Central bank battle lines are drawn
Thursday 15 June 1995
The Chancellor's case for opting in was set out by proxy last week through the report organised by the Action Centre for Europe, the pro-European pressure group on whose governing council he sits. The Kingsdown inquiry essentially made a political rather than an economic case. If Britain opts out, it will lose the influence to mould the monetary union on our terms and will be forced to join a system constructed without our interests in mind.
There could be hardly any more significant aspect to the construction of EMU than the actual policy the ECB decides to adopt. Will it adopt Britain's regime of inflation targeting? Or will it adopt the monetarist regime that the German Bundesbank still claims to operate?
At a conference of central bankers and leading economists on these questions last week, the gaping holes in the construction of EMU were there for all to see - and thus the opportunity, in theory, for Britain to do some building of its own. However, the battle lines were also already drawn to a startling extent. The event, organised by the Centre for Economic Policy Research and the Irving Fisher Society, divided on German/Anglo- Saxon lines.
Otmar Issing, chief economist of the Bundesbank, argued that the German strategy of targeting money was successful and should be transferred to the ECB. Inflation targeting was "a second-best solution".
Mervyn King, chief economist of the Bank of England, accepted that the countries that had adopted inflation targeting were "aspiring to the premier league of central banks". But the regime had clear merits. It crystallised the commitment to price stability, helping to keep governments "on the straight and narrow".
Underlying the UK position is the failure of monetarism to deliver when given the chance in the first term of the Thatcher government. The misbehaviour of sterling M3, the principal target, as a consequence of deregulation and financial innovation, seriously misled Margaret Thatcher and Geoffrey Howe. The unintentionally savage monetary squeeze that resulted in the first two years of office had grievous effects on the economy. No wonder Nigel Lawson eventually junked monetarism in his Mansion House speech in 1985, 10 years ago.
Of late the German control target has been similarly misbehaving - first overshooting in the early 1990s and then undershooting more recently. The Bundesbank's commitment to monetarism is now regarded by the markets with considerable scepticism, as a useful alibi for whatever it chooses to do.
If monetarism is now on its knees in Germany as well as in so many other parts of the world, the Bundesbank can still make it work because of its reputation. Credibility is an overworked concept, but few would deny that if any central bank commands that reputation, it is the Bundesbank. No one doubts its commitment to low inflation and its determination to get its way.
A European Central Bank would, however, be starting from scratch. It would therefore come under pressure to operate a monetarist discipline rigidly, particularly from Germans anxious that they are being forced into a Gresham's Law exchange of a good monetary policy for a bad one.
However, the application of an inflexible monetarist discipline to Europe could be disastrous. No one knows what the European-wide demand for money will be in the context of monetary union. The ECB will be aggregating money supplies across diverse European countries, all of which reflect widely differing financial structures and attitudes to holding money.
Furthermore, the very onset of monetary union is likely to bring about unforeseen changes in the demand for money. lt is likely to lead to a huge shake-up in European financial systems that will upset all the monetarist equations. The very problem that threw a spanner into the monetarist works in Britain and the USA in the early 1980s - an unheralded change in the demand for money - could then manifest itself on a European scale.
What that could mean would be an uncalled-for recession. Indeed recession, whatever its causes, was bound to lead to a questioning of the legitimacy of the ECB by "politicians who will campaign for exit", Mervyn King warned. No prizes for guessing whom he might have had in mind in the context of Britain.
Would inflation targeting be any more satisfactory? Its advocates at the conference had to accept that the regime had not really been tested, whether in the UK or in other countries like New Zealand, Canada and Sweden that had set inflation goals. For the most part, inflation targets had been introduced at a time of deep recession, so the real test was yet to come as recoveries matured .
By the time the ECB starts operating, we will know better if inflation targeting can pass that test. But for all the willingness to debate the issue, few attending the conference - held, revealingly, outside Frankfurt - could be in any doubt of the German commitment to endowing a European bank with the Bundesbank's approach. What that almost certainly means is that the ECB will be set up on monetarist principles.
The Kingsdown inquiry held out the prospect of being able to influence the process of monetary union, if Britain opts in. That is almost certainly a false prospectus. The reality is that our capacity to influence thestructure of the ECB is limited by the nature of the bargain struck over EMU. The Germans are being asked to make the real sacrifice, giving up the mighty mark. So they hold all the cards.
The danger is that EMU is being foisted on a largely reluctant German public by politicians still in thrall to old fears about the danger of an unshackled Germany. The ECB will therefore have to be more German than German. This could prove highly dangerous if it embraced monetarism. As Frederic Mishkin, chief economist of the Federal Bank of New York, said: "Fanaticism about monetary targeting would be a terrible mistake for a central bank being set up from scratch."
The Kingsdown inquiry described EMU as "a leap in the dark". As we learn more about the likely policies of the ECB, that looks like an understatement.
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