Central bank battle lines are drawn


It is a sobering thought that Kenneth Clarke's extension of the inflation target beyond the end of the current parliament will have a lifespan of less than two years if, as the Chancellor would wish, Britain participates in European economic and monetary union. The next election is generally expected to be in spring 1997, and if the EMU goes ahead on time, the European Central Bank (ECB) will be operating by the start of 1999.

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.

On the last day of campaigning before the polling booths open, the SNP leader has written to voters in a final attempt to convince them to vote for independence
scotland decidesIs a huge gamble on oil keeping the First Minister up at night?
Arts and Entertainment
Rosalind Buckland, the inspiration for Cider with Rosie died this week
booksBut what is it like to be the person who inspires a classic work of art?
Life and Style
techApple has just launched its latest mobile operating software – so what should you do first?
A male driver reverses his Vauxhall Astra from a tow truck
newsThe 'extremely dangerous' attempt to avoid being impounded has been heavily criticised
Arts and Entertainment
Lionel Messi in action for Barcelona
filmSo what makes the little man tick?
Arts and Entertainment
tvReview: An undercooked end (spoiler alert)
ebooksAn unforgettable anthology of contemporary reportage
Arts and Entertainment
Pharrell dismissed the controversy surrounding
musicThe singer said 'the last thing I want to do is degrade'
Cesc Fabregas celebrates his first Chelsea goal
footballChelsea vs Schalke match report
Arts and Entertainment
Toby Jones (left) and Mackenzie Crook in BBC4’s new comedy The Detectorists
tvMackenzie Crook's 'Detectorists' makes the hobby look 'dysfunctional', they say
Life and Style

Olympic diver has made his modelling debut for Adidas

Latest stories from i100
Have you tried new the Independent Digital Edition apps?
Independent Dating

By clicking 'Search' you
are agreeing to our
Terms of Use.

iJobs Job Widget
iJobs Money & Business

Trainee Recruitment Consultant Birmingham

£18000 - £23000 per annum + Comission: SThree: The SThree group is a world lea...

Trainee Recruitment Consultant - Birmingham - Real Staffing

£18000 - £23000 per annum + Commission: SThree: Real Staffing are currently lo...

Recruitment Consultant - Soho - IT, Pharma, Public Sector

£20000 - £25000 per annum + OTE £35,000 first year: SThree: The SThree group i...

Sales Executive

£20 - 24k (Uncapped Commission - £35k Year 1 OTE): Guru Careers: We are seekin...

Day In a Page

Mystery of the Ground Zero wedding photo

A shot in the dark

Mystery of the wedding photo from Ground Zero
His life, the universe and everything

His life, the universe and everything

New biography sheds light on comic genius of Douglas Adams
Save us from small screen superheroes

Save us from small screen superheroes

Shows like Agents of S.H.I.E.L.D are little more than marketing tools
Reach for the skies

Reach for the skies

From pools to football pitches, rooftop living is looking up
These are the 12 best hotel spas in the UK

12 best hotel spas in the UK

Some hotels go all out on facilities; others stand out for the sheer quality of treatments
These Iranian-controlled Shia militias used to specialise in killing American soldiers. Now they are fighting Isis, backed up by US airstrikes

Widespread fear of Isis is producing strange bedfellows

Iranian-controlled Shia militias that used to kill American soldiers are now fighting Isis, helped by US airstrikes
Topshop goes part Athena poster, part last spring Prada

Topshop goes part Athena poster, part last spring Prada

Shoppers don't come to Topshop for the unique
How to make a Lego masterpiece

How to make a Lego masterpiece

Toy breaks out of the nursery and heads for the gallery
Meet the ‘Endies’ – city dwellers who are too poor to have fun

Meet the ‘Endies’ – city dwellers who are too poor to have fun

Urbanites are cursed with an acronym pointing to Employed but No Disposable Income or Savings
Paisley’s decision to make peace with IRA enemies might remind the Arabs of Sadat

Ian Paisley’s decision to make peace with his IRA enemies

His Save Ulster from Sodomy campaign would surely have been supported by many a Sunni imam
'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

'She was a singer, a superstar, an addict, but to me, her mother, she is simply Amy'

Exclusive extract from Janis Winehouse's poignant new memoir
Is this the role to win Cumberbatch an Oscar?

Is this the role to win Cumberbatch an Oscar?

The Imitation Game, film review
England and Roy Hodgson take a joint step towards redemption in Basel

England and Hodgson take a joint step towards redemption

Welbeck double puts England on the road to Euro 2016
Relatives fight over Vivian Maier’s rare photos

Relatives fight over Vivian Maier’s rare photos

Pictures removed from public view as courts decide ownership
‘Fashion has to be fun. It’s a big business, not a cure for cancer’

‘Fashion has to be fun. It’s a big business, not a cure for cancer’

Donatella Versace at New York Fashion Week