Stephen King: High priests of orthodoxy at the ECB need not fear straying from the ancient texts of monetarism

ECB members might wear hair shirts as a reminder they have a serious job to do
Click to follow
The Independent Online

Members of the ECB are the high priests of monetary orthodoxy. They do not like to give in to temptation. It's almost as if they chose to be located in Kaiserstrasse to demonstrate that they are of both strong mind and character. They may be faced with numerous temptations of both the monetary and, for all I know, the more sordid kind, but at no point are they likely to buckle. They are steadfast in their adherence to monetary conservatism. Given half a chance, they might choose to wear hair shirts to remind themselves constantly that they have a serious job to do. No taking risks with inflation, or, indeed, with the red-light district. You can trust the ECB's members: they will not yield to temptation.

Monetary orthodoxy can be described in a variety of ways, but for the ECB, there are two pillars that support the entire orthodox monetary framework. The first of these is the inflation target. Originally, the ECB defined this as an inflation rate of less than 2 per cent, but when fears of global deflation arose in 2002 and 2003 the ECB chose to be more precise, suggesting a desired range for inflation of between 1.5 and 2.0 per cent. By doing so, the ECB tried to dispel criticism that it would be indifferent were the eurozone to find itself heading into deflation. The second pillar is monetary growth, or, if you like, the level of liquidity within Europe's economy. Even if inflation itself is not rising, excessive monetary growth might be regarded as an uncomfortable early-warning indicator of problems ahead, eventually reflected either in rising inflation or, alternatively, in rising asset prices.

Orthodoxy basically preserves the sanctity of money. The ECB has no intention of defrauding the public, either through higher inflation or through liquidity-driven movements in asset prices that all too often reach vertiginous heights only to be followed by startling declines. As a result, the ECB takes the view that a job well done is a job that preserves financial confidence: no rise in inflation expectations, no distortions in the monetary measuring rod, no deterioration in economic performance. In this world of orthodoxy, money's role is to provide stability. With temptation lying all around, Frankfurt's monetary high priests stick to the ancient texts.

The distinction between the monetary and the real economy is, though, not as clear as the ancient texts might sometimes imply. Money plays a wide-ranging role. Without it, we would be living in a hopelessly inefficient barter system, requiring each of us to find the person who wanted, directly, to trade their particular good for our particular good. The search costs involved in finding the right person would be enormously high: the existence of money, a universal means of exchange, removes these search costs and, hence, leads to a much more efficient allocation of resources. In this sense, money provides a benefit to the real economy: it allows higher production than would otherwise be the case and, hence, makes all of us better off.

The ECB would, no doubt, argue that in this area the euro has been an enormous success. By removing national currencies and replacing them with the euro, the eurozone as a whole now has a medium of exchange that works as well in Spain as it does in Germany, as well in France as it does in Greece. No one would, these days, advocate creating separate currencies for London and Manchester. The ECB presumably hopes that in years to come no one would think of arguing in favour of separate currencies for Italy and Belgium.

So far, so good. The problem with orthodoxy, however, is that it may encourage an excessive amount of conservatism, affecting not just the ultimate objectives of monetary policy but also the tactics that are adopted along the way. To avoid ultimate temptation, the ECB chooses to tie its hands, making sure that its actions could never be misconstrued as, monetarily, overly adventurous. It's a bit like walking to the Bahnhof through an extended, more circuitous route: better to go the longer, unadventurous way than to be wrongly accused of being up to no good - even if, as a consequence, you end up missing your train.

One way in which the ECB ties its hands is through its devotion to the achievement of price stability at the possible exclusion of other objectives. All central banks would agree that price stability is the Holy Grail of monetary policy, but some would argue that, once achieved, there are other issues that central banks need to think about. The Federal Reserve, for example, also has objectives for the levels of employment and long-term interest rates. Put another way, the Federal Reserve is under pressure to help maximise the level of output so long as price stability is not compromised.

It's a lot less obvious that the ECB is under similar pressure. Indeed, the ECB would argue that monetary policy has a very limited role. The only way to maximise output through monetary policy is via the achievement of price stability. As soon as monetary policy is given other objectives, the central bank is in trouble.

The world, though, is not quite so simple as that. All central banks have to form both hypotheses about how inflation develops and views about the early-warning signs that indicate that inflation is on its way. These hypotheses and views are based partly on the institutional arrangements that exist within an economy. For an economy with flexible labour markets, where wages both rise and fall through the economic cycle, the chances of a sustained rise in inflationary pressures are perhaps lower than in an economy with rigid labour markets where wages are basically "sticky" and cannot easily decline.

The European Central Bank thinks it inhabits the second of these two worlds. Unemployment is high more because those who have jobs protect their own interests - keeping wages and non-wage labour costs high - than because there is a lack of demand. This is a perfectly reasonable view. However, it is a view that, for some countries in the eurozone, appears to be unravelling. German wages, for example, have come under significant downward pressure in recent years, not so much because of domestic labour market reform but more because of the persistent threat of capital exodus: having cheap labour available in central and eastern Europe certainly concentrates the wage negotiator's mind. And, because of this downward pressure, German consumer demand has been left pitifully weak even if German exports have performed well.

This, in turn, means that the inflationary shocks of old are no longer quite so worrying. High energy prices no longer threaten the old-fashioned wage-price spirals; instead, they threaten the virility of domestic demand. The problem for monetary orthodoxy lies not so much in the ultimate commitment to price stability, but rather in the fear that a departure from the previous script will be seen as a sign of excessive inflationary risk-taking: appearances become more important than reality. But just as a walk along Kaiserstrasse need not imply that you're a dirty old man, a more relaxed attitude to supposed inflationary threats need not undermine the ultimate commitment to monetary discipline.

Stephen King is managing director of economics at HSBC

stephen.king@hsbcib.com

Comments