Mr George outlines monetary and exchange rate policies for sustainable growth
Speech by the Governor of the Bank of England, Mr E A J George, at The Central Bank
Policies Conference, Macau, 17 May 1999.
Mr Chairman, Ladies and Gentlemen, let me begin by saying that it is a real pleasure to be
here with you today in Macau and to participate with such distinguished central bank
colleagues in your conference.
One of the very agreeable things about coming to the other side of the world to participate in
an event like this is that it enables me to step back from the daily hubbub of my office, the
financial markets in the City of London, and the media, and reflect in a broader way on what it
is we are all actually trying to do. It is in fact much more agreeable than working!
In a broad sense, of course, our ultimate objective as central bankers is clear, and it is reflected
in your conference title when you talk about "leading the way to sustainable growth". I would
add high rates of employment and rising living standards to that objective.
Very often in the past, certainly in my own country, but not just in my own country, that
fundamental objective was seen to be largely a matter of demand management - of pumping
up demand by expansionary fiscal and monetary policies - with too little regard to the
structural, supply-side, capacity of our economies to meet that demand. There is not much that
overall fiscal policy, still less monetary policy, can do directly to affect the supply-side
capacity of the economy: they operate essentially on the demand side. And our recurrent
experience showed that excessive demand growth spilled over into inflation and a worsening
balance of payments which ultimately had to be corrected - the infamous boom and bust
cycle. This macro-economic instability damaged the supply side of the economy, with a worse
outcome over time in terms of our ultimate policy objective. It is now very widely understood
that "stability is a necessary condition for sustainable growth" and that, of course, has become
the universal central banker's mantra.
But the question is stability of what? You obviously cannot sensibly aim to stabilise
everything. The aim has to be sustainable growth of the economy as a whole. But that cannot
mean stable growth for every sector of the economy or for every business enterprise.
Consumer demands change over time and so, too, do technologies and production techniques.
Open market competition to identify such changes, and to exploit them to meet social needs
more efficiently, is a vital driver of improvement on the supply side of the economy. At the
micro-economic level, that means that particular sectors and individual businesses will
continually rise and fall; and that is why established producers everywhere often see new
competition, perhaps especially international competition, as an unwelcome threat. But at the
macro-economic level what we have to remember is that every dollar earned is a dollar
available to be spent or reinvested back into the economy, whoever earns it. So, at the
macroeconomic level, competition - the driver of economic progress - is a positive sum game; it
increases the potentially sustainable growth rate nationally, regionally, and internationally.
How far each country individually is able to take advantage of this increased potential
depends upon how flexibly it can adapt to changes in comparative productive advantage -
which in turn depends upon the supply-side characteristics of our separate economies. But
there is no doubt that we all stand to benefit. That is why I have always believed
fundamentally in the principle of free trade and open capital markets which enhance
competition. It is why I have always welcomed the rapid growth we have seen in the emerging
market economies - and why incidentally I look forward to China's accession to the WTO.
We cannot then sensibly aim to obstruct structural changes. But nor can we realistically hope
to avoid all shorter-term fluctuations, associated with the business cycle for example or as a
result simply of random shocks. What we are looking for is a stable macro-economic
framework for the economy as a whole, which will help to moderate rather than aggravate
shorter-term fluctuations, and one within which change can occur in response to longer-term
real economic factors, undistorted by unnecessary, erratic, movements particularly in nominal
values.
In a totally closed, national, economy I suspect that the most effective way of achieving this
would be to aim to stabilise the rate of consumer price inflation - at some very low level
representing effective price stability. We might, certainly, as an intermediate step aim to
stabilise the rate of growth of the money supply, if we were confident that the demand for
money was sufficiently stable and predictable, but the reason for targeting the growth of the
money supply would ultimately be to stabilise the rate of inflation, so the distinction is
operational rather than substantive.
But it is important to understand that effective price stability would not be intended simply as
an end in itself. In order to maintain price stability, what in fact we would need to do is to
keep overall demand in the economy continuously broadly in line with supply-side capacity,
so that the actual rate of inflation is really a measure, or barometer if you like, of our success
in maintaining macro-economic stability in a much wider sense. If we succeed in maintaining
such stability, that would also contribute, indirectly, to improving the supply side of the
economy by reducing nominal uncertainty as a factor in spending or saving or investment
decisions and thereby improving resource allocation.
Macro-economic stability in this sense can of course be affected by either overall fiscal policy
or by monetary policy. But frequent fiscal policy changes - to tax rates or expenditure
programs - can generate micro-economic uncertainties so that short-run macro-economic
stabilisation is normally left primarily to monetary policy. It is important nevertheless that the
two arms of policy pull in the same general direction to avoid unwanted sectoral or related
regional distortions.
In a totally closed economy therefore the objective of macro-economic stabilisation and the
respective roles of fiscal and monetary policy would be reasonably clear.
