Otmar Issing, Vitor Gaspar, Ignazio Angeloni, Oreste Tristani. Monetary Policy in the Euro Area: Strategy and Decision-Making at the European Central Bank. New York and Cambridge: Cambridge University Press, 2001. x + 199 pp. $70.00 (cloth), ISBN 978-0-521-78324-8.
Reviewed by Albrecht Ritschl (Institute for Economic History, Humboldt-Universitaet zu Berlin)
Published on H-German (July, 2004)
This book is not just another description of monetary policy making by the European Central Bank (ECB). Written by Otmar Issing, the ECB's chief economist, jointly with leading ECB research economists, this book is essentially an official statement of policy. As such, the message it conveys between the lines is just as interesting as its verbatim interpretation.
The ECB and the creation of the Euro together constitute an almost unparalleled historical experiment: sovereign states, several economic heavyweights among them, have joined forces in establishing a common currency without giving up their fiscal sovereignty, or without making a firm commitment to political unification. This is a risky endeavor, and one without the guidance of historical experience.
Of course, monetary integration in post-war Europe has a long tradition that extends back to the European Payments Union of 1950. That system already included credit facilities and drawing rights within a fixed exchange rate framework. There even existed fiscal disciplining devices for member countries that violated the rules of conduct. The first test of this system came as early as 1951, when West Germany overdrew its balances, refused to raise interest rates and cut public spending, and thus posed a threat to the whole new system. Back then, the disciplining worked: two emissaries sent in by the OECD devised a painful stabilization program, forced its implementation onto a hesitant government, and achieved a turnaround that paved the way for forty years of West German currency stability.
The early success of the EPU was no small achievement, given the track record of failed monetary cooperation since the inter-war period. The breakdown of the gold standard after 1931, Germany's debt default of 1933, and the horrors of World War II, all combined to create poor starting conditions for postwar monetary cooperation. But as the stabilization program proved successful, it broke these pessimistic expectations, as an economist would term it, and converted the Germans to monetary orthodoxy. This doctrine would become the cornerstone of Bundesbank monetary policy for forty years to come. No monetary history of postwar Europe can give an adequate account of monetary integration without paying due attention to this small event and its big consequences.
Bolstered by the freshly acquired virtues of monetary and fiscal stability--not exactly a German trait during the inter-war period--West Germany's Deutschmark began its surprising rise towards becoming the undisputed anchor currency of Western Europe. Along with it, Bundesbank doctrine gradually turned into the object of dispute and admiration.
In a fixed exchange rate system with capital mobility such as the EPU and the Bretton Woods standard of the 1950s, there is little scope for central bank policy on a national level. Unless a country is the dominant player, such as the United States in the Bretton Woods standard, monetary policy is rather passive, and consists in following the interest rate movements of the system leader step by step. The quantity of money and the national price level both are endogenous to the international flows of goods and funds; there is just precious little an individual member bank can do about it.
Not so the Bundesbank in the 1960s. Defying theory, it sought to exert domestic anti-inflationary policy in spite of its international commitments. Just as France and the US in the interwar years had ignored the rules of the game pertaining to the gold standard by amassing reserves, the Bundesbank sterilized capital inflows during America's Vietnam War inflation. As a consequence, reserves piled up at the Bundesbank, and Bretton Woods came under repeated speculative attacks until it collapsed in 1973. Bundesbank orthodoxy against inflation thus contributed to the breakdown of the Bretton Woods standard, just as French and American orthodoxy in the late 1920s contributed to the breakdown of the gold standard in 1931.
The various fixed exchange rate systems of Europe after the collapse of Bretton Woods in 1973 all grouped around the Bundesbank. Playing non-cooperatively and forcing the breakdown of Bretton Woods had thus paid off; the new system honored the proven anti-inflationary stance of the Bundesbank. It was during this time that the Bundesbank adopted monetarism and, specifically, monetary targeting. The Bundesbank policy maintained its monetary orthodoxy to the very end, and stuck to its monetarist principles up to the establishment of the ECB.
This is the implicit starting point of the book by Issing and coauthors. ECB policy has faced a dilemma since its inception in 1999. On the one hand, the ECB felt the need to define a modern, widely accepted approach to monetary policy. The only obvious candidate for this nowadays is inflation targeting. On the other hand, the ECB could not distance itself from Bundesbank doctrine if it was to inherit its rock-solid credibility. This in turn would call for an adherence to monetary targeting Bundesbank-style. The two are hardly compatible, and the resulting problem is not an easy one to sort out.
