Jens Weidmann: Of dentists and economists - the importance of a
consistent economic policy framework
Speech by Dr Jens Weidmann, President of the Deutsche Bundesbank, before the
Juristische Studiengesellschaft, Karlsruhe, 11 February 2014.
* * *
1. Introduction
Ladies and gentlemen
Paul Samuelson once said, "I don't care who writes a nation's laws, or crafts its treatises, if I
can write its economics textbooks."
Paul Samuelson wasn't just one of the foremost economists of the last century, he was also
a master of the punch line. And I can well imagine that this knack made him a firm favourite
among fellow economists.
Yet in my opinion, this viewpoint fails to consider important links between economic theory
and legislation. The economic analysis of law provides a large number of examples of the
extent to which legislation affects economic life. And a good proportion of legal rules are
ultimately based, among other things, on economic insights such as that independent central
banks are the best guarantors of price stability, or that the monetary financing of
governments undermines a stability-oriented economic order.
Thus, economists ignore the consequences of legislation and jurisdiction at their own peril. I
would say that a lively exchange of ideas between lawyers and economists not only makes
sense: it is absolutely imperative. I am therefore delighted to be able to carry this dialogue
forward with you here today, and I thank you for your invitation.
2. Economic policy: regulations or leeway?
Just how fruitful an exchange of ideas between economists and lawyers can be is illustrated
by a concept that has had a lasting influence on German economic policy: that of regulatory
policy.
It was a most odd coincidence, as the legal scholar Franz Böhm later put it, that brought
himself, his colleague Hans Grossmann-Doerth and the economist Walter Eucken together in
1933 at the Faculty of Law and Political Science at the University of Freiburg. It is here that
the three set about researching and teaching, and that was when German ordoliberalism, the
"Freiburg School", was born.
Shaped by the experiences of the global economic crisis and of a totalitarian command
economy, the core element of ordoliberalism is competition, yet no longer competition in the
classic - unbridled - sense, but a protected, orderly competition. Or, as Federal President
Joachim Gauck described it in his speech at the Walter Eucken Institute a few weeks ago:
"Neither is it an order that subjects the individual to state paternalism, nor is it a market in
which the strong can become so big that they themselves dictate the rules."
Ordoliberalism, then, is about more than striving for economic efficiency. As the Federal
President also pointed out: "By breaking long-standing privileges and cemented power
structures, competition offers scope for more participation, more inclusion."
What is crucial with regard to ordoliberalism is an appropriate framework within which orderly
competition can take place. According to Walter Eucken, such a framework can be described
as what he called "constitutive and regulative principles of a competitive order".
Of central importance in this respect is a smoothly functioning pricing system. This is
because, in a market economy, prices play a decisive information and steering function,
regardless of whether they are the prices for goods, services or assets.
Walter Eucken adds to this fundamental principle six other principles which together
characterise a competitive order: open markets, freedom of contract, constancy (in the sense
of consistency or reliability) of economic policy, liability for one's own actions, private
ownership and the primacy of monetary policy, the latter being of particular interest to me as
a monetary policy maker.
Thus, economic policy must fulfil two tasks. First, it has to spell out these principles in the
form of suitable rules to ensure that they become operable - which in some circumstances
may also mean justiciable -, that they can be set in relation to each other, and that they
actually develop a binding force. Second, economic policy must align the requirements of a
competitive order with other political ends, for example if the results of market processes are
undesirable from a social-political perspective.
Keeping an eye on the social consequences of market processes is an important supplement
to regulatory policy and the hallmark of a social market economy. The relationship between
market forces, their social consequences and interventions to correct them is often complex.
This means that obvious measures aren't always the best ones, and sometimes they aren't
even effective: it is indeed true that good intentions do not always produce good results.
It's for policy-makers to weigh up different objectives, and economists cannot take that
responsibility from them. But economists can and should point out the economic costs and
side-effects of the different courses of action available.
A cursory consideration of this job description perhaps seems to suggest that the Keynesian
ideal of the economist as a dentist might become reality. To quote Keynes: "If economists
could manage to get themselves thought of as humble, competent people on a level with
dentists, that would be splendid."
I am afraid, however, that this notion of the economist's role will remain a pious hope. Most
economists are indeed humble or competent people - and sometimes they are both.
