What the Bundesbank can learn from the Fed

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The Independent Online
Hans Tietmeyer, president of the Bundesbank, tells a story in which a computer is asked to choose the governor of the future European Central Bank. The computer has no doubt - it should be Alan Greenspan, chairman of the Federal Reserve in Washington. He alone, says the computer, has the required experience of running monetary policy in a large currency area, consisting of many different states, joined together in political union.

Apart from giving some insight into how the Bundesbank views the link between monetary and political integration, this story is interesting because it encapsulates a feeling becoming widespread in Europe - that we have a lot to learn from the way in which monetary policy has recently been conducted in the US. This is a novelty since, for most of the post- war period, the world has looked to the Bundesbank, not to the Federal Reserve, for guidance on how to run monetary policy.

Yet recent evidence in favour of the Fed has become compelling. From 1993 to 1996, real GDP in the US has grown by 10.2 per cent, while that in core Europe (Germany and France, which have essentially followed a common monetary policy) has grown by 4 per cent. Over that period, America has created more than 9 million jobs, while the EU has shed over 2 million. As a result of this strong economic expansion, the US has rather painlessly reduced its budget deficit from 4.4 to 1.6 per cent of GDP while in core Europe the deficit has remained stuck at 4 per cent, despite countless packages of tax rises and cuts in public services.

On the other side of the ledger is the inflation performance of the two areas. In the US, inflation has remained stuck at just under 3 per cent throughout the period, while in core Europe inflation has fallen from 3.5 per cent in 1993 to 2 per cent now. So the European countries have enjoyed a relative improvement of around 1.5 per cent in inflation, but this has come at the expense of a cumulative loss of output over four years of over 6 per cent. Clearly, there are many in Europe who are beginning to wonder whether this was really worthwhile.

In France, for example, President Chirac complained strongly last week about the stance of monetary policy, saying that interest rates were "clearly too high". By tradition, the federal government in Germany does not openly criticise the Bundesbank, but it would be surprising if the same sentiments were not being expressed in private in Frankfurt. Essentially, Chancellor Kohl and President Chirac have started to focus on the political hell of yet again trying to cut public spending sufficiently to hit the Maastricht targets on budget deficits next year.

This has been made immeasurably more difficult by last winter's mini- recession in Continental Europe, which still appears to be dragging on. Not only are the politicians beginning to feel that they are running up a descending escalator - with the central bankers controlling the speed of descent - but it is also beginning to dawn on them the whole EMU project is becoming associated in the political consciousness with recession and budget cutbacks. And it has also dawned, belatedly perhaps, that monetary policy offers them a route out of this impasse.

The central bankers in Continental Europe would no doubt reply that inflation was substantially above their 2 per cent objective a couple of years ago, so they had to keep monetary policy tight to retain credibility. There might be some truth in this. They would also point out that real short-term interest rates have been below their historical average since the middle of 1993, so it is hardly fair to accuse them of imposing a draconian monetary squeeze. But it is disingenuous to claim that the overall stance of monetary conditions in the EU can be summarised simply by the level of short rates. In fact, the central bankers themselves have often been in the lead in pointing out that long bond yields are at least as important as short rates in determining monetary conditions, and many economists would wish to add the exchange rate into the mix as well.

Central bankers are not wholly in control of bond yields or the exchange rate. But nor are these factors totally outside their control, and their behaviour must be taken into account when setting short rates. One way of doing this is to devise a weighted index of overall monetary conditions, with the weights being determined by the impact of each of the different monetary inputs on GDP growth. John Simpson of Goldman Sachs has recently done this for all of the main industrial countries, and the results for the US and Germany are shown in the graphs. (Note that the index of monetary conditions is plotted with a lead of nine months to show what it implies for the future growth of industrial production.) It is interesting to observe the sharp contrast between the US and Germany throughout the period since 1992, and especially in 1995. Whereas overall monetary conditions in the US have been persistently supportive of economic growth, there has only been a short period where this has been the case in Germany (or in France, for that matter). It is not difficult, in this context, to explain why a mini-recession developed in the EU last year, or indeed to explain why the slowdown in the US was nothing like as severe as it was in Europe - the difference is fully picked up by the behaviour of the monetary conditions index.

The two factors that drove European monetary conditions towards tightness in 1995 were the rise in the mark against the dollar, and the earlier increase in bond yields, which was more savage in the EU than the US. Although it is often said by policy-makers that the drop in European activity last year was hard to explain, and indicative of a deeper rooted problem of cost competitiveness, this is not supported by these data. It looks suspiciously as if there was just an old-fashioned policy mistake, with the central bankers failing to cut short rates sufficiently to offset the restrictive effects of rising bond yields and an appreciating exchange rate.

This error, if such it was, seems to have been largely eliminated, and the monetary index implies the policy stance is already expansionary enough in Europe to ensure a solid recovery in output over the balance of this year. But the central bankers cannot afford to take this for granted. The renewed rise in the mark last week, and in bond yields this year, are reminders that the authorities need to keep short rates low, or drop them further, to prevent a re-run of the unintended tightening of 1994/95. There is little doubt that, if Mr Greenspan were governor of a European central bank, he would do just that. Perhaps the Bundesbank will do the same at its meeting on Thursday.

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