View from City Road: Some madness in Germany's method

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It took the Bundesbank many years to persuade the markets that the broad measure of money supply was a reliable signal of inflationary pressures. But the idea that targeting M3 is a science, not a black art, has backfired lately as the cherished equation has unravelled.

Bundesbank council members have had to fall back on that unreliable ally, Special Factors, to explain Germany's haywire money growth. Yesterday, a relieved Hans Tietmeyer, the Bundesbank president, said the distortions were now fading, and he emphasised that targeting money supply growth remained the centrepiece of Germany's anti-inflation policy. Alternatives, such as Britain's inflation-targeting, are second best, he said.

True, but for reasons Germany is beginning to experience first-hand itself. Mr Tietmeyer argued that the medium-term link between money supply growth and inflationary risk remained an empirically proven fact. There is no question of giving up, or even fundamentally altering, such a tried and trusted mechanism, he said.

But the Bundesbank's defence raises a question. Why does this link between money growth and inflation appear to hold in Germany when it has broken down almost everywhere else?

A large part of the answer is financial market deregulation, where Germany has proceeded much more cautiously than most. This is turn has helped Germany to remain a credit-based rather than a capital-market economy, where bank deposits are the conduit for most M3 funds, making them more controllable by the Bundesbank.

But with internationalisation of capital markets and deregulation on the march in Germany, the Bundesbank will find its monetary targeting increasingly unreliable and uncontrollable.

How does the Bundesbank expect to sell its M3 method as the model for an eventual integrated European monetary policy, given that the conditions that appear to make it work in Germany hardly exist elsewhere?

Britain, for one, found broad money targeting worse than useless as its banking and capital markets deregulated. As Margaret Thatcher found to her cost, it was capable not just of causing confusion but also of sending deeply misleading signals.