Euro-guardians should give up banking on a moving target

Date: 18/06/1998

The newly created European Central Bank is sitting in front of a blank sheet. Tim Jones talks to former vice-chairman of the Federal Reserve Alan Blinder who believes that the ECB could do a lot worse than learn from the US' experience

TWO weeks into the life of Europe's new central bank, Alan Blinder fears its leaders have already made a fundamental policy error.

The former vice-chairman of the Federal Reserve, the US central bank, is dismayed by the ECB's plans to raise and lower the cost of borrowing according to the growth rate of money in use.

After the ECB governing council's inaugural meeting last week, president Wim Duisenberg restated his support for an approach long-practised by the German Bundesbank of choosing a 'monetary aggregate' (M1, M2, M3, etc), all measures of types of money in circulation, to determine inflationary trends and set interest rates.

“Flirtation with monetary aggregate targeting is rarely a wise policy and one I opposed for a long time in the United States,” says Blinder, who left the 'Fed' two years ago to return to his chair in economics at Princeton University.

The Bundesbank's favoured measure is M3, defined as banknotes and coins in public circulation, deposits which can be withdrawn from banks with anything up to three months' notice and certificates of deposit held by the private sector.

This may sound like the worst kind of economic esoterica but an unreliable money-supply measure can mean profound policy errors, leading to inflation, recession and discredited institutions.

“There's lots of history from lots of countries which says that even if you find, for a particular - usually short - historical period, a reasonably tight relationship between some M and something you really care about, like inflation, it generally proves to be ephemeral,” warns Blinder.

“There's no good reason to bet that it will last, especially in a situation like the founding of euro-land where there's going to be a lot of capital flowing across national boundaries into different types of bank accounts and in to and out of the banking system.”

He warns the ECB that monetary targeting will only work if the bank can forecast people's preference for money over other stores of wealth with reasonable accuracy.

“In a system that is so new, trying to project the demand for euro over diverse areas seems to me a daunting task,” he says. “So why do it? If you take the attitude that we have to make the best we can out of a difficult situation, then okay; sometimes life is like that. But there are plenty of clear alternatives such as inflation targeting, which do not require you to estimate what I fear cannot be estimated.”

Blinder's views are worth listening to. Having served on the White House staff as an economic adviser to President Bill Clinton, he became deputy to legendary Fed chairman Alan Greenspan in 1994. He resigned two years later, citing his desire not to lose his Princeton tenure and lamenting “rampant anti-government” sentiment in the US.

On resigning, he promised a 'non kiss-and-tell' book on Fed monetary policy and now his Central Banking in Theory and Practice adorns the shelves of most of the new men and women in Frankfurt.

Shunning the inaccuracies of monetary targeting, Blinder urges the ECB to set interest rates according to a forecast inflation target for the whole euro-11 area.

That does not, however, mean adapting policy to cater for faster economic growth rates and greater inflationary threats in parts of the zone: a phenomenon now under way in Ireland, the Netherlands and Finland.

“You have to get away from the idea that you should ever care in Frankfurt about inflation differentials between, say, Ireland and Italy. It's not relevant,” says Blinder. “There are times in the States when there are small differentials in inflation rates between California and New Jersey, but that's irrelevant to monetary policy.”

But, since Ireland, Italy, Spain and Portugal will have to cut their interest rates to get them down to Franco-German levels in time for the advent of the euro in January, might this not unleash inflation in those countries and threaten the stability of the euro-area?

“I don't think it can, because too many goods are tradable,” says Blinder. “With tradable goods, inflation rates have to pretty near equalise across the countries and there can only be very small differentials. Where it's most likely to show up, and I'm drawing on my US experience here, is in house prices where, in booming areas, real estate values rise, and in certain services which tend to be immobile.

“It will be things like barbers, local restaurants and movie houses, things that are inherently local but can't be traded, where you can get the inflation differentials.”

Soaring house prices in Dublin and Amsterdam could feed through into inflation, because people will feel richer and may even borrow to spend using their inflated real estate as collateral.

“That could be dealt with by fiscal measures or not at all, but definitely not by monetary policy,” says Blinder. “Housing prices are rising rapidly in Manhattan at the moment and, I imagine, in the Silicon Valley. So what? These are not relevant facts for the Federal Reserve.”

Since March last year, the Fed has been in an extraordinary situation. Even though the US economy is growing at a prodigious rate (nearly 4&percent; last year) and continues to pile up jobs, the central bank's decision-making body, the Federal Open Market Committee (FOMC), has held its key interest rate steady at 5.5&percent;.

During Blinder's first year as vice-chairman, the FOMC hiked rates by three percentage points.

“The main thing staying the hand of the FOMC is that inflation is extremely low and even falling rather than rising,” he says, although he disputes the opinion of some economic gurus that the US now has a 'new economy' where the old trade-off between inflation and unemployment has been abolished.

On the contrary, like any classical economic theorist, Blinder believes the US has a 'natural rate of unemployment', the rate below which inflation starts to accelerate.

“We have been blessed by a series of fortuitous events,” he says, citing falling energy and computer prices, and revisions to the way the consumer price index is calculated.

The FOMC voted to leave interest rates unchanged at its last gathering in May. Now all eyes are focused on the meeting starting on 30 June.

“To me, the key question is: how long can this good luck continue to roll?” says Blinder. “If you believe that it is pretty much over or about to end, then that would be a good reason to tighten monetary policy. If you believe it could stay with us a good while longer, and are willing to take some risk that you could be wrong and therefore inflation will rise - but only a little bit - then you have a good case for standing pat on monetary policy. The latter side of the argument has prevailed so far at the Fed, and I agree with that.”

According to Blinder, interest rates in the US are unlikely to rise much before the arrival of the euro simply because these disinflationary influences do not look like changing any time soon.

“You can't see these things too far into the future, but I can certainly see it holding right through 1998,” he says.

“Tick off what they are. They're changes to the CPI measurement system: we know they're permanent. They're energy prices: they look quite quiescent. They're the extraordinary falls in computer prices and the indications are that these ferocious price declines are continuing. They're falling import prices and we know they're going to continue because of lags and what the dollar has already done. It is only health care benefit costs where things seem to be turning.”