But none of us - very fortunately in any wider context - actually lives in a closed economy.
We are all vulnerable to external shocks to varying degrees, including of course, increasingly,
shocks resulting from international capital flows. Free trade and open capital markets do, as I
noted earlier, bring huge benefits in terms of supply-side improvements from which we all,
potentially, stand to gain. But there is no doubt that economic globalisation can at times
massively complicate our national efforts at macro-economic stabilisation and it is this
problem which I should like to address in the rest of my remarks.
A key issue is how far we can protect our internal macro-economic stability through our
choice of exchange rate regime. My short answer to that question - from the UK's experience
- is that there is, sadly, no ideal solution!
The effective options range from floating, through some form of adjustable peg, to a
quasifixed exchange rate by way of a currency board or, ultimately, full monetary union. Each
option has its pros and cons.
Let me start with floating. At first blush the idea of allowing the exchange rate to take the
strain, as a kind of buffer, insulating the domestic economy from shocks emanating abroad
appears very attractive. Unfortunately it does not necessarily work like that. A floating
exchange rate may move erratically in response to market news, causing unwarranted
movements in the real exchange rate. That, of course, may be an important influence on
domestic costs and prices; it may affect the relative competitiveness of domestically and
foreign-produced goods and services leading to changes in the net external trade position,
affecting aggregate demand in the domestic economy. So the insulation provided by a floating
exchange rate may prove to be more apparent than real.
The UK has been floating since 1992. For some years we experienced very little tension
between our domestic and external policy needs. But then, from the autumn of 1996 we saw a
sudden appreciation of some 20-25% in our Effective Exchange Rate against the core
European currencies, and seemingly, largely related to uncertainties about the future
characteristics of the European single currency. Whatever the reason the strengthening of the
exchange rate had a dampening effect on the domestic price level, and a subsequent
deterioration of our trade balance (accentuated over the past year or so by the global economic
slowdown) reduced aggregate demand in the economy. Monetary policy accordingly needed
to be less restrictive than would otherwise have been appropriate to offset these effects on
domestic demand. The aim was not to achieve a particular level of the exchange rate but to
compensate for its deflationary impact. When the exchange rate weakens - as we anticipate
that it will in due course - then monetary policy will at some point need to offset that
influence in the opposite direction. But in the meantime we have had to manage as best we
can a severe imbalance between different sectors of the economy, with the internationally
exposed sectors taking a considerable hammering. Despite reasonable macro-economic
stability in the economy as a whole, the environment has been anything but stable for those
sectors.
For a period before 1992 we sought to manage the exchange rate, initially by informally
shadowing the DM and subsequently by pegging sterling within the framework of the
European Exchange Rate Mechanism. Both these episodes ended in tears, essentially for the
same reasons: attempting to manage the exchange rate required us to pursue macro-economic
policies which were inconsistent with our own domestic macro-economic needs. In the first
case shadowing the DM involved accentuating a domestic boom; in the second case our
membership of the ERM, at a time when reunification required abnormally tight monetary
policy in Germany, involved us in pursuing an unnecessarily restrictive monetary policy
deepening and prolonging recession. In that case, too, the formal commitment made exit more
difficult, the exchange rate fell very sharply, and we made a very substantial financial loss as a
result of massive foreign exchange intervention seeking to defend the ultimately indefensible.
While they lasted these regimes provided a degree of nominal exchange rate stability which
no doubt helped the internationally exposed sectors of the economy. But the price ultimately
was substantially increased instability in the economy as a whole.
Of course, some commentators have argued that the problem we had within the ERM was the
exchange rate at which we entered rather than the form of the arrangements. I am not
convinced. The divergence between our domestic policy needs and those in Germany was
such that it seems unlikely to me that any plausible difference in the exchange rate initially
chosen for the peg would have made very much difference. But in any event the range of
uncertainty surrounding the choice of a sustainable peg is an important part of the problem
with any pegged or fixed rate regime.
The UK has not recently experienced a fully fixed exchange rate regime - although we remain
a potential member of European Monetary Union. But the basic economic pros and cons of a
fixed rate regime are somewhat similar. Essentially the very real advantages are nominal
exchange rate certainty within the Euro-zone - which accounts for some 50% of our external
trade as well as participation of the domestic economy in broader, more liquid, pan-European
financial markets. (The City of London is, of course, already a full participant in the European
financial markets - indeed it is the major contribution that we can make at this stage in the
development of the new currency.) These are very considerable potential economic benefits
which will lead to more efficient resource allocation across the euro area. The potential
downside is the risk that at times the single European monetary policy will not meet the
domestic monetary policy needs in all the individual participating countries - in other words
that there will be problems of sectoral and regional divergence which are very familiar in
larger economies at the national level, but on a larger, regional European, scale. The jury is
still out on this question.