But in the past few years, insights gained in the field of economics have probably
experienced more ardent debate than the latest findings on dentistry. For given the
complexity of reality, the dynamics of an increasingly interlinked global economy and the
uncertainty that upheavals like the financial and economic crisis in particular generate, there
are often no simple answers to economic policy questions. What is more, these answers may
change with time.
On the one hand, the specific set-up of an efficient competitive order is subject to constant
change. As the framework conditions shift, so the regulatory principles I have just mentioned
may have to be re-operationalised. At the same time, it is important to weigh other social
policy objectives anew against the requirements of a competitive order, if necessary. On the
other hand, not even a rule-bound, regulatory policy-driven economic set-up can do without
discretionary decisions.
Generally speaking, therefore, rules are needed to give validity to regulatory principles such
as the principles of competition and liability. They have to narrow the scope for action of
participants in the economic process in such a way that market forces produce better
economic results - results which are also more sustainable and more socially just than those
of unbridled competition or of a centrally planned economy.
To this end, the appropriateness of a given regulatory framework must be constantly
reviewed, and adjustments made where necessary.
One such example is Agenda 2010. At that time, the rules laid down in employment and
social welfare laws had shown themselves to be major obstacles to labour market entry,
even in times of an economic upswing. In consequence, unemployment continued to rise
across the business cycles until it reached a level that was no longer sustainable.
The measures that were then taken boosted flexibility, lowering the barriers to entering the
labour market. For example, the liberalisation of temporary employment makes it easier for
employers to hire job-seekers. Moreover, the amalgamation of unemployment assistance
and social assistance and the shortening of the period of entitlement to unemployment
benefits increased the incentive to take up employment.
Competition on the labour market has tended to become stiffer as a result, and no doubt also
tougher for some. But it has also helped the labour force in Germany to swell to around
42 million - more than ever before. Moreover, the number of persons registered as
unemployed has dropped from a high of more than 5 million to just under 3 million at present,
and the chances of an unemployed person finding a new job are far greater than they were
before the reform.
Further evidence of the success of the reforms is that, in the wake of the upturn, not only
atypical jobs were created. For instance, from 2003 to shortly before the crisis, the number of
temporary workers advanced by almost 400,000. At the same time, however, the number of
jobs subject to social security contributions posted an increase of around 1,250,000. Nor has
this picture changed since the economic slump.
But this outcome also owed a great deal to the fact that the social partners could respond to
the shift in the economic setting with a degree of leeway, notably by concluding more
employment-friendly wage agreements as well as the liberalisation clauses designed to
safeguard employment which have been a standard feature of collective agreements ever
since the "Pforzheim agreement" back in 2004. Research findings suggest that these
measures were key contributory factors in restoring competitiveness1 and in keeping the
increase in unemployment2 to a minimum during the economic downturn brought about by
the financial crisis.
The financial crisis likewise showed us just how important it is to have the right setting for a
functioning competitive framework. The central regulatory tenet - that those who enjoy the
benefits must also bear the costs - was neutralised for major banks who could count on
being rescued by the taxpayer because of their importance for the economy.
Keeping profits in the private realm, but expecting taxpayers to foot the bill if a crisis arises
undermines responsible behaviour. Rules that are consistent with the principle of liability and
which ensure that banks, say, take a leaf out of the business community's book and shoulder
their losses themselves in future without jeopardising financial stability, are vitally important
for a functioning economic order.
This is a prime example of the tensions I was referring to earlier on in my speech between
the regulatory framework and discretionary economic policy intervention. Principles-driven
policy action and a set of clearly defined rules which limit the scope for economic policy
discretion make economic policymaking more predictable and can help to defuse many
problems such as that of time inconsistency, which is a topic I shall return to later in my
speech. Questions were even raised during the crisis as to whether complying with this
regulatory framework was always necessary or even possible in the first place.
Insolvency law fleshes out the principle of liability. But had it been rigorously applied, without
exception, to systemically important financial institutions, many fear that this would have
come at a prohibitively high cost as a result of the risk of contagion to other financial market
participants and the escalation of the crisis.
If I may, I would now like to look into a number of selected policy spheres to give you a rough
idea of how rules-based and ad hoc decision-making ought to interact in principles-driven
policymaking - and where the strict limits of discretionary policymaking need to lie.
2.1 Monetary policy
I will kick off with a policy area which is especially close to my heart, and not just for
professional reasons - monetary policy.
