Macroeconomic policies of the European economic and monetary union 155
2 THEORETICAL UNDERPINNINGS OF THE EMU
stabilizer’). But these fluctuations in the budget position take place around a balanced budget on average over the cycle.
3. Monetary policy can be used to meet the objective of low rates of inflation (which are always desirable in this view, since low, and stable, rates of inflation are conducive to healthy growth rates).1 However, mon- etary policy should not be operated by politicians but by experts (whether banks, economists or others) in the form of an ‘independent’ central bank (ibid., pp. 40–41). Indeed, those operating monetary policy should be more ‘conservative’, that is place greater weight on low inflation and less weight on the level of unemployment than the politicians do (Rogoff, 1985). Politicians would be tempted to use monetary policy for short- term gain (lower unemployment) at the expense of long-term loss (higher inflation). An ‘independent’ central bank would also have greater cred- ibility in the financial markets and be seen to have a stronger commitment to low inflation than politicians do.
4. Credibility is recognized as paramount in the conduct of monetary policy to avoid problems associated with time inconsistency.2 This is an argu- ment that reinforces the requirement of central bank independence. It is argued that a policy which lacks credibility because of time inconsist- ency is neither optimal nor feasible (Kydland and Prescott, 1977). The only credible policy is the one that leaves the authority no freedom to react to developments in the future, and even if aggregate demand poli- cies matter in the short run in this model, a policy of non-intervention is preferable. It is precisely because of the time inconsistency and credibil- ity problems that monetary policy should be assigned to a ‘credible’ and independent central bank. Such a central bank should be given price stability as its sole objective.
5. The inflation objective is preferred to a money supply objective. The inflation objective is neither a simple rule that inflation is the only target, nor is it discretionary: it is rather a framework for monetary policy whereby public announcement of official inflation objectives, or ranges, is undertaken along with explicit acknowledgment that low and stable inflation is monetary policy’s primary long-term objective. This improves communication between the public and policy makers and provides dis- cipline, accountability, transparency and flexibility in monetary policy.
The inflation objective has been described as ‘constrained’ or ‘enlight- ened’ discretion, in that an inflation objective serves as a nominal anchor for monetary policy. Thus monetary policy imposes discipline on the central bank and the government within a flexible policy framework. For example, even if monetary policy is used to address short-run stabilization objectives, the long-run inflation objective must not be compromised;
this imposes consistency and rationality in policy choices (in this way,
Macroeconomic policies of the European economic and monetary union 157 monetary policy focuses the public’s expectations and provides a refer- ence point to judge short-run policies). Although the ECB allegedly does not pursue an ‘inflation targeting policy’ of the type described in Chapter 2 (Duisenberg, 2003a; Issing, 2003b; see also our discussion below), it does, nonetheless, pursue a monetary policy strategy with ‘the clear commitment to the maintenance of price stability over the medium term’
which ‘implies a stable nominal anchor to the economy in all circum- stances’ (ECB, 2001b, p. 49; see also ECB, 2001c, p. 6; 2001d, p. 6).
6. The level of economic activity fluctuates around the NAIRU, and unem- ployment below (above) the NAIRU would lead to higher (lower) rates of inflation. The NAIRU is a supply-side phenomenon closely related to the workings of the labour market. The March 2003 issue of the ECB’s Monthly Bulletin puts it as follows: ‘the outlook for the euro area economy could be significantly improved if governments strengthen their efforts to implement structural reforms in labour and product markets. Such re- forms are important to ultimately raise the euro area’s production potential, improve the flexibility of the economy and make the euro area more resilient to external shocks’ (ECB, 2003b, p. 6), a point repeated in the April 2003 issue of the Monthly Bulletin. Domestic inflation (relative to the expected rate of inflation) is seen to arise from unemployment falling below the NAIRU, and inflation is postulated to accelerate if unemploy- ment is held below the NAIRU. However, in the long run there is no trade-off between inflation and unemployment, and the economy has to operate (on average) at the NAIRU if accelerating inflation is to be avoided. In the long run, inflation is viewed as a monetary phenomenon, in that the pace of inflation is aligned with the rate of interest. Monetary policy is thus in the hands of central bankers. Control of the money supply is not an issue, essentially because of the instability of the de- mand for money that makes the impact of changes in the money supply a highly uncertain channel of influence.
7. The essence of Say’s Law holds, namely that the level of effective demand does not play an independent role in the (long-run) determina- tion of the level of economic activity, and adjusts to underpin the supply side-determined level of economic activity (which itself corresponds to the NAIRU). Shocks to the level of demand can be met by variations in the rate of interest to ensure that inflation does not develop (if unemploy- ment falls below the NAIRU).3
Most of these general ideas can be seen as formalized (explicitly or implic- itly) in what has become known as the ‘new consensus’ of macroeconomics,
and a simple three-equation model describing the ‘new consensus’ has been set out in Chapter 2. The three relationships that summarize the ‘new consen- sus’ contain all the essential elements of the theoretical framework of the EMU (see also ECB, 2003a). There are, however, two important differences worth highlighting. The first is that the ECB does not pursue ‘inflation target- ing’. We discuss this issue below, in the section entitled ‘Monetary Policy’, but here it suffices to quote Duisenberg (2003a), who is adamant that the ECB approach does not entail an inflation target: ‘I protest against the word
“target”. We do not have a target … we won’t have a target.’ The second is that, in the ECB view, the demand for money in the euro area is a stable relationship in the long run; most central banks would suggest the opposite in the case of their economies.4 This is also an issue we pursue further below.