Stability and Prosperity in Monetary Union

The International Monetary Fund (IMF) reported that countries in this interim stage encountered difficulties in maintaining macroeconomic stability.4

Monetary policy needs to look beyond its core focus on low and stable inflation and pay much greater attention to financial stability. The debate now is how, exactly, to factor this imperative into monetary policy, and how to coordinate the work of monetary and regulatory authorities.

The IMF s management shares many strategic considerations repeatedly raised by the Bundesbank, which has argued that the Fund should limit its activities to its core mandate promoting monetary and financial stability. Thus, the IMF s role in the international monetary system should not go beyond applying its key instruments for promoting macroeconomic stability surveillance and economic policy advice.

At the heart of the debate currently being conducted within leading economies treasuries and central banks, as well as in supranational bodies such as the International Monetary Fund and the BIS is the relationship between monetary policy and financial stability. The BIS, for example, has suggested that financial stability is closely connected with monetary policy, and has advised policymakers to start weaning their economies off of easy money sooner rather than later.

In October 1998, just before the start of the European Monetary Union, the Governing Council of the European Central Bank (ECB) adopted a stability oriented monetary policy strategy. This strategy comprises three elements First and foremost it contains a clear commitment to the primary goal of the ECB, which is to safeguard price stability. Price stability was defined as an annual increase in the price level of below two percent over the medium term.

We continued to guide monetary policy by our assessment of the risks to price stability over the medium term. This medium term orientation paid off.

The International Monetary Fund continued to assist the Government, through a close policy dialogue, in maintaining macroeconomic stability, especially in the area of fiscal policy.

The question is not whether or not to include monetary analysis in the monetary policy strategy, but how to reconcile the results from the monetary and the economic analyses to achieve a comprehensive and consistent assessment of the risks to price stability. In the strategy of the ECB this is the role of crosschecking.

Contrary to those who regard the discussion of an alternative monetary framework as premature, there are good reasons for China to begin right now to build the institutional foundation for the transition to an independent monetary policy. Indeed, early adoption of a low inflation objective would help secure the monetary and financial stability that China needs as it allows greater exchange rate flexibility.

But this will require a shift in the ECB s attitude. Europe needs a monetary policy that views aiding employment growth in northern Europe as more important than continental price stability.

The price stability mandate has been trumped by concerns about growth. The fear is that tightening monetary policy to bear down on inflation could snuff out the faltering economic recovery.

In addition, to ensure price stability, it will be necessary to further reduce the need for domestic financing of Government deficits through reduced recurrent spending and sound fiscal and monetary policies.

But reality has shown that this approach is not tenable. Problems might originate at the national level, but, owing to monetary union, they quickly threaten the stability of the entire eurozone banking system.

A normal monetary union, which is what the eurozone aspires to be, requires a normal central bank to carry out the entire range of central banking functions. This starts with ensuring price stability.

Back in 1997 1998, during the Asian crisis, the G 7 flatly rejected Japan s proposal for an Asian Monetary Fund. Now the IMF has even accepted a minority lender role, with the bulk of assistance coming from the European Stability Mechanism (ESM), a new institution often viewed as an embryonic European Monetary Fund.

But the UK government could and undoubtedly would veto any such adaptation of the Bank of England s responsibilities for monetary policy, financial stability, and banking supervision. Any other conceivable model of monetary union including one based on a central bank as unaccountable as the European Central Bank would be subject to the same rejection.

The new banking union, however imperfect, and the European Central Bank s vow to save the euro by doing whatever it takes, are essential to sustaining the monetary union. Another crucial innovation has been the development of the European Stability Mechanism, which, like the International Monetary Fund, has the capacity to execute vast financial bailouts, subject to conditionality.

The demand that the ECB should be the central supervisory authority in an integrated capital market met strong resistance, above all from Germany s Bundesbank, which worried that a role in maintaining financial stability might undermine the Bank s ability to focus on price stability as the primary goal of monetary policy. There was also bureaucratic resistance from existing regulators.

This does not mean imposing rigid inflation targets. But a predictable monetary policy aimed at delivering medium term price stability with a flexible exchange rate where appropriate  benefits both the private sector and, most importantly, the poor.

At the same time, fiscal adjustment remains essential to Italy s short and long term stability. According to the International Monetary Fund, the budget deficit is declining, and the primary surplus (net revenues minus interest payments) is growing.