Walter Eucken believed that monetary policy was crucially important: "All endeavours to
realise a competitive framework are in vain unless a certain level of monetary stability can be
assured. Monetary policy thus has primacy for the competitive order," he wrote in his
Principles of Economic Policy. You won't be surprised to hear that as a central banker, I
share Eucken's views on the importance of monetary policy.
A key problem in the sphere of monetary policy - one which is a factor in many other areas
of economic policy as well - is that of time inconsistency. Let me illustrate this phenomenon
using an example originally created by the US economist Professor Alan Blinder.
Imagine a professor who is pursuing two goals. First, he wants his students to study as hard
as possible; second, he wants to spend as little time as possible marking examination
papers, say. The professor then announces that he intends to set an examination at the end
of the semester. This, he hopes, will provide the students with an incentive to acquire the
necessary knowledge.
However, once the students have studied for the end-of-semester examination, the professor
has an incentive not to set an examination after all because he does not want to mark the
examination papers. But because the students are aware of the professor's incentive, they
will study insufficiently or not at all.
How can this problem be solved? By stating in the examination regulations that an
examination will be set at the end of the semester, come what may. In other words, the
university binds itself in advance to a fixed rule.
In their renowned paper "Rules, discretion and reputation in a model of monetary policy", the
US economists Robert Barro and David Gordon3 explain why the time-inconsistency problem
gives rise to an inherent inflation bias.
In the short term, monetary policy can impact not just on inflation but also on economic
activity and hence on employment, although the monetary policy I am talking about here is
not mandate-consistent expansionary monetary policy in times of weak economic growth and
low inflation rates, but additional monetary policy stimulus.
Expansionary monetary policy surprises drive inflation higher but real wages decrease,
prompting enterprises to hire more staff, and briefly boost employment and growth.
Politically, this can be quite an attractive outcome that will initially be welcomed by the
general public.
Yet the macroeconomic outcome looks quite different if employees are expecting this kind of
monetary policy move - inflation again begins to climb, but real wages remain static because
employees - anticipating a more expansionary monetary policy stance - have already
managed to secure higher wages.
And that's the worst of all possible worlds - higher inflation but no stimulus for the economy.
This phenomenon, otherwise known as stagflation, plagued many industrialised countries in
the 1970s.
Now the crux of the matter is that precisely this poor outcome will transpire as long as
monetary policymakers gear their stance towards short-term sentiment about their policy.
Because economic agents will always expect an expansionary policy measure and factor it
into their expectations - just like students who anticipate that no examination paper will be
set and give up studying.
As a consequence, the only way to resolve this dilemma is for monetary policymakers to
make a credible commitment to a stability strategy - and thus to credibly forgo the option of
using expansionary monetary policy surprises to give the economy a short-lived shot in the
arm.
Tying central banks to a very strict set of rules, that is, to an automatic system for regulating
the money supply, was something that Milton Friedman had in mind. True to his belief that
"money is too important to be left to central bankers", Friedman put forward a proposal back
in the 1960s that central banks should be required to increase the money supply by a
constant percentage so as to counteract the inherent incentives to pursue an inflationary
monetary policy.
But this would only work if there was a stable correlation between monetary growth and
inflation, and the central bank had a sufficiently reliable degree of control over the money
supply. But the correlation between the money supply and inflation is not always sufficiently
stable over time, least of all in times of crisis, so one of the key prerequisites for managing
the money supply is lacking.
This is why Barro and Gordon saw central bank independence and a commitment by
monetary policymakers to maintaining price stability as a suitable means of achieving price
stability while at the same time granting the central bank a degree of monetary policy leeway.
And so it was. A host of empirical surveys including those by Alesina and Summers4 and by
Grilli, Masciandaro and Tabellini5 confirm the success of independent central banks which
are mandated to maintain price stability.
And to get an idea of just how beneficial it can be to incorporate a degree of flexibility into a
clear commitment to the primary goal of price stability, we only need to look at the role
played by central banks in stabilising the global economy when the financial crisis was at its
worst in the autumn and winter of 2008.
But how can we make sure that a degree of monetary policy leeway does not distract us from
the goal of price stability? In two ways: by embracing the primary goal of price stability and
central bank independence; and by fostering public confidence and thus underpinning the
credibility of the central bank's stability strategy.
