Monetary Policy and the Macroeconomics of 'Soft' Growth

I greatly admire FITOUSSI's wealth of insightful quantitative description. But disagreement is possibly due to the fact that his descriptive exercises appear to me full of prescriptive intent. And then the disagreement may be due to the fact that we have different notions of "the long run". Because of the length of time that learning and even expectation formation seem to take with regard to many phenomena of macroeconomics and many of the ultimate consequences of economic policy, and in particular because convergence to the theoretical equilibria takes so long – as the exchange rate literature of the last decade has shown – I understand by the long run a time span of about ten years and more. But as FITOUSSI intends to discuss "soft growth", and economic growth is a long run concept, I take it FITOUSSI also wishes to speak about such a long run.

Closely related to the questions of the long run consequences of monetary policy and of the consequences of which long run, is the ambiguity of the term "restrictive monetary policy", as used by FITOUSSI. Does he take restrictive monetary policy to mean a policy designed for an effective transition from a historically high inflation rate regime to a low inflation rate regime, in other words a policy of constantly lowering the rate of inflation? If so, there is now disagreement: For at least with a large volume of nominally fixed contracts and/or with sticky expectations, such a policy will, of course, cause high nominal interest rates, on historical evidence also high real interest rates, furthermore most likely a real exchange rate appreciation. Thus, it will have possibly strong real effects in lowering growth and increasing unemployment. But to my mind such a policy of lowering inflation is, by its very nature, only temporary. Or does FITOUSSI take restrictive monetary policy to mean a policy of permanently keeping inflation at a negligible level, e.g. in the zero-to-two percent range of measured inflation and around a mean of one percent, which the Bundesbank considers no inflation because measured inflation tends to overestimate the loss in real purchasing power by about one percent (TÖDTER & ZIEBARTH, 1997, p. 47)? Then I see no increase in real interest rates due to such a policy. Thus, our disagreement can be pinpointed in the following way: If "restrictive monetary policy" means keeping the rate of inflation permanently at a negligible level, and keeping it steadily at such a level with very little variation, I see no long run effect of such a policy in raising real interest rates, but, if anything rather a slight real interest rate decreasing effect. I therefore do not understand why such a "restrictive monetary policy" can be said to be a cause of "soft growth", i.e. economic growth below its potential level and with substantial underutilization of resources, in particular with high unemployment. Thus I completely disagree that it can be the correctly understood policy aim of a majority of European countries; in fact I do not understand how it could be the correctly understood long run policy aim of any one European country, participating in the EURO, to have anything but such a stable negligible inflation rate policy for the coming common European currency. The desire for an expansionary monetary policy is a desire for short run real benefits at long run cost, arising in particular from higher real interest rate and greater uncertainties in the long run.
 

(2) One tends to be constantly surprised to see how much economic thought is conditioned by historical experience and by monetary quantitative constellations. Possibly man is even genetically preconditioned to overgeneralize from present observations.
 
In reading the – of course extremely well substantiated – data presented by FITOUSSI for "Europe as a whole", I feel as if I were coming from another planet, and not only from another European country, Austria. As is well known and quoted in the international literature as an interesting example (ISARD 1995, p. 27 ff.), Austria's currency has been closely linked to the German Mark for about the last quarter century and extremely closely so since 1980, the Schilling fluctuating relative to the DM within only one seventh of a percentage point (7.03 to 7.04 Schilling to the Mark) in the 1990s. A similar policy has been followed by the Netherlands, only slightly less so by Denmark, and, relative to the Belgian Franc, even more strictly so by Luxembourg. These small countries as such may be insignificant; but their experience has already come close to what most European countries will go through within a common European currency setting and therefore it is of more than parochial importance. Having known no autonomous monetary policy for seventeen years now, in other words importing German policy whatever may happen, one is, of course, more likely to believe in the long run insignificance of monetary policy. In other words, one tends to read the copious economic literature on the long run neutrality of money with a much greater degree of belief.

