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Friday, August 08, 2008

Feldstein: A Tale of Two Monetary Policies

Martin Feldstein says there are good reasons for the difference in monetary policy between the Fed and the ECB, the most important being that unions are stronger in Europe than the US. This means there is a greater chance of a wage-price spiral developing in Europe forcing the ECB to adopt a tougher stance on inflation: 

The crisis: a tale of two monetary policies, by Martin Feldstein, Commentary, Financial Times: The European Central Bank and the Federal Reserve are facing similar problems but pursuing different policies. The ECB has been raising interest rates while the Fed has been cutting them. ... Which central bank is doing the right thing? Or could they both be?

Inflation is a significant problem in both the eurozone and the US... Both economies are also facing declining economic activity with falling employment... The sharp rise in the prices of energy and food ... will undoubtedly spill over into higher prices... The primary challenge for both central banks is to limit this inflationary shock to a one-time pass through, avoiding the ... wage-price spiral that drove inflation rates in the 1970s to double-digit levels. Preventing a repetition of that requires convincing the public that today’s high inflation rate will soon decline.

Despite the similar problems faced by the two central banks, there are important differences that justify their separate strategies. The contrast between the ECB’s mandate to achieve price stability and the Fed’s “dual mandate” to balance the goals of price stability and employment is ... a reflection of fundamental differences between the two economies. Those differences make it more difficult to tame inflation expectations in Europe and therefore require the ECB’s tougher policy.

The role of trade unions is the most important difference. Only 7.5 per cent of US private sector employees are union members... In contrast, more than 25 per cent of employees in the European Union are members of trade unions and in some EU countries the wages set in union contracts are automatically extended to other companies in the same industry.

Because of this union power, the ECB must persuade union members and their leaders that it is determined to bring inflation down to its target level... The ECB’s tough stance and exclusive emphasis on price stability is crucial to shifting inflation expectations and persuading unions to accept the rise in food and energy prices without pressing for offsetting wage gains.

In contrast, the Fed does not have to worry in the same way about union power... Wage setting is decentralised and wage contracts do not have the formal links of wages to inflation that intensified the wage-price spiral of the 1970s.

Differences in the inflation histories also influence today’s appropriate policies of the ECB and the Fed. Although Americans remember the double-digit inflation of the late 1970s and early 1980s, there has been no US experience similar to the earlier hyperinflations in Germany and other EU countries. The ECB pursues a tough inflation target policy to persuade Europeans that there is not even a small probability of returning to those conditions.

Finally, the ECB recognises that it is still a very young institution that must prove ... that it will follow the successful anti-inflation tradition of the German Bundesbank. ... The ECB is only now facing its first challenge of imported high inflation...

The power of Europe’s unions, its history of hyperinflation and the need to develop credibility for a young institution all justify the ECB’s tough stance. Because the Fed does not have these problems but faces a potentially serious recession, it is prepared to gamble that the weakness in US employment and the general decline in economic activity will prevent a wage-price spiral without further increases in the interest rate. ... I think the Fed’s current interest rate strategy makes sense but would be too risky for the ECB.

There's another hypothesis that says the reason the ECB is able to focus more on inflation is because of the stronger social safety net that is in place in Europe relative to the US. With a stronger social safety net, variations in employment are less costly and that allows more focus on inflation.

I don't think either explanation gets at the essential reason for the difference in strategies among central banks with some more committed to inflation fighting than others, at least in their official pronouncements.

If you look at the history of who adopted inflation targets first, you will see that the order was New Zealand, Chile, Canada, UK, Sweden, Australia, Norway, Brazil, Hungary, Poland, Mexico, and the Czech Republic (I may not have the order exactly right, source), and the move to inflation targets was largely driven by a desire for more central bank independence. When monetary policy is in the hands of elected officials, the result tends to be high rates of inflation. There is a tendency for elected officials to print new money to pay for government spending rather than using politically more explosive means such as increasing in taxes, cutting spending, or increasing government debt, and this leads to high rates of inflation. Moving from government control over the money supply to an independent central bank dedicated to long-term objectives is a way to solve this problem, but there is a need for the new institution to be credible. That's where explicit inflation targets come in. They are a transparent way of committing to a target, and this allows the credibility of the monetary authority to be easily assessed.

There may be a correlation between high degrees of unionization and highly interventionist governments that is driven by societal preferences for, say, a strong social safety net for workers. And highly interventionist governments may, if they can get their hands on monetary policy, tend to be inflationary. But it's not the unions that are the problem, the problem is the lack of an independent monetary authority and lack of commitment (or lack of ability to commit) to long-run price stability goals. Countries that have moved to a more independent central bank with transparent inflation goals have experienced lower inflation rates even when they have high degrees of unionization. It was the desire for an independent monetary authority and the need to establish credibility that led to the difference in emphasis on inflation and output between the US, which already had a relatively independent and credible central bank, and other central banks around the world.

Finally, it is misleading, I think, to characterize the ECB as strict inflation targeters, "inflation nutters" to use Mervyn King's term for it. Output targets remain important. First, in the short-run, inflation targeting central banks will allow inflation to move outside the target range if they are worried about weakness in output and employment. Second, an inflation target above zero, say 2%, recognizes the potentially destructive effect of deflation on output (a reason why many people have urged the Bank of Japan to adopt an inflation target above zero - deflation has been a problem for the Japanese economy). Thus, output is clearly part of the central banks' objective function. Third, well, let me quote Bernanke:

Several authors have made the distinction between so-called "strict" inflation targeting, in which the only objective of the central bank is price stability, and "flexible" inflation targeting, which allows attention to output and employment as well. In the early days of inflation targeting, this distinction may have been a useful one, as a number of inflation-targeting central banks talked the language of strict inflation targeting and one or two came close to actually practicing it. For quite a few years now, however, strict inflation targeting has been without significant practical relevance. In particular, I am not aware of any real-world central bank (the language of its mandate notwithstanding) that does not treat the stabilization of employment and output as an important policy objective. ... Moreover, virtually all (I am tempted to say "all") recent research on inflation targeting takes for granted that stabilization of output and employment is an important policy objective of the central bank. In short, in both theory and practice, today all inflation targeting is of the flexible variety.

I don't disagree that unions can magnify inflation pressures and give inflation more inertia, but the answer to the inflation problem is an independent, credible central bank. Without that, inflation is likely to be a problem whether strong unions are present or not.

    Posted by on Friday, August 8, 2008 at 03:06 PM in Economics, Monetary Policy, Social Insurance, Unemployment | Permalink  TrackBack (0)  Comments (18)


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