because the US government debt has to be serviced, or faith in this system will turn south. LIkewise there is this idea that gold is overtaking the fiat currency, and this must be stopped also, which requires rate hikes to put the dollar back on track. The move is also set to target asset inflation, in home prices, before it creeps into the overall numbers. Thank goodness for Global Warming, who needs heating oil? So there are several reasons for the rate hikes, and none of them have to do with the strength of the economy, which is an almost entirely monetary phenomona.

  20. In making comparisons with the US isn’t it important to separate out all the many factors that are specific to the US and have been so significant in recent years (level of immigration, de-facto reserve currency role, dollar bills in the world’s black economy, and the ability to run deficits like nobody else) from the argument about central bank roles and convergence.?

    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?

  21. “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.? ”

    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)

  22. “Bayoumi and Eichengreen (1993, p. 223) conclude that “. . . our finding that supply shocks are larger in magnitude and less correlated across regions in Europe than in the United States underscores the possibility that the European Community may find it more difficult, initially, to operate a monetary union than the United States.’’

    quoted by Roisland and Torvik: Optimum Currency Areas Under Inflation Targeting

    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:

  23. 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.

    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.

  24. 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.

  25. Captain Video: “That’s fine for economics textbooks, but the proof of the pudding is in the eating.”

    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.

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