Stephen King: Bernanke vs Trichet... Who's your money on?

The Federal Reserve is keen to move away from the risk management approach
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The Independent Online

Other than boxing, we seem over the past few days to have been staring at an increasingly disunited world. Evander Holyfield, the 44-year-old former champ, has embarked on a comeback trail that he hopes will lead to him winning the undisputed world heavyweight championship some time next year. Whether he is wise, at his age and with his wealth, to pursue such a dream is another matter altogether but, nevertheless, he is, at least, able to dream.

Elsewhere, dreams of a united world are becoming increasingly difficult to conjure up. We have the Disunited States of America, where the US Republican administration will have to get used to living with a Congress controlled by Democrats. At this stage, it's difficult to know what to make of the Democrats' victory. People appeared to be voting more against the Republicans than for the Democrats and, hence, the Democrats' mandate is a little unclear: an anti-sleaze, anti-war-in-Iraq and anti-Bush victory is all very well, but it is not obviously pro-anything.

Many Democrats have spoken of a more "pro-American" policy that attacks aspects of globalisation. To the extent that any of this filters through into policy, China-bashing may become a more frequent occurrence, alongside attempts to keep American businesses at home and, for that matter, out of foreign hands. The Doha round of trade talks may become even more difficult to resurrect and, at the same time, President Bush may, next summer, lose his "fast-track" negotiating rights with other trading nations. It is, though, very early days so much of this may prove to be no more than idle speculation.

Disunity this week has not, though, been confined to the bipartisan world of the American political system. Remarkably enough, the world's most powerful monetary mandarins have also been engaged in a bit of a punch-up. I'm not suggesting that Ben Bernanke, the chairman of the US Federal Reserve, has landed an upper cut on the chin of Jean-Claude Trichet, the president of the European Central Bank (ECB), but there's certainly a disagreement brewing away.

All was revealed at the fourth ECB conference on "The Role of Money and Monetary Policy in the 21st Century" (something of a grand title given the extraordinary changes in approach to monetary policy from decade to decade throughout the 20th century.)

In essence, the disagreement revolves around the sorts of things a central bank needs to look at and control in order to ensure continuing economic stability. Specifically, M. Trichet thinks money supply has an important role to play whereas Mr Bernanke thinks money supply is next to useless when it comes to interest rate decisions.

Perhaps this is a harsh caricature of the scale of the disagreement. Nevertheless, it captures something about the fundamental beliefs held at the Federal Reserve and the European Central Bank. For the Federal Reserve, money supply is no longer useful, largely because of the impact of persistent financial innovation.

Ben Bernanke may well sign up to Milton Friedman's famous dictum that "inflation is always and everywhere a monetary phenomenon", but Mr Bernanke doesn't think this is enough. One might as well argue that, when driving a car, "speed is always and everywhere a petrol phenomenon", but knowing how much petrol is being used won't, in itself, be sufficient to work out how fast the car is going: size and weight - of both car and driver - also matter, as do prevailing traffic conditions, speed limits and the degree to which the driver is a crazed petrolhead.

As Mr Bernanke observed last week, "the rapid pace of financial innovation in the United States has been an important reason for the instability of the relationships between monetary aggregates and other macroeconomic variables".

Does this mean that the European Central Bank's - and, for that matter, the Bank of England's - dalliances with money supply are pointless? I don't think so. In his concluding remarks at the conference, Mr Trichet found "compelling the argument that monetary analysis be used to monitor (and possibly offset) macroeconomic risks which are not related to price stability at shorter horizons, but which may nevertheless have important consequences for maintaining price stability over the medium and long run, like risks to financial stability".

These comments reveal a disagreement about the role of monetary policy that goes back over almost a century. Mr Bernanke's view is based on the idea that monetary policy should be used primarily to control inflation and that, because the linkage between money supply and inflation is weak, money supply can play only a small role.

Mr Trichet's view is a bit more complex. Money supply might eventually have some ill-defined impact on inflation but, in the short-term, its importance lies more in its influence on financial variables - house prices, equity prices, levels of debt - that may, or may not, have a longer-run impact on inflation but which can still trigger waves of economic instability.

Both views stem from economic developments in the 1920s and 1930s. For Mr Bernanke, the 1929 Wall Street crash was bad enough, but the mistakes that followed were even worse: interest rates didn't fall far enough, insufficient liquidity was provided and politicians really messed things up with the Smoot-Hawley tariff.

For M. Trichet, an earlier tightening of monetary policy, designed to prevent the stock market from rising so giddily in the late-1920s, would have lowered the chances of policy mistakes from arising in the first place.

In both cases, there's a recognition that markets get it wrong. For M. Trichet, markets can be overly-exuberant: for Mr Bernanke, markets can be overly-depressed. But their views differ on the role central banks should play under these circumstances.

This is more than just a historical debate. Both the ECB and the Bank of England have suffered increasing doubts about the inflation-targeting approach in recent years. They're not sure how best to measure inflation when there are persistent relative price shocks associated with globalisation so, for them, a separate measure of monetary laxity or tightness is a desirable thing: in the absence of other alternatives, money supply seems like an attractive option.

The Federal Reserve is keen to move away from the risk-management approach favoured by Alan Greenspan, a system which was always in danger of turning into a personality cult. But, with the Fed having disowned money supply in recent years, the only other available option seems to be some form of inflation-targeting regime, even if globalisation is threatening the stability of this kind of approach (ironically, the rejection of money supply is, itself, a reflection of problems with globalisation, specifically the Federal Reserve's concerns about offshore holdings of the dollar).

Which approach is more likely to succeed? All monetary regimes seem, eventually, to come unstuck, hence the constantly changing approach of central banks over the past 100 years. The resurrection of money supply seems a bit like a throwback to times past. Many would argue this is not a good thing. The ECB, though, takes comfort in money supply, recognising that its control was, at least mythically, a central plank in Bundesbank policy over the years.

Abandoning money supply altogether might, within European circles, be seen as sending "the wrong message". But to claim that inflation-targeting is anything new would also be stretching history a little too far: inflation-targeting is not so different from the old gold standard and, given the ups and downs of interest rates in recent times, is increasingly looking like the "stop-go" policies of the 1960s.

Still, despite the disunity, at least there's a healthy debate. And, at the end of the day, disunity or otherwise, I expect our central banks to have more success with monetary policy than Mr Holyfield will have in his unified boxing ring.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

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