Central banks can build up credibility in two ways. First, by successfully safeguarding price
stability for years. A track record like that also protects their independence. As Harold James
once put it, confidence is the hard-won "core working capital of central banks" which it would
be very costly to jeopardise.
Another way in which central banks can bolster the credibility of their stability strategy is by
committing to an appropriate monetary policy strategy and interpreting their mandate
narrowly. Indeed, what the Economist wrote back in 1990 remains true to this very day: "The
only good central bank is one that can say no to politicians".
Independent central banks need strict limits to their flexibility, such as a ban on monetary
financing, so that their independence is not ultimately called into question, especially so in a
framework that is as complex as the European Monetary Union. Only this will ensure that the
goal of price stability does not take a back seat to preserving government solvency, even in
times of crisis.
2.2 Fiscal policy
Both theoretical analyses and historical experience show that sound public finances are key
to a successful, stability-oriented monetary policy - especially in a monetary union. This is
one reason why it also makes sense to create rules for fiscal policy.
However, it is clear, too, that these need to be different to monetary policy rules, because
fiscal policy involves a much greater degree of redistribution, which requires democratic
legitimacy. Because the parliaments have fiscal sovereignty, an independent staff is hardly
possible, though limits on the room for fiscal policy manoeuvre are - through a debt brake,
for instance.
Of course, this also depends on how the rule is structured. An effective rule should leave
enough room for policy makers to accommodate the economic situation or extraordinary
events such as natural disasters. In the conflict between binding force and flexibility, the
actual binding effect of the rule should be the deciding factor.
On the one hand, a nominal debt ceiling such as in the United States appears to be binding if
it can be used time and again to push the government to the brink of insolvency in political
power struggles stemming from a lack of consensus on a medium-term consolidation
strategy. On the other, the ceiling has so far always been raised at the last minute following
difficult political negotiations, which implies that it must be possible to design a more effective
fiscal rule that is binding in the long term.
We have had similar experiences in Germany - under Article 115 of the Basic Law, the
government has usually been able to extend the limits on new borrowing - which were, in
any case, fairly generous - simply by diagnosing a "disruption of the macroeconomic
equilibrium".
The lessons from the European debt crisis have also taught us that, in practice, the binding
effect of our rules was not very strong. Since the start of monetary union, Germany, France
and Italy have exceeded the deficit limit of 3% in seven, eight and even nine years
respectively.
Whether the reforms will put real teeth into the Stability and Growth Pact and the Fiscal
Compact in this respect depends heavily on the European Commission and how it uses its
extra scope for discretion.
The first time the Commission applied the new rules, it showed itself to be very flexible,
granting Spain, France, Slovenia and Cyprus longer deadlines to make adjustments than
those actually envisaged in the Stability and Growth Pact.
I believe that such exemptions should be made only in well-founded exceptional cases, for
this ultimately weakens the structural consolidation requirements and postpones them until a
later date. Making exceptions for a large number of countries simultaneously undermines the
disciplining effect of the fiscal rules.
In view of past experience with fiscal rules, in particular, I strongly believe that the euro area
can only be maintained as a stability union in the long run if its framework sufficiently
embodies a key principle of regulatory policy: the principle of liability.
In the context of public finances, this means that those who make decisions on spending
must also take responsibility for them. In other words, there must be a balance between
control and liability.
In principle, the Maastricht framework assigned both liability and control to national
governments. During the crisis, the EFSF and ESM bailout funds stabilised the euro area but
also increased the mutualisation of liability for previous national errors.
To restore the balance between control and liability, I only see two plausible options: either
we shift powers to monitor and intervene to European level by creating a fiscal union, or we
strengthen the member states' individual liability and responsibility in a return to the
Maastricht framework. This also ultimately means that sovereign insolvencies cannot - and
must not - be ruled out. They must be possible without also causing the financial system to
collapse.
The current balancing act between individual responsibility and mutualised liability is likely to
lead to new strains in the long run. To exaggerate slightly, as Adorn said, "there is no right
life in the wrong one".
2.3 Financial market regulation
In order to make the financial system more resilient to crisis, and thus to restore greater
validity to the principles of competition and liability, changes will also need to be made to
financial market regulation.
A particularly severe problem which arose during the crisis was one I mentioned earlier, the
"too-big-to-fail" problem: whenever banks become too large or interconnected to be would up
without jeopardising financial stability, this undermines the liability principle and ultimately
disrupts competition, and represents an invitation to act irresponsibly. That has to change!
