Frameworks for Monetary Stability

25 Remarks

Carlo Cottarelli, and Tomás Baliño
Published Date:
December 1994
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It is always a more pleasant task to open than to close a seminar, if only because, at the end, the sense of accomplishment is always mixed with regret for having to interrupt discussions that have acquired a momentum of their own—or, actually, stopping them, when (as economists would say) their marginal utility is still positive, if not rising.

Ending a seminar is not only a less pleasant task, but also a more difficult one than opening it. At the opening, there are only prospects; there is potential. At the end, in contrast, there are only outcomes, and these do not always live up to the prospects or to the potential. I do believe that this is not the case with this seminar, even though we have been dealing with subjects on which it is difficult to draw definite conclusions. As it has repeatedly been remarked in the various sessions, the history of central banks is a history of evolving institutions—institutions that have proved to be remarkably adaptable to changes in economic, political, and social conditions. And they have been very successful precisely because of their ability to adapt.

Although categorical answers are elusive in matters of central banking, I can, at least, summarize a few of the themes that have emerged during the course of the seminar. These themes, I believe, reflect well the “state of the art” in the fields of central banking and monetary policy. First, however, I should make clear that I will not be able in these brief remarks to do full justice to all the papers presented in the seminar and the points that were made. For this, I can only apologize in advance.

Let me begin with one of the most important of the themes—namely, the recognition of the limits of monetary policy. There is now wide agreement, among economists as well as policymakers, that monetary policy can control only nominal variables, and that changes in the money supply can affect, on a sustained basis, only prices, nominal interest rates, and nominal exchange rates. A corollary of this proposition is that monetary policy is not an appropriate instrument to influence directly such real variables as output and employment.

Although monetary developments cannot affect real variables sus-tainably, disorderly monetary conditions—leading to monetary instability—can and do hamper growth, employment, and economic activity. The obvious implication is that the best contribution monetary policy can make to real economic performance is to establish and maintain stable monetary conditions.

Thus, there is at least full agreement that the target of monetary policy should be monetary stability. Most frequently, this is interpreted as the achievement of domestic price stability—that is, stability in the internal value of money. However, this is only one dimension of the aim of monetary stability; the other is the maintenance of the external value of the currency—namely, exchange rate stability, a subject to which I shall return later.

A second theme concerns the choice of the appropriate institutional arrangements to bring about and maintain domestic price stability. As Michael Mussa, among others, has made clear, “irresponsible” policies that lead to unduly large increases in the money supply and unsustainable Fiscal deficits are to be avoided. He has also shown that there is consensus concerning the remedies against hyperinflation. But agreement has not yet been reached on how monetary policy should be handled to cope with less acute cases, nor on how it should be managed in ordinary circumstances. We have looked at this issue by asking whether monetary policy should be guided by rules or by discretion. Of course, answers in this area can only be faulty: after all, there is no such thing as an absolute rule; nor is total discretion a realistic prospect. Yet there are situations in which tight rules are called for. As I argued in my own presentation, many economies, including those in transition, can benefit from well-defined rules. I need only recall here the interesting discussion we had on the advantages of currency boards.

Of course, the choice is hardly ever between rules and discretion, but rather between “rules cum discretion” or “discretion cum rules.” In our discussions, we have examined these two approaches at work. We have exchanged views on the experience of the exchange rate mechanism (ERM), its achievements, and its limits. I personally believe that it was a successful experiment that contributed to improving monetary and fiscal discipline in the European Monetary System (EMS). If anything can be learned from the tensions to which the ERM was subject in 1992 and its subsequent loosening in August 1993, it is not that rules do not work. It is rather that rules have limits when the constraints they set on policies are not observed; in those circumstances, there is no alternative to a measure of discretion and flexibility.

Various countries’ experiences in using “discretionary” monetary policies were also discussed, and excellent papers examined how monetary policy has recently been managed in the United States, Japan, and Canada. These papers stimulated discussion of some relatively new aspects of the debate on the monetary policy transmission mechanism, such as the relevance of asset prices and asset price inflation. They have left undetermined, however, the analytical links between policy instruments and policy objectives.

As you know, in the choice between “discretion cum rules” and “rules cum discretion,” my a priori preference is for the latter. The main reason is that, in my view, the attainment and maintenance of price stability has much to do with policy credibility which is fostered by clear and transparent rules that result in important disciplinary measures relating to monetary and fiscal management. It may be argued that rules are neither necessary nor sufficient, but they can surely help.

