Surely the real issue here is that "determined economic reform" has a very mixed track record of delivering the goods anywhere ... the UK's performance is a very ambiguous recommendation indeed, and the UK is the only remotely comparable economy to Germany which has switched from a European to a US model of governance.

And structural solutions to cyclical problems ... it strikes me a) that, echoing previous comments of mine, that "determined economic reform" is being put forward as a good in itself here really, rather than as a solution to anyone's problems, and b) that Brad unaccountably cuts the Economist a whole load of slack on a whole load of issues, on which he would usually excoriate their often worryingly misleading analysis.

Brad -- Do I ever agree with you. Fortunately the idea of sacrificing German workers for the supposed well-being of the Euro union is not politically feasible. Only in a high demand European economy could there be structural changes in the German labor market, for jobs lost would be readily gained elsewhere in Germany.

Also, I do not envision lower unemployment in Germany given the limits on expansion due to what seems too restrictive fiscal and monetary constraints.

What is the basis of the claim that the European Central Bank (ECB) has set interest rates too high?

The ECB's present nominal refinancing rate is 3.25% when Eurozone inflation in the 12 months to August was running at 2.1%, down from 2.6% in the previous month, and therefore still above the ECB's self-imposed target of maintaining the zone's annual inflation rate within a maximum of 2%?

It can certainly be argued that the ECB made a bad decision in adopting an asymmetric inflation target and the Bank can be further criticised for the closed way in which rate setting decisions are made, with no publication of minutes and no public record of voting decisions. However, there is the question of maintaining credibility.

Having, whether wrongly or not, adopted a particular target the Bank was arguably not in a position to cut its rate when inflation was running above the target range and without serious risk to the Bank's credibility downstream with likely repercussions on inflation and policy response expectations. The Bank is still young and looking to establish its standing for monetary rectitude. Moreover, the Eurozone's Growth and Stability Pact - with its maximum limit on national fiscal deficits of 3% of GDP - is under challenge by the governments of three leading Eurozone economies at this time.

In Germany, employers have also been under strong pressure during the spring/summer season of wage bargaining with a national election in prospect and when the German economy accounts for around a third of the whole Eurozone GDP and unions are increasingly citing European cross-border comparisons in bargaining.

On a reasonable assessment, the ECB had good reason to be cautious. There is also the alternative diagnosis of the Eurozone's problems, namely that the primary cause of the zone's combination of above-target inflation rates along with high unemployment is "structural" or, after the trans-Atlantic fashion, the Eurozone's NAIRU is too high mainly as the result of market rigidities, partly through over-regulation, partly because differences in national languages, cultures and social security systems impede market responses.

A politically sensitive issue is the extent to which suppliers in Eurozone country markets have been placed to exploit the switch-over from national currencies to the Euro to push up prices. Some upward pressure on prices was to be expected as supplier sought to recoup conversion costs and through adjustments to marketing pricing points but some national consumer associations have been making adverse comments. The switch to the Euro has greatly increased transparency in making cross-border price comparisons. I have not followed this closely but claims are reported that the increased transparency has revealed wide-spread pricing-to-market practices with quite substantial cross-border price variations for the same product, presumably even after adjusting for national variations in V(alue) A(added) T(ax) rates. All much fertile territory for research?

It is obvious that in the absence of independent monetary policy and given stiff factor movements across borders and little trans-national (counter-cyclical) transfers, there is no way to finetune national economies but with national fiscal policy. The Growth and Stability Pact was written in times of higher growth expectations, it should be rewritten. The chance should be taken to rewrite in a way that makes it flexible enough to be of use in bad as well as good times...

P.S. I just caught myself writing like the Economist magazine itself ;-)

Technical annex on central bank inflation targets in W Europe

It is perhaps not widely appreciated that the inflation rate targets for the respective monetary policy regimes of the European Central Bank (ECB) and the Bank of England (BoE) are specified in terms of different price indices.

The ECB adopted a self-imposed target of applying monetary policy to constrain the annual inflation rate in the Eurozone within a maximum of 2%, where inflation is measured by the EU's official Harmonised Consumer Price Index (HCPI). On that basis, the latest published inflation rate was 2.1% for the twelve months to August, down from 2.6% in the previous month.

In the case of the UK, the BoE was set the remit by Parliament of maintaining the annual inflation rate at 2.5% +/- 1%, with the annual inflation rate measured by the UK's official Retail Price Index excluding mortgage interest, the so-called RPIX index. The latest published inflation rate for the UK on index was 2.0% for the twelve months to August. However, on the basis of the EU's Harmonised Price Index the UK's inflation rate was 1.1%, which means the UK's inflation rate is verging on half that in the Eurozone when measured in terms of the EU's official price index.

