Some reflections on handling monetary policy in a global environment
Prof. Otmar Issing, Member of the Executive Board of the European Central Bank, International Research Forum on Monetary Policy, Frankfurt, 5 July 2002.
I would like to start by congratulating the organizers of the International Research Forum on Monetary Policy who have managed to gather an interesting set of papers to this conference. A common theme of these papers is that they discuss the international dimensions of monetary policy. This is a topic of particular relevance for all central banks, and I would like to take this opportunity to express my views on these matters.
First, I will discuss some aspects of the economic linkages among the regions of the world. Second, I will mention some recent ideas about monetary policy co-ordination, a topic that has gained attention among academics particularly after the introduction of the euro. I will then address some practical issues of such co-operation, in "normal" and in "crisis" circumstances, and discuss the meaning of global responsibility, as I interpret it. My main message will be that although there are important linkages in the world economy, I do think that monetary policy in normal circumstances could not – and should not – be explicitly coordinated at the international level.
2. Economic Linkages
With the creation of the monetary union, several open economies transformed into the euro area, a big relatively closed economy with characteristics similar to those of the US. More than 300 million people live in it, compared to 275 in the US. The degree of openness as measured by the ratio of exports to GDP fell from an average of around 35% in the pre-EMU countries to 15%, reflecting the high degree of trade between countries within the euro area. For the US, the figure is slightly lower at 11%, but imports are comparable in both regions at 15%. Even so, we are not living on separate islands but there is interdependence in various dimensions between our economies and this will of course have an impact on how economic policy is conducted.
Trade of goods and services is of course the most tangible link between our economies. It is an important and direct determinant of economic activity both on the demand and supply side, and enhances our common welfare by allowing for international specialization. The interaction between interest rates, exchange rate dynamics and trade is complex, and time constraints prevent me from addressing it in detail. From the viewpoint of my argument, I wish to stress that it is important for any central bank to monitor the developments in foreign economies and markets in order to assess the economic outlook and risks to price stability in the domestic economy.
Financial markets play an increasingly important role in the international transmission channel. Here, two complementary effects can be identified. First, there is a substantial degree of cross-border ownership that immediately transfers the effect of changes in market value in one region to other regions of the world. For example, the downturn of the US equity markets had direct wealth effects for euro area residents owning US stocks (who of course also gained in the preceding upturn). This effect has recently increased in importance, due to the doubling of holdings of foreign assets that occurred during the last two decades. Furthermore, there seems to be a large correlation between returns on equity markets around the world, especially in times of declines in stock prices. Economic theory implies that deepening of financial markets would lead the way towards greater "consumption risk sharing" which in principle is a good thing. Although, due to the large correlation, the additional gains from diversification need not be big.
The IMF recently emphasized a "confidence channel" as a further element of linkage. The idea is that large country-specific shocks, such as September 11, can transmit to the rest of the world through heightened perception of uncertainty. For example, both consumer and business confidence dropped simultaneously across the major economies shortly after the WTC-attack. This idea might also have relevant consequences for savings decisions of households. For example, if households experience large negative losses in one market this might drive them towards reducing their holdings of risky assets also in other markets due to increased risk aversion.
Another type of linkage is related to the extent that the global economy is driven by common shocks. The obvious example relevant for the last three decades is of course oil price shocks. Although the western economies reduced their dependence on oil in response to the first oil price shocks, the oil price remains an important source of economic uncertainty. Very recently, the world experienced another global shock in the unprecedented rise and subsequent fall of ICT related companies. This episode was probably harmful for the development of capital markets by hurting confidence among households. The question is what implications such events have for monetary policy. I am afraid central bankers cannot do much and especially they must not loose sight of their primary goal – i.e. maintaining the focus on medium-term price stability. This is the contribution the central bank can make to help foster a smoother flow of capital to business investment which in turn promotes a stable long-term productivity growth, the importance of which Governor Gramlich stressed in a recent speech.
At the ECB, we monitor the developments in global markets just mentioned in order to identify risks to the economic outlook and to price stability. Of course, we are not alone in doing so, but rather in quite good company! For example, by examining in a simple way the press statements that supplements the interest rate decisions of the FOMC for the latest interest rate cycle, out of the 17 policy changes, 6 were partially motivated by external conditions. Closer to home, the Bank of England almost always give a direct reference to the external outlook when motivating policy changes. Of course, Great Britain is more open than the euro area since her exports to the euro area neighbors (around 50%) still goes through a currency exchange. Finally, the Bank of Japan regularly describes foreign developments and there are plenty of references in the policy discussions. To conclude, all the major central banks follow carefully the world economic developments. This can be labeled "awareness", in the sense that even though policy is conducted exclusively towards achieving domestic goals, proper account is taken of how the domestic economy is affected by the global environment. Whether monetary policies should be explicitly coordinated is an altogether different question. President Duisenberg briefly elaborated on this question in his introductory statement this morning. I will expand on this issue in a moment, but let me first make a very brief detour to take stock of some important ideas that have emerged in the recent academic debate.
