ECB architects destroy pivot role for monetary base
A key argument for targeting high-powered money (the monetary base) is grounded on the belief that, given a firm monetary anchor (in this case a target for high-powered money growth), the market would do a better job of steering interest rates close to the ideal equilibrium path (and in discovery of the natural or neutral interest rate level – a crucial element in the auto-piloting process) than the monetary bureaucracies (central banks).
Very short-term money rates would be highly volatile as was the case under the gold standard regime. The volatility would stem from passing shortages and excesses in the market for bank reserves. The average level of these rates, though, over several weeks or months, should be fairly stable. Anyhow it is the rates for medium-term and long-term maturities which would have the greatest information content.
The Austrians would be in favour of discretionary twigging of the monetary expansion rule to take account of new information regarding the likely profile through a time of the real demand for money (especially high-powered money) consistent with overall equilibrium. And some deliberately controlled overshoots or undershoots of the rule could be required to attain long-run price level stability even though that means some monetary instability. Essential to the operation of the monetary base (high-powered money) targeting is first, the unrestricted scope for the differential between the rate of return on excess reserves (beyond the legal minimum) and on other risk-free assets to fluctuate so as to balance supply and demand in the market for bank reserves. Second, an institutional structure must have been designed in which demand for monetary base is likely to be a stable function of a few key identifiable variables, including in particular real incomes. The first requirement is achieved where the rate of interest on reserves (and excess reserves) at the central bank is fixed at zero throughout (albeit subject to an emergency drop to a negative level in a financial panic and severe recession). The second requirement is satisfied by a high level of reserve requirements on the public’s transaction deposits with the banks.
The ECB in its design of monetary framework jettisoned both requirements for the operation of monetary base targeting or for any fulcrum role for monetary base in policymaking. Moreover, its scheme for paying interest on reserves had the potential to become an infernal destabilizing force during a severe financial crisis, as in fact was to occur in 2007.
High reserve requirements were rejected in part to meet UK objections (see p. 9) but also in line with current fashionable views of not cramping banking industry competitiveness by imposing a tax on transaction deposits sold by resident banks as against other near-alternative assets including offshore deposits.
In the mid-1990s the Bundesbank had reduced reserve requirements substantially already towards countering competitive pressures for German banks from Luxembourg in particular. But it continued with payment of zero interest on reserves right up to the end of its sovereign existence.
Such concerns about competitiveness were doubtless a factor (albeit mitigated by Luxembourg becoming a part of EMU and thereby subject to any reserve requirements) in why the architects of EMU’s operating system decided in favour of paying interest on deposits with the ECB at only a modest margin below official repo rates. But another newer factor was the concern to reinforce the new central bank’s power to control short-term interest rates within tight limits of the chosen official peg (adjusted, typically by micro-amounts at a time, in line with monetary micro-policy decisions).
Professor Issing rejects advice from Vienna and Chicago There is no evidence from any published material or from any other source that Professor Issing’s secret committee designing the monetary policy framework (in summer 1998) gave weight to the Austrian School’s arguments.
‘Giving weight to’ does not mean comprehensive endorsement. The committee could have raised important practical reservations. In particular, in view of the newness of EMU and public scepticism about the ECB’s likely success in avoiding inflation, there had to be an easily understandable target to measure (this success). Austrian ‘poetic’ concepts of monetary stability might have jarred with that purpose.
It can well be doubted whether a sceptical public would have had patience with the sophisticated argument that monetary inflation need not show itself up as rising prices for goods and services but as rising asset prices, or that a rising price level for goods and services might not be symptomatic of monetary inflation.
It would have been possible in principle for Professor Issing’s Committee to include the concept of monetary stability alongside a goal of long-run price level stability even though this had not been specified in the founding treaty.
In so far as public scepticism meant that such a dual mandate (stable price level in the very long-run plus monetary stability) was impractical, then creation of a new monetary union was likely to be at a considerable cost in terms of generating monetary instability.
The omission of an overriding concept of monetary stability along Austrian School lines played a key role in the global credit bubble and-bust which was to follow.
Under its self-imposed code of secrecy, the ECB has never released transcripts or other documentary evidence of key discussions between its policy makers – including their chosen external advisers – in the critical months before the euro’s launch. Perhaps if these officials had known that all evidence, including the transcript of the discussions, would be published, the deliberations on this key issue would have been fuller and more efficient.
The ECB’s first chief economist and founding board member Professor Otmar Issing writes (see Issing, 2008) that he did discuss within his research team the concern that severe monetary disequilibrium capable of eventually producing credit and asset bubbles could coexist with observed price level stability (as defined by a target average inflation rate over say a two-year period set at a low level). And there is also some autobiographical evidence (from Professor Issing) to suggest that there was a passing informal review of something similar to the Friedman proposal for money supply targeting without an explicit short- or medium-term numerically expressed aim for the price level. None of these deliberations, however, which occurred in a necessarily very short period of time during summer and early autumn 1998, translated into any impressive design features of the monetary framework (Yes, there was the sketch of what was subsequently described as the ‘monetary pillar’, but this remained little more than a blurred section of the original architectural sketch)
A second possible way in which to make the Treaty’s specification of price level stability operational, policy choice 2 (for an outline of policy choice 1 was for the ECB to reject the definition of the ultimate aim in terms of a very long-run price parameter (as in choice 1). Instead, the ECB would stipulate a medium-term (say two years) desired path for say the overall consumer price index (CPI), expressed as an average annual rate of change. A practical problem here, amid the many theoretical problems already discussed on the basis of Chicago and Vienna critiques, would be that the so-called harmonized index of consumer prices (HICP) hammered out in committee by the EU Statistics Office excluded altogether house prices or rents and once estimated remained unchangeable even if subsequent re-estimation revealed past error.
In seeking to achieve this two-year path for the price level, the central bank could set a target for growth in a selected money supply aggregate (choice 2a), adjusting the target on the basis of any serious new evidence concerning the relationship between money and inflation. Its tool for achieving the money target could be either strict pegging (adjustable)
of a key money interest rate (for example, overnight) or the setting of a subsidiary target for so-called high-powered money growth (reserves and cash) while allowing even the overnight and other short-term rates to fluctuate within a wide margin as determined by conditions in the money market.
Or alternatively the central bank (in its pursuance of the two-year path for the price level) could set no target for money (choice 2b), and instead rely on forecasts for inflation based on an array of econometric tools to be applied to a whole range of variables to be monitored, one of which could be money supply. In this case, the central bank would adjust repeatedly the peg for very short-term rates so as to forge a path for those that would (hopefully) achieve the ultimate objective for the price level (over a two-year period).
(Rate-pegging is a ‘fair-weather’ operational policy. If continued during a financial crisis it becomes a catalyst to a vicious cycle of instability. A variation of choice 2b (let us call this 2ba) would be to give money supply a special place amid these monitored variables and set an alarm to ring if ever money supply growth estimated over a given stipulated interval strayed outside its specified range. In principle, the alarm would not be turned off even if the monitors determined that no danger existed in the form of the price level target being missed over the ‘medium-term’ (meaning in practice two years) unless they were also satisfied that there were no other dangers present (for example, inflation in the long run or a bubble in the credit market).
Response to the alarm would include a change in the official interest rate (normally specified with respect to a very short maturity in the money market), which under all versions of policy 2b is set on an entirely discretionary basis in line with policymakers’ views about how changes in short-term money market rates influence the actual inflation outcome.