Recent developments in the financial sector, such as increased indebtedness and the
burgeoning growth of the shadow banking sector, require new rules as well. There must
three primary objectives behind these new rules. First, banks have to become more resilient;
in other words, they have to acquire a higher quantity of higher-quality capital to protect
themselves against potential losses. Second, we need effective resolution mechanisms so
that, in a worst-case scenario, banks can exit the market without endangering financial
stability. Third, we need to ensure that these rules cannot be circumvented by taking
business elsewhere, such as, for instance, to the shadow banking sector. The rules of the
game have to apply to all alike.
I would like initially to discuss in more detail the objective of improved capital buffers. The
new international rules, generally referred to as Basel III, have already taken us a great deal
further in this respect. Banks now have to hold more capital and higher-quality capital.
However, there are some who believe the Basel III risk-based approach to be fundamentally
wrong. The discussion is ultimately about whether capital adequacy rules should be simple
or complex. Thus far, capital rules have been complex rules: the capital to be held is
determined according to the risk profile of each individual bank's assets.
Critics such as University of Bonn economist Martin Hell wig, however, assert that "material
risks are not captured at all" by the risk weighting. And he adds that "banks use the risk
weighting to expand their business to, in some cases, one hundred times their capital."
And yet the fundamental theory behind risk weighting is quite plausible: if the same
percentage of capital is to be held for all assets across the board, this gives banks an
incentive to invest particularly in riskier assets in order to increase their return on equity. That
will do no favours to financial stability, either.
Mark Carney, Governor of the Bank of England, therefore favours a pragmatic approach,
saying that sometimes both a belt and suspenders are needed to keep one's trousers from
slipping. Therefore, in his view, a one-size-fits-all rule, in the form of a uniform debt ceiling,
should coexist with the current risk-weighting rules.
I think this approach makes sense: where there is a threat of major losses that could bring
the financial markets even to the brink of meltdown, there is justification - or even a need -
for installing multiple security systems. What's needed for nuclear reactors, for instance,
does not seem like a bad idea for the financial system, either.
It is also important, though, that these security systems cannot be circumvented by moving
assets to less regulated areas such as the shadow banking sector. Much remains to be done
in this regard, starting with the enforcement of extensive reporting requirements.
To strengthen the liability principle, it is crucial, too, that a bank which, for instance, does not
have a sustainable business model be able to exit the market without putting financial
stability at risk. Otherwise, competition in the banking sector will be undermined.
The implications are shown by a study published as a Bundesbank Discussion Paper6
Absent an effective bank resolution mechanism, banks could become overly generous in
their lending decisions and efforts in terms of ongoing loan monitoring could fall short. Capital
would then no longer be allocated to its most productive use; instead, there is a danger that
particularly risky lending would tend to be overfunded for too long. And that would weaken
the forces of macroeconomic growth.
An effective resolution mechanism thus strengthens not only financial stability, but also
economic growth. The decisive factor here is not to make the taxpayer foot the bill for
resolution - indeed both shareholders and providers of loan capital should bear the losses
incurred.
This is exactly the approach underlying the work conducted at European level on a new
Banking Recovery and Resolution Directive (BRRD). However, there may also be reasons
why the BRRD, adopted at the end of last year, gives countries the option of departing from
the directive's strict liability cascade in cases where financial stability is under threat. This is
possible, for instance, by exempting certain liabilities or by permitting the use of public funds
in the context of a "Government Financial Stabilisation Tool" as a last-resort measure.
However, the market can only impose discipline on the banks in full measure if such
exemptions are tightly restricted.
3. Conclusion
This foray through various areas of the economy has shown that the economists' toolkit is
more likely to be the topic of contentious public debate in the future than the dentist's drill.
Keynes' hope is therefore unlikely to come to pass, too.
Although economists are not dentists, they are seen by many as the economy's doctors, as
has been recently noted by Dennis Snowier, President of the Kiel Institute for the World
Economy. At the core, what this means is that, if a new crisis emerges, the best possible
therapy needs to be found quickly.
In full keeping with evidence-based medicine, we should therefore not lose sight of principles
which have withstood the test of time in economics and have been proven by empirical
evidence - including, above all, the concept of an independent central bank committed to
monetary stability.
I now look forward to our discussion!