Jürgen Stark: Towards a stability-oriented policy framework
Speech by Mr Jürgen Stark, Member of the Executive Board of the European Central Bank,
at the conference "Reconstructing the world economy - redesigning the macro-framework",
organised by the Korea Development Institute and International Monetary Fund, Seoul,
25 February 2010.
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Ladies and Gentlemen,
In discussing the current macroeconomic framework, I will focus on the institutional aspects
that have proved successful, in particular, from the European perspective. These are central
bank independence, the centrality of price stability for monetary policy and the need to adopt
a medium-term, rules-based perspective in the conduct of monetary and fiscal policies. The
financial crisis has not contested or discredited these three principles.
However, it is certainly true that other aspects of the international consensus framework
merit some deep re-thinking. I will take this opportunity to share my thoughts on four such
elements, namely inflation targeting, central banking as risk management, monetary policy
and asset prices, and fiscal policy.
The reference model
Inflation targeting, together with the canonised version of the New Keynesian model on which
it is predicated, is perhaps the main building block of the pre-crisis consensus paradigm.
Although they are closely connected, I wish to separate the policy prescriptions from the
underlying model, and address each in turn.
The shortcomings of the New Keynesian modelling paradigm have been recognised before.
But addressing them has not yielded a paradigm shift to overcome them.
The first shortcoming of this paradigm is its inability to explain and recognise the importance
of financial frictions and the role of money. Money is at best ignored - and at worst derided -
as a redundant and unnecessary complication. This has to do with the fragile theoretical
foundations of the mechanisms which - in this paradigm - account for the connection
between the real economy, financial imbalances, and the state of confidence and inflation.
This disregarding of money goes hand-in-hand with the assumption of the absence of risk.
The mainstream model excludes default. If assets are formulated at all, they all net out. No
risk generated in the financial sector can affect the real economy. The financial crisis has
clearly exposed the flaws in this assumption. It has led to a misapprehension of the root
causes of the crisis and its propagation mechanism.
Liquidity and money are key for the ECB's monetary policy strategy. Far from showing that
the ECB's strategy lacks theoretical foundations, the crisis has borne out our broad-based
approach and exposed the incompleteness of the transmission mechanism in the reference
model.
The second shortcoming of this paradigm is its undue focus on small economic fluctuations
around benign states of the economy. This left economists unprepared in terms of being able
to predict the crisis and its impact.
Third, the paradigm rests on the built-in assumption that the announcement of an inflation
target automatically yields credibility. The canonised version of the model does not allow for
an understanding of how institutional strength and a track record affect credibility.
Institutional strength requires central bank independence, for which, in turn, legal
independence is a necessary, but by no means sufficient prerequisite.
Inflation targeting
The reference model has been at the heart of inflation targeting approaches. In brief, inflation
targeting can be summed up as follows:
First, take inflation and output gap forecasts as summary statistics of the state of the
economy.
Second, ignore a host of variables, particularly money and credit. Assume that these adjust
to the state of the economy, but do not influence it independently.
Third, fine-tune the policy instrument so that inflation forecasts - whatever the nature of the
shocks that might have caused them - are stabilised, and output volatility is minimised, at a
pre-set horizon.
It has long been known that it is misleading to limit the information set to output gap and
inflation forecasts. Output gaps are ill-defined and cannot be accurately measured.
Furthermore, inflation forecasts are not summary statistics of the state of the economy.
Different underlying shocks - even though they might lead to the same inflation forecast -
can have vastly different implications for policy.
Risk management
It has frequently been argued that central banks should act as risk managers by organising
their framework around events with a high deflationary impact. To minimise the likelihood of
deflation, central banks should err on the lax side and aim at significantly higher inflation
rates. With this in mind, the IMF asks whether a permanent inflation target of 4% is
appropriate. The proposal is nothing less than asking whether in the pursuit of price stability
central banks put macroeconomic stability at risk.
I do see the temptation for governments to ask for higher inflation in order to monetise the
dramatic build-up of public debt in nearly all advanced economies. This is why calling on
central banks to raise inflation rates permanently is most unhelpful. It deflects from the most
pressing problem that, currently, macroeconomic stability is threatened by the unsustainable
position of public finances in nearly all advanced economies. I can only reject the idea of
raising inflation rates permanently. I would not like to imagine the consequences if, on top of
the current financial fragilities and in an environment of high public debt, the general public
were to lose trust in the purchasing power of money.
