Waiting for someone to devalue: Franco Modigliani and Robert Solow on Europe's slow-reacting central banks

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The Independent Online
THE MEMBERS of the European Monetary System and much of the rest of Europe have been suffering under a staggering amount of unemployment and the associated waste of billions in potential economic output. To attack this problem there is an immediate need to cut interest rates, promptly and sharply. That was impossible because of the high interest rates the Bundesbank felt appropriate for Germany, and the narrow range of exchange-rate fluctuations allowed under the EMS. But now that much wider fluctuations are allowed - the band has been expanded from 2.5 per cent to 15 per cent - it is puzzling that banks do not seem to be taking advantage of their new freedom.

No official interest rates have been reduced, except in Spain; this has helped to keep market rates high and the actual devaluation to a mininum. If things continue this way, nothing will have been accomplished to put Europe on the way to recovery.

What accounts for this puzzling behaviour, and what does it portend? It is implausible that the central banks actually believe that reducing the current high rates would not contribute to growth; there must be some other explanation.

The most important one is probably their irresistible impulse to punish speculators for having forced them into doing what they had committed themselves not to do. That would mean making the speculators bear losses, or at least denying them appreciable gains, by holding devaluation to a minimum through what Helmut Schlesinger, when he headed the Bundesbank, used to call 'great prudence in interest policies'.

Another explanation is that the banks have become seized by the dogma that abandoning their currency parities betrayed the European cause and demeaned national pride - an absurd view under current circumstances. Certainly there was a time when being part of a system of fixed parities, led by the Bundesbank with its strong bias against inflation, provided an effective way of bringing otherwise unmanageable inflation under control in many countries. At that time, the interest rates that seemed good for Germany seemed good enough for the EMS, and devaluation was seen as demeaning. Today the circumstances are largely reversed. Inflation is no longer a serious problem for other countries, but it still is for Germany. In terms of interest rates, what is good for Germany's economy - which is overheated by the costs of incorporating its eastern territories - is poison for all the other countries. Sticking to a fixed rate against the mark is a recipe for stagnation and unemployment in the rest of Europe, and it does not bode well for the idea of European unity. If people start to equate a united Europe with blind adherence to Bundesbank policies, a united Europe may not seem worth the cost.

A third element of the behaviour of Europe's central banks can be attributed to psychology. The banks stuck to the mark because they felt constrained to do so and they defended that policy as good for their countries despite its enormous cost. They now want to show that it was a good policy by continuing to pursue it.

Finally, central banks may on the whole prefer fixed to floating exchange rates because when currencies float there is more room for market forces and less for central bankers to fiddle with intervention and interest rates. That could explain an eagerness to re-establish, de facto, a system of narrow bands.

There may be other reasons we cannot divine; the ones we suggest are likely to erode over time in any case. How long will it be before common sense wins and interest rates fall?

The Italian experience is illuminating. Last autumn, when speculators forced a 15 per cent devaluation, the first reaction of the Bank of Italy and of the Italian public was humiliation because of the drop in the value of the lira, and indignation against the speculators for having overwhelmed the central bank. The Bank of Italy endeavoured to minimise the opprobrium and punish the speculators by raising interest rates and intervening to support the currency. The September devaluation actually decreased by three percentage points in the following month. The central bank appeared to hope that Italy would soon be ready to re-enter the EMS and submit again to Bundesbank policies. Fortunately, more mature thinking prevailed.

By the end of November, the Bank of Italy began to appreciate the gains in the domestic economy accruing from lower interest rates and a cheaper lira, which promoted exports. From November to March, interest rates were nodded down and the lira resumed its depreciation, finally reaching a maximum of roughly 30 per cent. And because the unions had signed an agreement to forgo wage increases in new contracts, the devaluation was, for a change, a real one.

Since then the exchange rate has been allowed to fluctuate, even recover somewhat, but the downward pressure on interest rates has continued. Three-month Treasury bills - the main source of government finance - now yield about 8 per cent, compared to 15 per cent during last autumn's crisis and 12 per cent just before. The benefits to Italy have been palpable: an enormous rise in net exports and a sizeable reduction in interest payments and budget deficits, important because of Italy's enormous public debt. By midsummer there were clear signs of recovery, while the rest of the EMS countries were still heading down.

It is a reasonable guess that most of the other EMS countries will take about as long as Italy needed to take advantage of the float and start lowering both interest and currency rates. If this operation were undertaken simultaneously by most of the EMS countries, there would be no competitive devaluation within the group. Each country would enjoy a higher income because of its easier internal economic policies and its increased exports outside the group, as well as through the favourable implications of the rise in other members' income. Even without explicit co-operation, the result would be the same if countries learnt from the Italian and British example of setting their currencies free and lowering their interest rates. This would also influence Germany. If their common interest rates are a couple of percentage points or more below the Bundesbank's, strong pressure will develop for Germany to reduce its rates, too. Their own revaluations will moderate Germany's inflation by lowering its import prices and thus undercut the rationale for its tight policies.

At the same time, Germany will lose competitive advantage from relatively higher export prices. This will further dampen its economy, strengthening the case for a less deflationary policy inside Germany.

This scenario could have two helpful results. First, lower interest rates in Europe - perhaps including Germany - would be followed by a strong recovery. Second, the Bundesbank will have been nudged into a policy course designed by the others, not vice versa. This would demonstrate that a countervailing power to Germany and its central bank can be organised by the rest of Europe. When all major countries are finally realigned and the time comes to return to a redesigned EMS, the very fact of such a balance weight will prove a positive force for all of Europe.

The authors are Nobel laureates in economic science and professors at the Massachusetts Institute of Technology.

International Herald Tribune.

(Photograph omitted)

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