I still disagree that the ECB's inflation target is aysmmetric. The actual wording is 'price increases of less than 2 per cent'. That means 0% to 2%, i.e. symmetrical around 1%. You can argue that it is too low, but that is a different argument.

Jean-Philippe

Of course there is a case for reviewing the Eurozone's Growth and Stability Pact with its restriction on maximum fiscal deficits. However, the nagging worry is still that the zone's combination of high unemployment and inflation relates to the zone's high NAIRU or the structural impediments to market flexibility. If so, fiscal boosts with deficit financing are as likely to induce higher inflation rates across the Eurozone as higher sustainable GDP growth. As (perhaps too) often in EU affairs the Pact was likely as much motivated by political as economic concerns.

The early economic gloss was that the upper restriction on fiscal deficits in the Pact was necessary to maintain the Euro's reputation against the contingency that some Eurozone governments would maintain old habits and persist in deficit financing of government spending, relying on the good standing of Euro denominated bonds to gain favourable issue terms in international capital markets. The feared outcome was that the volume of bonds to finance inordinate deficits would tend to force up borrowing costs for all Eurozone countries even though the ECB is not obligated to underwrite or repurchase sovereign bonds and the markets would therefore appropriately value each at their appropriate default risk.

There was also a political sub-text in that the European commitment to creating a monetary union and signing the associated Pact provided a splendid political opportunity for some governments to permanently renounce old ways. There was much rhetoric of the kind at the time the Maastricht Treaty was signed a decade ago, as I recall.

The Treaty embodied a set of advisory criteria on the eligibility criteria for EU member states to participate in the monetary union, covering maximum inflation rates, national debt/GDP ratios, fiscal deficits and maximum bond yield disparities, all to encourage the others, so to say. The present challenge to the terms of the Pact so early in the life of the Euro is therefore not an entirely welcome eventuality.

I followed Financial Times reports during 1998 of the vetting of prospective Eurozone applicant countries on the lead up to the intended launch of the Euro at the start of 1999. On early passes, only Luxembourg and the UK qualified according to the advisory criteria, and the UK had negotiated an opt-out to monetary union participation in the Treaty. By the end of 1998, after certain adjustments, it was announced that 11 EU states were eligible. The UK was not among them because it had opted out and, importantly, because the Pound had not been part of the European Exchange Rate Mechanism for two years prior to the scheduled start of the Euro in January 1999.

In much of the continuing debate in the UK as to whether the UK should sign up, the actual transition mechanism of joining is a somewhat neglected topic. Strictly, the UK Pound should become part of an Exchange Rate Mechanism linked to the Euro for two years prior to entry and maintain a relatively stable exchange rate over the period. But that prospect tends to revive bleak memories of what happened in 1992 when the UK fell out of the ERM. In the event, with lower inflation and unemployment rates in the UK compared with the Eurozone and the best GDP growth among European G7 economies, the prospect of joining looks less than enticing, an assessment evidently reflected in a long succession of UK opinion polls.

Correction

The UK's very latest inflation indices for the preceding 12 months - just out - are 1.9% for the RPIX and 1.0% in terms of the HCPI.

Central banks need to be "somewhat" insulated from public pressures to adjust policy, but only "somewhat" insulated. I can not imagine someone in Britain wishing a Brussels banker far removed from British political influence to form British monetary policy.

European central bankers are remote enough from the several member countries. What is the point of such remoteness for the British? Trade union is important, monetary union less so.

Bob: I agree with your general note of caution about opening the fiscal valves.

>>The Treaty embodied a set of advisory criteria on the eligibility criteria for EU member states to participate in the monetary union, covering maximum inflation rates, national debt/GDP ratios, fiscal deficits and maximum bond yield disparities, all to encourage the others, so to say. The present challenge to the terms of the Pact so early in the life of the Euro is therefore not an entirely welcome eventuality.<<

But we should remid ourselves that these criteria were just a flash image of the German economy at that point. A little later, as you reminded us, only Luxembourg met all criteria (Belgium met all but the Debt/GDP ratio.) The original set of criteria were not based on any type of economic analysis but were just a way to soothe the German opinion of the time by arguing that everyone will have to catch up with Germany rather than Germany be draged down by, say, Italian then pathologically inflationary habits.

Thus, my opition that there is ample scope for a thoughtful revison of the GSP. I am assuming of course that European economists will have a say on this... That's why it's tempting to think of the status quo as a second best but the issue is the survival of the Euro zone itself, something the EU cannot afford to loose on.

jean-philippe
>>But we should remind ourselves that these criteria were just a flash image of the German economy at that point. A little later, as you reminded us, only Luxembourg met all criteria (Belgium met all but the Debt/GDP ratio.)<<

To all appearances, the (west) German model for central banking was a good basis for a new European central bank. After all, Germany had a far better record on inflation control after the currency reform of 1948 than the other three major European economies (Britain, France, Italy) and, at least up to 1973, strong economic performance. What is challenging for Keynesians of most flavours is that the German banking model was basically "monetarist".