In fact, for these countries, Austria, the Netherlands, Denmark (given in the order of the closeness of their link to the German Mark) and, in another constellation, Luxembourg, monetary policy seems to have been not quite neutral in the long run, but has, if anything, deviated rather in the opposite direction from that suggested by FITOUSSI: Luxembourg has the lowest unemployment rate in Europe, followed by Austria with, at present, an unemployment rate of 4.5 percent (but less youth unemployment than even Luxembourg). The Netherlands and Denmark also show unemployment rates much below European average. Luxembourg, Denmark, Belgium and Austria (in that order) show the highest purchasing power adjusted real per capita national income levels, achieved in the case of Austria since the late 1970s and the 1980s. Calculated since the 1980s Austria showed the lowest average real interest rate in Europe, lower than Germany. An important econometric exercise (HANDLER 1989) has shown that Austria probably has a positively inclined PHILLIPS-curve with respect to expected inflation.

Of course, German policy has not actually achieved a negligible average inflation rate within this period; nor was the band small in which its rate of inflation fluctuated. Though not showing good monetary policy practice it was, however, at least the best autonomous policy in Europe. And it should be noted – against FITOUSSI – that as far as it was good policy for Germany (which may be seriously doubted for around 1990), it was good policy not only for Germany: It was, evidently, even better policy for Austria, the Netherlands and Denmark, because these suffered much less unemployment and also turned out better than Germany on other economic indicators. It seems to me a very important European experience that those countries which merely adapted to the monetary policy of another country showed the best economic performance, though, of course, only if they stuck to it for a very long time.

Finally, the whole mystique of Austrian policy during the last quarter century was centered around the idea that real economic success could be achieved by having, on average, a currency appreciating policy, i.e. linking the Schilling to the generally appreciating German Mark. To demonstrate credibility of its so-called "hard currency policy" Austria even appreciated by 4.5 percent relative to the DM in 1979-1980, causing a credibility recession in 1981 (i.e. zero growth in that year). Appreciating the Schilling with the D-Mark was even quaintly termed "Austro-Keynesianism" (SEIDEL 1979), though, as HABERLER (1982, p. 67 ff.) rightly remarked, the name "Austro-Monetarism" would, in fact, have been more appropriate. Anyhow, this policy showed no longer-term negative real effects, neither on growth nor on employment, which makes it easier for an Austrian to believe that nominal exchange rate changes are also neutral in the long run, if not that appreciation is once again slightly beneficial. It may have helped, however, that in the last decade (and also before that) Austrian manufacturing industry witnessed a strong real depreciation relative to Germany: From 1986 to 1996 hourly labour productivity of Austrian manufacturing industry increased relative to Germany by 2.0 percent a year and industrial hourly unit labour cost fell relative to Germany by 1.3 percent a year, i.e. altogether an astounding 13 percent (GUGER 1997, p. 480 f.). Against this background it may be easier to understand that trade union politicians introduced the first steps towards the appreciation policy around 1975 (see FRISCH 1976 for an economic rationale), while industrialists opposed it. And taking account of the high degree of competitiveness of the Austrian economy, they may have been quite correct, as appreciation may have had short-run favourable effects on the Austrian wage share without negative effects on employment: At least in 1981, the year of the credibility recession after the appreciation relative to Germany, the Austrian wage share reached its highest level of more than 75 percent. The slight decline from then on to some 70 percent can be explained partly – by another explanation than that given by FITOUSSI – by the dying away of this short run appreciation effect.
 

(3) Coming from this empirical background, I would therefore argue that in the long run a stable monetary policy achieving a negligible rate of inflation on average, with negligible variation at that, will not increase the real rate of interest but much rather achieve the lowest real interest rates possible, taking account of real factors. For theoretical underpinnings of this statement, I would above all rely on the strong empirical regularity that a lower average rate of inflation is highly correlated with a lower variability of inflation and that therefore a low expected rate of inflation entails also a low expected value of its variance. I would then argue that a stable monetary policy aiming at a steady negligible rate of inflation (one percent within a zero-to-two percent corridor) would eliminate a risk premium in the real rate of interest due to price level uncertainty and to individual nominal price uncertainty. I would argue that such a policy would minimize the real costs of nominal contracts, which are unavoidable because of the high transaction and control cost of writing real price (indexed) contracts; and it would furthermore minimize the real costs of learning new prices (NOUSSAIR et. al 1997).
 
