A currency's strength in the ERM is determined by market expectations. These are shaped not by ex-post indicators, but by ex-ante ones. Take, for example, the Irish punt. Until sterling left the system on Black Wednesday, the punt was trading comfortably in the ERM. It was sterling's subsequent fall which - given that Ireland does about one-third of its trade with the UK - persuaded many market operators that the then ERM parity was not sustainable. They were not looking at the external indicators then available, but at their (or their economists') forecasts of those same future indicators.
I have an alternative proposal. It tries to achieve the same aim as Mr Holtham's - ensuring that the Bundesbank, in setting its own monetary policy, takes account of monetary conditions in other countries.
To reconcile the conflict between its internal and external monetary responsibilities, the Bundesbank should switch its monetary target from M3 to Domestic Credit Expansion (DCE). The idea of DCE was developed at the IMF during the Fifties, with countries that had chronic current account deficits in mind. Money growth rates for such countries are depressed by intervention to support their exchange rates, so a target for DCE - which excludes the impact of external flows - is inherently tougher in these cases than a target for broad money growth. When the UK received balance of payments support from the IMF in the mid-Seventies, the performance criteria were for DCE, rather than M3.
But the principle of DCE is just as valid for other countries. When the Bundesbank intervenes to support weaker ERM currencies, DCE rises more slowly than M3, because (unlike for M3) the impact of external flows is excluded.
For Germany, targeting DCE need not be more inflationary than targeting M3. Indeed, in some cases it could be more disinflationary. Imagine that the federal government tried to finance unification via innovation, akin to the then US government's method of financing the Vietnam war. A loss of confidence in the DM would be almost bound to follow. In that case, M3 growth would fall below that of DCE, so the Bundesbank would have more support for an interest rate rise if DCE was the target.
For the markets however, a switch to DCE by Germany would reinforce the message transmitted so emphatically by the Franco-
German statement of 23 September: that if necessary the Bundesbank is prepared to intervene to defend the EMS, even at the cost of blowing M3 off course. With luck, the resultant enhancement of ERM credibility would itself keep currency pressures at bay, so that the Bundesbank's commitment to intervene without limit would not be tested. German financial stability ultimately rests on the credibility of the Bundesbank.
By making explicit what is implicit, and switching from M3 to DCE, the Bundesbank could confer that same credibility on the EMS.
JONATHAN M. HOFFMAN
Credit Suisse First Boston
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