Based on our experience it seems clear, as I say, that there is no clear best solution, applicable
at all times for all currencies, to reconciling the inherent problem of potential conflict between
the needs of domestic and external stability.
The choice depends very much upon the country's particular circumstances.
Floating may be more attractive to a country which has a small tradeable sector relative to the
size of its domestic economy, but in that case it will need an effective nominal domestic
anchor, such as a money supply or inflation target; and it will need an institutional structure -
typically an independent central bank - to reinforce the credibility of the commitment to that
nominal anchor.
At the other extreme a fixed rate regime may be more attractive to smaller, more open,
economies or where a credible domestic macro-economic framework is difficult to establish,
for example, for historical or political reasons. But in this case it is crucial to recognise that
domestic policy must be totally and unreservedly committed to maintaining the fixed
exchange rate. It is an extremely demanding regime but one which can work well - as we
have seen in Hong Kong - where there is a high degree of supply-side flexibility to act as an
alternative external shock absorber.
It has become increasingly fashionable recently to exclude anything between these two
extreme positions - an actively managed float or a pegged rate regime - as an unviable middle
ground. It is argued essentially that because they do not exert a sufficient discipline on policy
in either direction, or therefore represent a sufficiently clear policy framework, they tend to
intensify market tensions when a divergence between the policy needs of domestic and
external stability does in fact arise.
I am reluctant to accept that so-called "corner" view in any absolute sense. When tension does
arise between external and domestic objectives, you cannot avoid the impact on domestic
policy altogether even with a floating exchange rate regime - as I explained in the context of
our own recent experience. It may help to reduce that tension to attempt to manage the float to
some degree, by supporting appropriate domestic policy action with exchange market
intervention, though I agree that such intervention may serve as little more than a signal where
a currency is internationally widely traded and held. Similarly there can, I believe, be
circumstances in which domestic discipline may be reinforced by an exchange rate peg, but it
is vital in that case that the authorities should identify a clear exit strategy before serious
tensions are allowed to emerge. That - I know from our own experience - is much easier said
than done!
Mr Chairman, these dilemmas are certainly not new. But clearly they are liable to be
accentuated by the massive increase in global capital flows over recent years, which has not
only complicated the choice between alternative possible exchange rate regimes but also made
the management of any of those regimes substantially more difficult.
So there is a further question we need to address which is whether there is anything we can do
to reduce the volatility of these massive capital flows beyond pursuing disciplined
macroeconomic policies. That of course is the subject of a whole series of conferences on its own;
and there is certainly a good deal that we can do. Let me conclude by mentioning some of the
items on my own shopping list in this context.
First, at the recipient end, a crucial condition for living with financial globalisation is
improvement of market structures to ensure that capital inflows are productively employed.
That involves attention to structural issues, such as accountancy standards, bankruptcy laws,
and governance questions. It involves appropriate sequencing of capital account liberalisation
- and arrangements to ensure that the particular risks to the borrowing country, for example,
attaching to volatile short-term inflows are properly recognised - and reflected in the price
paid by the borrower. That in turn involves effective management of foreign currency assets
and liabilities in particular, including management of their relative liquidity, by both the
public and private sectors. It involves, also, ensuring that borrowers, and their creditors, are
unambiguously clear as to who is ultimately responsible for the liability at the time it is taken
on. It involves increased attention more generally to the soundness of financial systems -
which is to be the subject of our discussion this afternoon. And perhaps above all it involves
improved transparency - of policies, of standards, and of financial and economic data - to
enable investors and lenders to make informed assessments of risks.
But there is a great deal too that the international financial community can do, as it were from
the provider end. This includes the intensive efforts being made, particularly by the IMF, to
encourage sound macro-economic and structural policies - and greater transparency - in all
IMF member countries. It includes intensified efforts by financial regulators particularly - at
the national level but also working collectively through the new Financial Stability Forum, the
Basle Committee and IOSCO for example - to improve prudential standards of financial
behaviour. And it includes the provision of official financial support to countries that are
pursuing sound policies - in parallel with continuing private finance, on which the risks
would have been reduced both through the parallel official finance itself and through official
international endorsement of the borrowing country' s policies. In this context I think we in
the official sector may have placed too much emphasis in international discussions on "bailing
in" the private sector - which can sound ominous, even threatening - where what we really
need is recognition of our mutual interest in public-private sector partnership.
It is a heavy and complex agenda which is being very actively pursued in many different
international groupings, involving both the industrial and emerging countries, across a broad
front. We are I believe steadily moving towards consensus or many of the issues and this is
"leading the way towards sustainable economic growth" into the next millennium. In the
meantime we are collectively having to manage the consequences of the recent global
financial disturbances and their economic after-effects. Happily we have recently been making
progress on that too, particularly in many of the emerging countries here in Asia.