As to the additional costs of correctly anticipated inflation I would point to the increase in taxation of capital due to inflation in our usual nominal value tax systems. In order to equalize net real interest rates around the world, countries with higher average rates of inflation have to have higher gross real interest rates in order to compensate for the higher effective capital taxation. I am aware that minimum inflationary costs might be possibly bounded slightly away from zero inflation - and certainly well away from zero nominal interest rates; but I think an "optimum" average inflation rate will be very close to zero.

As to the exchange rate, I think that a nominal appreciation policy is, if anything, once again in the long run more likely to be on the beneficial side for growth and employment. It has been argued that appreciation stimulates productivity growth; and for the case of Austria some empirical verification of this has been found (MARIN 1986). This would imply something like an aspiration level theory of innovation: innovation being more likely when competition, above all international competition, increases. Though admittedly of limited plausibility such an argument is not wholly absurd.
 

(4) In so far as there was an actual increase in real interest rates in the 1980s and 1990s in European countries I would also ask, much more than FITOUSSI does, whether that was not due to more basic real forces and not even to the temporary effects of monetary policy at all. Have the 1980s not seen the switch of more and more emerging nations to export-led growth and thus to the opening up of new opportunities for investment the world over? Have not first the South East Asian Countries, including China, then South America and then, from 1989 onwards, Central and Eastern Europe shown an increased investment demand at high rates of return? Would such additional investment opportunities at given or, in the case of the United States, even continuously falling saving rates not push up real interest rates everywhere? Was it not the sign of well functioning and not of badly functioning "capitalism" and well functioning and not badly functioning investment markets, if capital was shifted out of the rich old European countries – and of Japan – by higher real interest rates to meet such a demand? To my mind, in parts of his argument FITOUSSI only makes clear that German Reunification not only pushed up French real interest rates, but also French unemployment. Actually, it has, of course, long been realized that the whole of Europe was negatively hit via higher interest rates due to German Reunification and the fall of the Iron Curtain and that only those countries came out as net winners whose additional exports to Central and Eastern Europe had a stronger positive impact than the negative impact of higher interest rates. Evidently, France was not one of the net winners.
 

(5) I now turn to a series of wider implications only hinted at by Jean-Paul FITOUSSI's paper. My questions here are all of a political economy nature.
 
It is frequently stated that by having a common currency countries lose an important policy instrument; and that they are then ill-suited to deal with external economic shocks.

I am very sceptical about the latter argument: Within a currency union you soon learn that most shocks are, in fact, endogenous; and by mere necessity you learn to adapt much better to those that are actually external, as e.g. oil price movements. (In fact, the currency appreciation policy was introduced in Austria in order to deal better, and with smaller real loss, with the first oil price shock in 1974/75).

But I am also sceptical of the first. The idea that you can never have enough policy instruments basically arises from the notion of the all-wise and benevolent economic dictator. In fact, in the real world, having many instruments can cause great uncertainty as to when to use which instrument and to what extent; it can cause political conflict and strife between various politicians and parties on this question; and in consequence it can cause much uncertainty among economic agents. In other words, the idea that the extension of the choice set cannot be anything but advantageous because it makes it more likely that one can achieve a higher level of satisfaction depends crucially on the assumption that the process of choice as such is costless. If, however, a more complex choice set also increases the costs of making a choice, it may be better to have only restricted choice. The decrease in the number of admissible policies may be more than compensated by the greater ease and clarity of making a choice and by the economic agents better understanding what the likely policies are going to be.

So why not take monetary policy as an outside datum and no longer try to influence it? This is the idea of the "nominal anchor" of a basic currency taken one step further: the advantage of having a whole sphere of policy, i.e. monetary policy, as a given "anchor" for other policies to be adjusted to.
 

(6) Rightly or wrongly, French politicians above all are perceived in Germany and Austria to demand a higher than negligible inflation and a currency depreciation policy for the EURO. Merely asking for such a policy can be politically dangerous and very costly in terms of financial market reactions.
 