The ECB initially resolved the issue in a typical political move. It denied the existence of a dilemma and announced what became famous as its "two-pillar strategy": both inflation and monetary targeting would be employed, but the exact weighting of these two principles in case of conflict was left unclear.
The book takes on the unhappy task of dealing with this issue, although without spelling out the problem too openly. Monetary theory nowadays has moved far past monetary targeting. Monetary aggregates have proved difficult to control; the relationship between the quantity of money and output is less than stable. Even hard-headed monetarists would nowadays concede that monetary targeting is impractical for most purposes. The mantra of today's central bank policy is inflation targeting, where the central bank sets an inflation target (which might be a target zone), and uses interest rate policies to stabilize the inflation rate around the target. If there is a stable relationship between inflation and the quantity of money, then either inflation or monetary targeting is redundant. If no stable relationship exists, then inflation targeting seems more straightforward. In contrast, targeting a monetary aggregate with uncertain links to anything seems rather suboptimal. So much for the current consensus.
The first two chapters of the book lay out these modern debates in some detail, trying to avoid the use of mathematics and of advanced statistical tools. Still, this part of the book necessarily uses all the jargon and the technical terms. While highly valuable as a review of recent theory debates from the ECB's perspective, only readers with economic training can fully benefit from reading it. No serious attempt is made to cast doubt on the current mainstream or to rehabilitate monetary targeting; there is just a matter-of-fact summary of the current state of the art, and a good one at that.
To comfort its readers, the book then embarks on a description of Euroland's economy, providing concise but nicely done comparative tables. Readers looking for classroom material will find these sections to be quite useful. Basics like monetary aggregates and their composition are laid out in detail, and the whole section is clearly written to be palatable for an interested but less technically oriented audience. Hardly anything here seems controversial; yet, the devil is in the detail.
Much effort has been spent on defining an internationally consistent price index, the HICP, to provide an unbiased measure of inflation across the Euro area. Examining its composition (in table 3.3, p. 55), what stands out are the surprisingly low and varying weights of housing across member countries. This has to do with the way in which the cost of housing is valued. U.S. practice is to include the imputed cost of owner-occupied housing.
The European index does not do that; it limits itself to recording rents actually paid by tenants, and excludes the imputed rent of owner-occupied housing. As trends in real estate prices in Europe vary substantially but home ownership rates are medium to high, this decision has major implications for the result. Inflation in economies where house prices have gone up sharply (like Spain) is grossly understated by the HICP, while it is overstated in countries where house prices have fallen (like Germany). As a result, the current spread in national inflation rates is strongly underestimated by the HICP. This in turn makes the problem of harmonizing inflation rates in Europe look less serious than it probably is.
The substance of the book's message comes out in chapter 5. Having no excuse any more, it finally tackles the question of the necessity of a two-pillar strategy, and actually gets rid of the problem in a surprising dialectical twist. Building on recent results, it claims that not even the Bundesbank ever followed a monetary target, but just used the metaphor in communication with the public. Come to think of it, this is actually a pretty remarkable exercise in discourse analysis. Not that we believe in any way in what we say, we just use the catch phrase as a communication device! Of course, things are not that easy, and the authors soon note that their attempt at self-defense actually plays into the hands of their critics If all the money talk means nothing and the public criticizes it, then why retain it?
Despite the seeming contradiction, in chapters 6 and 7 the book staunchly defends retention of the monetary pillar. It now does what was missing in the beginning and attacks the critics of the monetary approach head-on. Not that the argument is always convincing: mostly, the attempt is made to assign to money the role of additional information that somehow, sometimes might not be included in prices. But again, reading between the lines is what matters here. Whatever the intellectual merits of the monetary target, it links the ECB to the heritage of the Bundesbank. The monetary doctrine is like an escape clause that allows the ECB to deviate from its inflation targeting rules and apply the (supposedly stricter) monetarist logic whenever it seems fit. The Bundesbank did so in the past, when it reacted to what it perceived as inflationary dangers from government policy. The ECB quite obviously reserves its right to do the same, although it does not say so very openly. Apart from a lot of useful and well-written information, this is what the book seems to be all about.
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Citation:
Albrecht Ritschl. Review of Issing, Otmar; Gaspar, Vitor; Angeloni, Ignazio; Tristani, Oreste, Monetary Policy in the Euro Area: Strategy and Decision-Making at the European Central Bank.
H-German, H-Net Reviews.
July, 2004.
URL: http://www.h-net.org/reviews/showrev.php?id=9574
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