Until Germany's federal constitution was changed in the 1970s at the instance of Walter Heller, the then economics minister, the federal government was precluded by the constitution from applying Keynesian demand-management fiscal policy because the federal budget was required to balance. Meanwhile, the Bundesbank, the West German central bank, controlled growth of the money supply. Whatever else, the West German "economic miracle" of the 1950s and '60 cannot be attributed to fine-tuning demand management.

By press reports, the European Central Bank seems to have had a protracted internal debate in the 1990s prior to the Euro launch on whether to target Eurozone money supply, on the Bundesbank model, or the zone's inflation rate. It seems an inflation target won among the options but I am not clear that debate has entirely receded.

Around the time of the launch of the Euro in 1999, Duisenberg, president of the ECB, made a series of speeches insisting that the relatively high levels of unemployment in the Eurozone were primarily due to "structural" factors, not demand-deficiency. There is no compelling reason to suppose that assessment was flawed or that circumstances have changed significantly since.

An interesting challenge for mainstream trans-Atlantic economists is to explain how and why legislation by the Socialist government in France, from 1997 until the election this year, to cut the maximum working week to 35 hours seems to have been the prelude to subsequent relatively strong GDP growth in France's economy and a distinct pick-up in the rate of new job generation. This presents a puzzle to explain for those, like myself, who don't subscribe to the Lump of Labour theory of employment.

"An interesting challenge for mainstream trans-Atlantic economists is to explain how and why legislation by the Socialist government in France, from 1997 until the election this year, to cut the maximum working week to 35 hours seems to have been the prelude to subsequent relatively strong GDP growth in France's economy and a distinct pick-up in the rate of new job generation. This presents a puzzle to explain for those, like myself, who don't subscribe to the Lump of Labour theory of employment."

This is quite interesting - Please do development this observation even for the sake of non-economists.

The French 35 hour working week has been a surprise (at least to the Anglo-saxon world) success for at least two reasons. First, 35 hours wasn't a great deal different from the pre-legislation working week. Second, in return for the introduction of the 35 hour working week, employees and unions agreed to accept much more flexibility in working hours, working practices and other employment-related issues.

The cut in the statutory maximum working week to 35 hours in France was motivated by the idea of sharing available work around to abate the high unemployment in France but strongly opposed by employers' organisations at the time with predictions of impending disaster if it were rigorously applied in small firms and businesses linked to tourism.

About two years back, the then Socialist government in France became flexible and construed the 35 hours to mean an annual (I think) average for smaller firms. This meant that workers in smaller firms could be asked by employers to work more than 35 hours a week at peak times in exchange for time off in slack periods. This had the effect of making the labour market more flexible with the potential for cutting labour costs in smaller firms. But some press reports then claimed the outcome was a surge in industrial relations disputes as workers in smaller firms lost opportunities for over-time working at premium pay rates during peak periods. The incoming new centre-right government is proposing to repeal the legislation though the militant unions representing public sector workers have vowed stiff resistance.

A plausible alternative explanation for France's relatively strong GDP growth compared with Germany's is that the French Franc got locked into the Euro on its launch in January 1999 at an under-valued rate just as the DMark got locked into the Euro at an over-valued rate. Comparative international figures posted on the US/DOC/BLS website for employee compensation costs in manufacturing industries converted to US Dollars provide some credence for this interpretation. German employment costs appear inordinately high as compared with all other industrialised economies covered in the DOC/BLS survey while the corresponding employment costs in France are shown as attractively low by comparison.

I think you're making a fine point, Bob, there are several ways in which a labor market can be flexible: number of workers, flexibility of pay, and number of hours worked. Typically, the Euro zone as a different balance of these types of labor flexibility than the US although the US has probably an absolute advantage on all three criteria...

I am surprised to read a UK economist give to much good press to money supply targeting. My knowledge is limited regarding the Brittish economy and its monetary policy, but I have been under the impression that the prime episode of money supply targeting took place in the Thatcher years.

I got from reading a bit about that debate that it mostly resulted in an appreciated sterling and hign unemployment (although with perhaps higher labor productivity.) Essentially, many economists seemed to argue that Brittain was essentially using its sacrifice ratio to attain lower inflation, albeit at a terrible social cost. I am eager to read your opinion on this.

jean-philippe

>I am surprised to read a UK economist give to much good press to money supply targeting. <

But I'm not - I just think we should try to be objective about the issues. In the UK, it's verging on impossible to have a rational discussion about the failed experiment in "monetarism" in the early 1980s, which was formally abandoned in autumn 1985 and replaced by soft exchange rate targeting to put the UK on track to joining the European Exchange Rate Mechanism. That, as I attempted to explain above, ultimately led to another disaster - accelerating inflation at the end of the 1980s and joining the ERM in 1990 at an over-valued exchange rate for the Pound.