On January 1, the euro celebrated its sixth birthday. Today, we look back on a period in which the European Central Bank has successfully pursued a stability oriented single monetary policy serving more than 300 million citizens.

This does not mean imposing rigid inflation targets. But a predictable monetary policy aimed at delivering medium term price stability with a flexible exchange rate where appropriate benefits both the private sector and, most importantly, the poor.

This two pillar approach constitutes a framework for cross checking indications from the shorter term economic analysis with those from the longer term monetary analysis in order to obtain a robust view about the risks to price stability.

Monetary Mystification

Beyond capital rules, however, monetary policy and financial supervision must cooperate very closely on liquidity management, particularly through credit mechanisms. Given modern financial systems demonstrated ability to create (and destroy) liquidity endogenously via financial innovation and global mobility financial and macroeconomic stability may become more difficult to achieve if monetary instruments and macroprudential tools are not used in a consistent manner.

As a result, questions about the role of monetary policy and the independence and accountability of central banks, once confined to rarefied academic discussions, are fixtures of broad policy debate. But, rather than try to define a single approach, central bankers should aim to develop individualized approaches within the orthodox monetary policy framework, which revolves around price stability and independence.

Political scientists talk about democratic delegation the idea that a sovereign might want to tie its hands (through international commitments or delegation to autonomous agencies) in order to achieve better outcomes. The delegation of monetary policy to an independent central bank is the archetypal example in the service of price stability, daily management of monetary policy is insulated from politics.

But policymakers must recognize the damage being done by excessively high real interest rates. Monetary loosening is vital to prevent growth from slowing further, and thus to ensure economic stability at home and maintain the momentum of recovery worldwide.

It is time for central banks to accept this fact and adopt a comprehensive, long term monetary policy approach even if it means that, in the short term, consumer price inflation deviates from what is currently understood as price stability. Temporary fluctuations in a narrow and imprecisely measured CPI are a small price to pay to secure the long term stability of money.

The Hong Kong Monetary Authority bought Hong Kong dollars and sold Hong Kong dollars at the level of 7.85 according to the linked exchange rate system, in order to maintain the stability of the exchange rate of Hong Kong dollars.

A single monetary policy focused on price stability in the euro area cannot react to shocks that affect only one country or region. So, to avoid prolonged local slumps, it is critical that national fiscal policies can perform their stabilization role.

For the first few decades, this system leaned heavily toward peg, owing to the US dollar s direct convertibility to gold. This brought significant stability to the global monetary order, following the competitive devaluations of the 1930s that some economists considered damaging.

Just as the Bretton Woods framework restored order to the global economy after WWII, a new monetary framework, underpinned by a truly international currency, could strengthen much needed economic and financial stability. Everyone even the US would benefit from that.

Europe today has a common currency and the European Central Bank (ECB), which have proven to be bulwarks in defending monetary stability during the financial crisis. Any weakening of these two institutions would cause severe damage to common European interests.

The Monetary Cosmopolitans

China s Monetary Sterilization

International Monetary Fund

International Monetary Fund

At the beginning of the 1990 s, when the majority of the European Union s member states decided to form a monetary union with a common currency and a central bank, the idea of a central government lacked support. As a result, that phase of the monetary union s construction was postponed, leaving an impressive edifice that lacked a strong foundation to ensure stability in times of crisis.

NEW YORK We live in a world where, in theory, global economic and political governance is in the hands of the G 20. In practice, however, there is no global leadership and severe disarray and disagreement among G 20 members about monetary and fiscal policy, exchange rates and global imbalances, climate change, trade, financial stability, the international monetary system, and energy, food and global security.

The past two generations have witnessed the rise of independent central banks whose monetary policy, largely insulated from partisan politics, aims for the maximum possible employment and purchasing power consistent with price stability. Monetary policy in the industrial core has been far from perfect in this age of independent central banks, but it has been much better than what came before, representing a victory for technocracy.

Most central bankers really are targeting growth, inflation, and financial stability, if not necessarily in that order. The political bubble is an inevitable product of central bank independence, and preventing monetary policy from becoming a target for elected officials requires constant effort.

BEIJING Fixated on inflation targeting in a world without inflation, central banks have lost their way. With benchmark interest rates stuck at the dreaded zero bound, monetary policy has been transformed from an agent of price stability into an engine of financial instability.

So if price stability were the Fed s only goal, the federal funds rate should now be close to 4 . The Fed s rationale for continuing its ultra easy monetary policy is that its dual mandate requires it to be concerned with employment as well.