The central bankers' central banker speaks

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The Independent Online
The concluding commentary in the Bank for International Settlements' annual report is always worth reading, for it gives a thought- provoking guide to the main issues in international finance, both identifying the ones that matter most, and - most usefully - saying what sensible people might think about them.

This year is no exception. This particular section of the report is written by Alexandre Lamfalussy in his role as BIS general manager, but he is also a noted Belgian economist who has spent many years watching financial market developments.

He picks out four questions which the events of the past year have brought to the front of people's minds: what policymakers should do if the current economic cycle is not a 'normal' one and the recovery is unusually sluggish; how the financial services industry should be put on a sounder basis; whether the economies of Eastern Europe are recovering; and what is happening to exchange rate relationships, given the power of the foreign exchanges. The first and last in particular deserve a wider audience.

On the first, he is quite optimistic. It is certainly true that this is for some countries the worst recession since the Second World War, but it also follows the longest period of sustained growth, so it is certainly too early to conclude that the underlying potential for growth has somehow been damaged.

In fact there are several reasons to be hopeful about this. For example, profits have been rebuilt, personal savings are now quite strong, wage rises are under control, productivity seems to be rising in services as well as manufacturing.

There is, however, a specific problem in Europe with unemployment. The trend has been rising since the 1970s, and has been reinforced, he points out, by higher participation rates and in some cases by immigration.

He is not optimistic about this trend being reversed, particularly in view of the high social security charges in many European countries which add 50 per cent or more to the basic cost of employing people, and which make Europe less competitive against not just the US and Japan, but against the newly-industrialised countries of South-east Asia.

Measures that have attempted to soften the impact of unemployment may actually have made the problem worse.

Flexible wage-setting systems such as exist in the US, Japan and Austria offer the best hope for cutting unemployment, but these three systems are very different and there is no single model which high-unemployment countries can import to solve their problems. If unemployment carries on rising through the economic recovery there will be greater pressure for 'managed' trade, which is inevitably 'politicised' trade.

What can be done, aside from trying to encourage more flexible labour markets? Dr Lamfalussy simply calls for stable fiscal and monetary policies - fiscal policies which, by addressing public sector deficits, help to reduce long-term interest rates and bring back confidence, and monetary policies which in the medium term lean against inflation but in the short term are eased to encourage growth. Experience in the US and Japan suggests that easing 'can go quite far without rekindling inflation'.

On the condition of the world's banks, he feels that lessons have to be learnt from the deregulation of the 1980s. In particular, the costs of failure are so large as to put a big premium on prevention.

In Eastern Europe the first benefits of the structural changes are becoming evident, but until the West is more prepared to accept more imports from these countries their economic progress will be limited. As for the former Soviet Union, there is clearly a long way to go.

Finally, exchange rates. Here in Britain we saw the events of last September from an inevitably parochial point of view - the humiliation, or the liberation, of the pound. But, of course, it was not just sterling that was affected.

Elsewhere in its report the BIS points it out that last year was the most significant as far as foreign exchange was concerned since the breakdown of the Bretton Woods system 20 years ago.

What, if anything, is to be done? Here, it is revealing that Dr Lamfalussy has really no answer. As far as the ERM is concerned, he points out that it needs to accept more speedy currency realignments where the funadmentals demand a change of parity and defence of rates where they do not.

But he admits that it would be very difficult to manage such a system, either technically or politically. The alternative, moving more quickly to currency union, has obvious problems too.

As far as the rest of the world's floating rate system is concerned, it is extremely difficult to manage floating when the size of the capital movements which the market can generate are so large. The markets push exchange rates to levels that are clearly out of line, yet it is very hard to resist them.

If he has no magic wand to counter exchange rate instability, Dr Lamfalussy does have some specific advice for countries with 'newly floating' currencies: 'These countries will need to remain on guard against the inflationary risks - and stand ready to increase interest rates - if a shift in foreign market sentiment threatens too sharp a depreciation of their currencies. The hard-won gains in reducing inflation could easily be lost.'

There speaks the central bankers' central banker.