3. Policy co-ordination: recent ideas
The issue of monetary policy co-ordination has been at the center of discussion for decades if not centuries – the gold standard and the role of London and the Pound Sterling as an example. From more recent academic literature, we can find interesting approaches in the ongoing discussion. As always - which is stimulating - conflicting views on this issue can be found. Canzoneri and Henderson (1988) - both co-organizers of today's event - emphasized that the uncoordinated response to a common shock may be overly contractionary. The reason is that each central bank would try in vain to appreciate its currency in order to reduce import-price inflation (the beggar-thy-neighbor type of policy), suggesting a role for concerted monetary policy actions. However, these results are challenged in recent work by Obstfeld and Rogoff (1995), (2000), who provide a micro-founded analysis which allow them to consistently quantify the welfare-gains of internalizing spillovers, claiming that the likely gain from such coordinated policy is small, if not zero. Other authors have argued that this result may not be robust, as it is sensitive to assumptions regarding which currency exporter firms use when they set their prices. Such tension is also present in the papers presented at this conference. For example, Sutherland (2002) finds that the gain from co-ordination is dependent on the degree of risk sharing (with largest gain when there is full risk sharing).
Moreover, other contributions in the literature have examined model uncertainty finding that this typically reduces the scope for policy co-ordination.
The conclusive message of this literature has not yet been written, as research is still very much in the making. But, unfortunately, policy makers cannot sit back and wait for this answer. My sense of the state of the debate is that the most recent work has moved in the direction of shedding doubts on the earlier and more optimistic views concerning the benefits of systematic monetary policy co-ordination among large currency blocks (such as the US and the euro area). The benefits are far from clear, and there are risks, on which I shall comment in a minute. In recent times the "burden of the proof", I would say, has shifted from the camp of those arguing against to that of those arguing in favour of such co-ordination.
4. Practical aspects of policy co-ordination
I hinted above at some potential gains from co-ordination, as seen by recent academic research. But there are other elements, of more practical - or should I rather say "political economy" - nature, that are hard to incorporate in models but nonetheless crucial for policymakers.
Attempts to co-ordinate monetary policies internationally would have consequences for the incentives that policymakers are subject to and also (quite independently) for the public's perception of these incentives. The difficulty of agreeing and implementing co-ordinated policy plans is a first aspect of this problem. The second one regards the difficulty of holding policy makers effectively accountable at the domestic level if their policy actions are based on considerations going beyond the mandate that they have been assigned. Policy co-ordination may also distort the incentives facing individual policy makers, if policymakers in other countries are made partly responsible for attaining their own objectives rather than addressing policy challenges at home in their own domain of responsibility. Conversely, adverse policy outcomes could in such circumstances be blamed on the co-ordinated policy thus diluting a clear assignment of responsibilities, which is the precondition for effective policy incentives and accountability. The policy accountability framework would be distorted as a result.
Taking proper account of these qualifiers for the scope of co-ordination, my conclusion is that we can not draw any general lessons from the recent experiences, such as the co-ordinated response of the Fed and the ECB to the September events. I do not, therefore, expect concerted policy actions among central banks to become more frequent in the future, especially not when normal circumstances prevail. Such joint actions will be - and will have to remain - restricted to truly exceptional circumstances and extreme events. In addition, any such concerted action must be consistent with the mandate – the ultimate objective – of monetary policy. This raises a further difficulty when thinking about co-ordination, in that different central banks have different mandates, which could make it harder to reach common policy conclusions. In particular, in the case of the ECB, even in exceptional circumstances monetary policy must always remain clearly focused on its primary objective of maintaining price stability in the domestic economy. What may differ in such circumstances, however, is the time profile of the appropriate policy actions best serving that objective and the degree of co-operation among central banks in coming to a common understanding of the situation in the case of an emergency.
Without doubt, central banks - and monetary policy in particular - can make an important contribution to limiting the economic consequences that an extreme event like the September terrorist attacks may engender. However, apart from the immediate tasks of central banks in terms of ensuring the continued functioning of markets and of payments systems in emergency situations, the main contribution of central banks remains what it always is: the maintenance of price stability, i.e. safeguarding the value of money, over the medium term. Asking monetary policy to do more or to serve other purposes risks creating illusions about what monetary policy can do. As it has been aptly put by the Governor of the Bank of England, Eddie George, in a recent speech in Frankfurt: "It is important that the limitations of monetary policy - what it can and what in can't hope to achieve - are clearly understood. Otherwise expectations are likely to be disappointed, and disappointed expectations may lead to building pressure for alternative policy actions, which may not in the event be in our longer-term economic interest."
To my mind this note of caution also applies - perhaps with particular force - in the wake of a dramatic event and a situation characterised by high uncertainty. Then it becomes more - not less - important that monetary policy stays the course and provides a reliable anchor for expectations of the future. The first, and foremost, contribution of monetary policy in all situations is to avoid itself becoming a source of additional uncertainty. This means, in particular, that one must avoid creating any ambiguity as to the central bank's objectives and policy framework in such circumstances.
To conclude, my policy experience over the years leads me to believe that desirable economic outcomes - at the domestic as well as the global level - tend to be the natural result of independent decisions in most circumstances. If individual countries and currency areas are successful in pursuing sustainable non-inflationary growth at the domestic level this will - by itself - make an important contribution to non-inflationary growth and balanced developments at the global level. In most circumstances appropriate domestic policy objectives and a realistic notion of shared responsibility for the global economy tend to coincide. Indeed, in the case of the US it can be argued that economic policy has always been conducted, and rightly so, with a clear focus on domestic objectives. When doing this successfully the US has also made a significant contribution to growth and stability at the global level. The same logic applies to the euro area.