"Monetarism" in the UK failed on its own terms, namely it proved impossible to contain growth of the "money supply" within the targets set. The money supply actually grew faster than prescribed in official targets. Some at the time argued the experiment was doomed because, in the short-run at least, the UK's money supply is endogenously determined. Basically, all controls on external capital movements had been abolished in late 1979 and, with London capital market being the third largest in the world, the sheer volume of daily international capital transactions made it impossible to tightly control the money supply. I don't have a figure in my head for an estimate of the London foreign exchange market turnover then but an estimate in The Economist (October 1998) for mid 1990s put it at USD 600 billion a DAY, making it significantly greater than the turnover of the New York foreign exchange market..

There are also reasons to suppose that money demand functions at the time were not stable - perhaps because of the deregulation of the financial system - and the whole case for "monetarism" is premised on stable demand functions for money.

Incidentally, the FED also abandoned money supply targeting in the early 1980s, rather ahead of the UK. I came across this: "...since the 1950s, the emphasis the FED has placed on controlling the interest rate versus controlling the money supply has changed. Initially the emphasis was almost entirely on interest rates - indeed, it was not until 1959 that the Fed even began to publish money stock data. Until 1982 the emphasis on monetary targets increased more or less steadily. Since then the emphasis has shifted back increasingly towards interest rates, and to a more eclectic approach to monetary policy." Rudi Dornbusch + S Fischer: Macroeconomics; (1994), p. 419.

A retrospective view of the IMF on monetarism put it thus: "...instability of monetary demand, especially in the context of supply shocks and declines in potential output growth, complicated the task of monetary authorities. As a result, during the 1980s most central banks - with some notable exceptions - either abandoned or downplayed the role of monetary targets". IMF World Economic Outlook, October 1996.

What blocks rational discussion in the UK about monetarism is that it became irrevocably linked in the public mind with the social pain of the early 1980s when other factors applied which have no necessary link with "monetarism". Several come to mind:

- Appreciation of the Pound in the early 1980s when the UK became a net supplier of oil as production from the North Sea finds increased. The strong Pound greatly exacerbated the sales problems of uncompetitive traditional industries in export markets and at home in competition with imports.

- An unduly stringent fiscal stance in the 1981 budget intended to finally squeeze the UK's high inflation, inherited from the 1970s, out of the system. There seems to have been an official view prevailing at the time that labour markets clear virtually instantly after the fashion envisaged in the rational expectations literature.

- General market deregulation and liberalisation measures along with the start of the privatisation of state-owned industries, beginning with British Telecom in 1984.

Each of those factors had an impact on job security and alternative employment prospects independently of the experiment with "monetarism". The upshot is that "monetarism" is condemned in the political mythology very largely or entirely for the wrong reasons, all of which tends to irritate economists more familiar with the intricacies of the policy history of those times. For political spin, the challenge is that privatisation and market liberalisation have gained political respectability so it is much easier to attribute the high unemployment of the early 1980s entirely to "monetarism" even if that doesn't pass muster with serious research.

I am reminded of that passage from Murder in the Cathedral by TS Eliot: "The last temptation is the greatest treason, To do the right thing for the wrong reason." For economists, the interesting professional challenge is to explain how monetarism did work in West Germany in an era when fiscal fine tuning of demand by deficit financing was barred by the constitution. I am not persuaded that either the Bank of England (BoE) or the European Central Bank (ECB) should shift from inflation to money-supply targeting but it does make sense for both to consider what is happening to the money supply and credit volumes when taking a view on what is likely to happen to inflation rates downstream. I don't know about the position of the ECB but it has been publicly said by a past member of the BoE monetary policy committee that it takes some two years for a decision by the BoE to change interest rates to work through the economy. It would be plain silly to suggest that no account at all should be taken of money demand and supply functions in making such assessments.

Thank you, Bob. Great explanation.

>>For economists, the interesting professional challenge is to explain how monetarism did work in West Germany in an era when fiscal fine tuning of demand by deficit financing was barred by the constitution.<<

The 1950s were a period of rapid catch-up with Germany's potential. In those circumstances, with inflation control as a prime economic objective, monetarism may work well.

But in general, I think it is precisely the measurement issues that have put off a large part of the profession from arguing for money supply targets. After all, one can technically have all kinds of money targets, with a varying degree of expensionary or deflationary bias.

In practice, it seems to me to have been associated with a strong deflationary bias. This may be due, as you suggest, to the fact that the debate about rational expectations was raging simultaneously, and for understandable economico-historical reasons... and to the political tendencies of the authors who were arguing for money supply targets.

According to the newswires this Monday morning, Germany's stock market prices have fallen on news of Schroeder's election victory. Any suggestions as to why?