A third theme is whether a rule-based approach is feasible in a world in which monetary and financial activities are both increasingly diversified and interconnected. This is, perhaps, the key theme underlying many of the papers presented in this seminar. It has been made clear that the challenge to the feasibility of rules—and, indeed, also to the exercise of discretion—is now based on two major factors. The first is deregulation, financial innovation, and the consequent blurring of the traditional distinction between banks and other financial intermediaries. The second is increased international capital mobility, related to the liberalization and opening of domestic capital markets as well as to technological developments.

Deregulation and financial innovation, including the development and rapid growth of derivative instruments and markets, have important consequences for central banks. As noted in the seminar, these events affect the working of the payments system and pose challenges in the area of supervision and prudential regulation, but they have also affected the stability of the link between traditional monetary and credit aggregates and the final objectives of monetary policy. Several papers presented in this seminar have documented these developments in a number of countries, including India, Israel, the United States, and Japan. And, as shown by the experience of Hungary, many economies in transition are also undergoing a process of financial deregulation and innovation that will affect monetary aggregates.

Financial deregulation and innovation may have reduced the usefulness of quantitative intermediate monetary targets; increased capital mobility, in turn, has complicated the use of exchange rate anchors. As the experience of the ERM demonstrates, exchange rate pegs—unless supported by appropriate policies—may be seriously threatened by massive capital movements.

How important for monetary policy are the problems created by such factors? Clearly, they cannot be ignored, but neither should they be overemphasized. I believe that, at the end of the day, capital movements are an equilibrating, not a destabilizing, force. Free capital mobility is an essential ingredient for efficiency and, ultimately, also for macroeconomic stability. As for financial innovation, the debate on the role of nonbank financial intermediaries is certainly not new. It goes back at least to Gurley and Shaw and to the early work of James Tobin. It has been said that Financial innovation takes place in waves and that we are now in the midst of a new and powerful wave in which formerly stable statistical relations are undergoing substantial changes. The future will tell us whether a new plateau of stability will emerge after this wave has run its course. I am not too confident, because waves are bound to surge again.

A fourth theme is that the challenge posed by these developments will have to be met on three levels. First, as I have already noted, the usefulness of intermediate targets may have been reduced at least temporarily. Therefore, efforts will have to be made to clarify the link between proximate policy instruments and ultimate policy objectives—that is, monetary or price stability. These efforts are best accompanied by the promotion of central bank independence to prevent monetary policy from becoming hostage to political pressure. It is clear not only that an independent central bank should be given control over the instruments required to implement its mandate but also that its mandate should be fully specified. This point brings me to the aim of external stability of the currency, which is clearly a responsibility of the central bank. Without such an extension of their mandate, central banks are unlikely to be independent, for monetary independence encompasses exchange rate policy independence. Second, particular attention must be paid to the interactions between monetary policy, financial supervision, and the working of the payments system—the functional triad to which Tommaso Padoa-Schioppa has drawn attention. Third, it is necessary to bring the international dimension of central banking to the forefront because of its importance for these three functions of central banks.

While the issue of monetary policy coordination remains subject to debate, without such coordination only limited success can be achieved in maintaining price and exchange rate stability in today’s world. Of course, the closest form of coordination—the currency union discussed in one of the sessions—may be beyond reach for many countries, at least for a number of years to come. However, less stringent forms of cooperation are possible and desirable. These include, of course, the activities of the International Monetary Fund, an institution that, through the exercise of its surveillance function, can and should play a prominent role in this domain.

In sum, the participants have covered much ground during this seminar. The discussions have all pointed toward a critical area for central banking and monetary policy in the years ahead: the role of the monetary authority in fostering soundness and efficiency in financial markets. This topic flows naturally from our exchange of views and, in particular, from views related to Financial structure and Financial innovation. Like Tommaso Padoa-Schioppa, I see this subject as an aspect of central banking that has been relatively neglected in monetary policy discussions—a neglect that has occurred despite its close relationship with the traditional lender-of-last-resort responsibility of central banks. Besides posing serious challenges to monetary policy, deregulation and the opening of financial markets have brought the importance of supervision and prudential regulation to the forefront of monetary and financial management. Perhaps this theme will lend itself to a forthcoming central banking seminar.

Let me now close this seminar by thanking all of you, the participants, the speakers, and those in the Fund, who helped to organize and conduct it. I hope that all of you have enjoyed the ten days as much as we on the Fund staff have and also that you have benefited from the discussions as much as we have.

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