There is no evidence whatsoever to support that deviating from price stability and aiming at
an inflation rate of 4% would enhance economic prosperity or growth. On the contrary, no
one would seriously deny that inflation has a detrimental impact.
The inflation tax does not constitute just another tax distortion. It greatly exacerbates
distortions from existing taxes, contributing to a misallocation of resources and a rise in the
tax burden, especially for lower-income households, and ultimately depresses economic
growth.
It is an irrefutable empirical fact that inflation variability rises with the level of inflation, which
in turn increases uncertainty for investors and long-term interest rates through a rise in the
inflation risk premium.
A permanent increase in inflation curtails, rather than stimulates, long-term growth. A
considerable body of empirical research finds that the Phillips curve has a negative bent in
the long run: inflation and inflation volatility penalise capital formation and thus detract from
the economy's growth potential.
Empirical evidence confirms this negative relationship, with a 100 basis point permanent
increase in inflation being associated with a 10-30 basis point decrease in trend output
growth. Hence, if this is applied to the euro area, a 4% inflation target would shave no less
than half a percentage point per year off trend growth!
As for using monetary policy to manage macroeconomic risk, it should be recognised that
this would introduce harmful asymmetries. It avoids policy restriction when positive
supplyside shocks reduce inflation, fuelling asset price booms; and when the asset price boom
finally turns into a bust, it leads central banks to overreact to negative demand-side shocks.
So, financial instability meets two formidable multipliers, the first being a pro-cyclical
monetary response to expansionary disinflations in good times and the second being moral
hazard in financial markets, namely the expectation that the central bank will aggressively
protect the markets from "tail events" in bad times. These expectations encourage markets to
tend towards risky strategies, over-exposures and exuberance.
Monetary policy and asset prices
It is worth mentioning the role of asset prices in the conduct of monetary policy. A long series
of booms and busts over the past four decades have demonstrated that asset price
developments can pose serious threats to macroeconomic and price stability, and that,
therefore, central banks cannot simply neglect them. In this respect, it appears that a
comprehensive monetary policy strategy, which also gives prominence to money and credit
developments, might be better able to "lean against the wind" of financial exuberance.
Central banks should be equipped with a broad-based analytical framework for monitoring
and analysing in detail such developments. At the ECB, this approach is underpinned by the
monetary analysis, the second pillar of our monetary policy strategy.
Fiscal policy
For many commentators, the financial crisis has underlined the need for a return of the State
in managing macroeconomic developments. Of course, together with central bank liquidity
support, discretionary government intervention has been key in forestalling a repeat of a
1930s-style depression. However, we are observing a drift in public liabilities that will prove
hard to correct with the usual stabilisers. In some countries, this drift actually has nothing to
do with the financial crisis. It is rooted in the policy hyper-activism that was already in place
before the crisis. And this despite the obvious dangers of an overreactive fiscal stance, which
cannot be decided and implemented without long lags.
Here, fiscal rules, such as the Stability and Growth Pact in the European Union can help. If
given enough authority, rules can induce symmetric behaviour.
It remains to be seen how the discretionary fiscal measures adopted in response to the crisis
can be wound down and reversed to support fiscal sustainability in the longer run. Since the
ECB has started to gradually phase out its extraordinary liquidity support measures, fiscal
authorities should also start to withdraw stimulus to safeguard public solvency over the
medium term. To support this, we have the right mechanisms in place in Europe.
Governments will have to comply with and, as experience shows, even re-enforce the fiscal
rules enshrined in the Stability and Growth Pact.
Concluding remarks: some lessons
From this quick overview, I draw two lessons for monetary policy.
The first lesson to be learned is that central banks need to broaden - not restrict - their
overview of the economy. Monetary data are critical in warning against risks that are slow to
appear in inflation forecasts. Monetary analysis at the ECB consistently sent early signals
that risk was broadly under-priced, when inflation was quiescent and measures of slack were
moderate.
The second lesson is that price stability is the only anchor which can pin down the economy
in turbulent times. It is not sufficient to guarantee financial stability, but it is certainly
necessary to prevent financial instability.
Increasing the level of inflation that central banks should aim at would be a step in the wrong
direction. Our price stability mandate has not constrained us from responding forcefully and
successfully to the biggest disinflationary shock experienced in generations. With inflation
rates in the euro area currently projected to be slightly above 1% in the short to medium
term, deflation risks continue to be absent, and price stability has been maintained. Most
importantly, of course, price stability has not compromised macroeconomic stability.
Thank you.