It is politically dangerous because it has already forced a plebiscite as to the introduction of the EURO on Austria which, unimportant as such on an European scale, might lead to a similar plebiscite in Germany. By now the majority of the Austrian population seems to be against adhering to the EURO because of inflationary fears, so that it is very fortunate that our plebiscite is not likely to succeed, merely because it has been introduced by the wrong party towards which there is much opposition. In Germany a plebiscite fortunately would require a change in the constitution, which is always a difficult matter. But there the real danger is that the German Constitutional Court might declare it unconstitutional for Germany to take part in the EURO, which would scupper the whole project. According to this Court it would be unconstitutional for Germany to take part exactly if the EURO were likely to become a more inflationary currency than the German Mark (there is already a preliminary decision to this intent): For this would be an infringement of the inviolability of property rights guaranteed to Germans by their constitution.

Financial market reactions to the likelihood of a more inflationary EURO may easily lead to temporarily higher real interest rates, the very type of development which FITOUSSI deplores. It probably has already contributed to the recent devaluation of the German Mark relative to the dollar. FITOUSSI pointedly asks questions running somewhat like this: Who are the financial markets, after all? What is the political power behind a few financiers? And should governments take into account such nonentities? As long as there exists full capital market integration and full convertibility in Europe, capital market sentiment has, however, strong real effects whatever the political power behind capital markets.

Nor should one underestimate the political voting power and the impact of the value judgements of the economic agents behind the capital markets. Today capital markets are dominated by so-called institutional investors, and these are only another name for pension funds. Behind them is the vast number of "old age" pensioners, frequently nowadays not at all very old and politically very active. Low inflation in many European countries meant that pensioners frequently have large real savings which in turn means that for them keeping inflation low has become the paramount economic aim: Here is the constituency for strict monetary austerity. In how many countries of Europe does there still exist a political majority for more employment creation and less "softness" in growth?
 

(7) This brings me to my final point. "Europe as a whole" is a fine statistical concept, admirably used by FITOUSSI. But how much reality has it in terms of political decision taking or, if you will, in terms of a transitive, or even a definable social welfare function? The paramount economic value in Germany of Austria seems to be guarding the purchasing power of money. Austria, which expected to have, on average, an appreciating currency, has issued much foreign denominated debt, particularly in Yen and Swiss Francs; it is therefore highly interested in EURO appreciation (FITOUSSI, to my mind and from the standpoint of Austrian appreciation policy, greatly overestimates the size and stability of a political coalition in favour of depreciation of the EURO, in particular as the trade of EU-Europe outside its borders is less than 10 percent of GDP and many European exports are so high-tech that their price elasticity is low relative to moderate price or exchange rate changes). Italy with its high internally financed government-debt is above all interested in low nominal interest rates, which by the FISHER relationship can once more very well mean low inflation rates. Higher employment may be paramount in France or Spain; and so on. It appears to me very likely that preferences as to economic aims are to a marked extent not single peaked within European nations and even less so between European nations. Furthermore, due to differing historical experiences, preferences are likely to be only partial orderings, better defined only relative to those possibilities which have actually been experienced. This would be to argue that no social welfare function for "Europe as a whole" can be defined; and, furthermore, even as far as social welfare functions for each European nation can be assumed to exist, that politicians are unlikely to be able to judge what they are, frequently already for their own country and even more so for other countries with which they have to deal.
 
It has been suggested to me that in the future European common monetary policy it would be, as always, better to play a cooperative game than to play a NASH equilibrium strategy. But according to the above argument neither one would be feasible. For there would be no well-defined pay-off matrix of players; and the beliefs about pay-offs, as far as they can be defined, are not likely to be mutually consistent. Perhaps by and by one would learn about each other's pay-offs and beliefs, so that in future decades policy games might become possible; but, I think, not at the time of the introduction of the common currency. "Europe as a whole" does not exist in terms of policy formulation.

Which only means that the European Central Bank is likely to be politically uncontrollable by a council of ministers, who will seldom agree. Thus, I expect a European Central Bank which will strictly follow its statutory economic aim, viz. a negligible rate of inflation, and will follow this aim unimpeded by concerted political pressure. It is only to be hoped that not too much talk about the need of an expansionary monetary policy in order to fight "soft growth" will force it to engineer too much of a credibility recession to start with.
 
 

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