Monetary policy in Europe - Quo Vadis?
Speech by Willem F. Duisenberg President of the European Monetary Institute London, 27 November 1997
Ladies and Gentlemen, we are in a fortunate position in Europe. We have been able to prepare a new monetary regime for Europe at a time when a consensus about the role of monetary policy exists among central bankers and the large majority of politicians and academics. We are thus able to shape the new institutions accordingly.
Let me first explain what I mean by the current consensus about the role of monetary policy among macroeconomists. Second, having established the state of the art (and it is certainly still true that central banking is more of an art than a science), I shall briefly describe my vision of how monetary policy could ideally be run in Europe, while illustrating my view that the structure of the ESCB and its operating procedures are in line with these standards, and may thus be able to transform that vision into reality.
A consensus in monetary policy
The views expressed in the following statements would nowadays be shared by a large majority of economists:
1 Monetary policy cannot influence the growth rate of the economy by having an effect on aggregate demand in the long run. Economic growth depends on the productivity and the supply of factors of production such as labour and capital. No central bank in the world is able to increase its country's growth rate permanently by printing money or even by reducing the nominal interest rate to zero. The reason being that any excess demand over the production of goods and services will sooner or later be reflected in inflation. Persistent inflation is always a monetary phenomenon. Although monetary policy action can exert a temporary influence on the level of real economic activity - due particularly to sluggish adjustment of wages and prices. An "activist" monetary policy though aimed at boosting growth without due regard for price stability will merely cause inflation.
2 Expectations of market participants such as trade unions and employers are of crucial importance for the effect of any policy measure, and the expected reaction pattern of the central bank affects current decisions by the private sector. Let me give you an example. If the central bank is known to react to excessive wage demands by raising interest rates, thereby stabilising prices and temporarily reducing output, instead of by lowering rates to dampen the burden on firms affected by the wage shock, excessive wage demands may not occur in the first place. Thus, if the goal of price stability is evident and credible, stable monetary policy will become much easier to implement.
3 High inflation hampers economic growth. High and volatile inflation imposes substantial economic costs, such as those arising from increased uncertainty about the outcome of investment decisions and profitability, the distortionary effects on the tax system, rising risk premia in long-term interest rates and the reduced allocative effectiveness of the price and market system. In addition, social costs arise because the weaker members of society have more difficulty in protecting themselves against the adverse effects of inflation. There is agreement that inflation should be low, but no full consensus on what that exactly means in quantitative terms. Many of my European colleagues and myself would put the level at between 0 and 2%. Some others would envisage a somewhat wider range.
Implications for European monetary policy
On the basis of these views, the implications for a price stability oriented monetary policy in Europe are clear, and can be articulated as follows:
(i) given the desirability of low inflation, and since persistent inflation is always a monetary phenomenon, it follows that a central bank's goal should be price stability;
(ii) in pursuing the goal of price stability monetary policy may contribute to smoothing the level of economic activity in the short run, if inflationary pressures tend to follow a cyclical pattern. It should be noted that the success of such action depends crucially on the credibility of monetary policy;
(iii) it goes without saying that monetary policy and fiscal policy should be well aligned as an adverse policy mix would imply placing an excessive burden on monetary policy;
(iv) the importance of conditioning expectations and thus establishing the credibility of the central bank's anti-inflationary stance requires independent central banking. A monetary authority should be able to act free of political pressure, and according to transparent policy rules which should also be communicated to the public. A rule which aims at stabilising prices - either via a direct inflation target or a money supply target - will smoothen the business cycle and allow the economy to grow at its potential growth rate;
Some of the past mistakes and deficiencies of monetary policy which have contributed over time to the emergence of the consensus I have just described have stemmed from a lack of independence. This has included attempts to use monetary policy for fiscal purposes (such as trying to reduce the real debt burden by surprise inflation) and the many unsuccessful attempts to boost growth through inflation, ignoring the effects on market expectations. A central bank which abandons its price stability target for a transitory gain in economic activity only contributes to higher average inflation. A central bank which has been susceptible to public pressure usually hits the brakes too late, too hard and, I might add, with unnecessarily heavy wear and tear on the "tyres" - aggravating the volatility of the business cycle rather than smoothing it out. I say this despite some proposals (Joseph Stiglitz, chief economist of the World Bank) claiming that "we should not follow a policy of pre-emptive strikes, but rather one of cautious expansionism" with which I disagree. This kind of strategy would mean in case of doubt letting the central bank err on the side of being too expansionary. The argument is that the costs of a minor increase in average inflation will be more than compensated by gains in employment. In my opinion, this argument again neglects the effect of market expectations. When people realise the systematic bias in the central banks monetary policy rule, there will be no output gain attached to the undoubtedly higher inflation rate. Nevertheless, there are costs involved. Even starting from low levels, higher inflation means higher volatility, which will then be reflected in higher risk premia and thus higher real interest rates - and eventually lower growth rates.
The future ESCB
If we cast an eye over the structure of the future European System of Central Banks (ESCB) the impression we get is that lessons have been learned and economic theory applied in the best possible manner. Maintaining price stability will be the ESCB's primary responsibility. Without prejudice to this primary objective of price stability, the ESCB will support the general economic policies in the European Union. The Maastricht Treaty assigns independence to the ESCB for the purpose of carrying out its mandate. With regard to monetary strategy, monetary and inflation targeting are seen as the two benchmarks on the basis of which the ESCB's strategy in Stage Three will be selected. The credibility of its monetary policy is further supported by the budgetary provisions of the Treaty, which oblige Member States to avoid excessive budget deficits. The Stability and Growth Pact clearly defines the exceptional circumstances under which excessive deficits are allowed and provides for a procedure which will ensure that excessive deficits are swiftly corrected, should they nevertheless arise, thus protecting the euro area against an unfavourable policy mix. The ESCB is prohibited from financing government debt. Thus the ESCB is relieved of any possible pressure to accommodate public debt by means of an expansionary monetary policy, which could otherwise have been interpreted as a constraint on its independence.
I would like to conclude by stating that the essence of good monetary policy is good institutional design. Apparently, lessons have been learned and principles have been applied successfully. Europe has the opportunity to bring what has at times been a tumultuous chapter in its monetary history to a close. It should seize that opportunity and enjoy the benefits that sustained price stability will bring. The task ahead is to broaden and deepen the public's understanding of and support for the strategy and tactics of monetary policy and to lock in credibility for achieving low inflation, stable growth and lasting employment creation.