1st August 2008
The Malta Independent - Friday Wisdom
The Malta Independent - Friday Wisdom
I have grown to be highly suspicious
of strong assertions made by politicians. The stronger the assertion, the finer
the sieve I use to filter it through a credibility test. When Jason Micallef
says he is re-contesting because he still has a lot to give to Labour I question
whether what he really means is that he still has a lot to take by keeping his
well-paid job rather than join the ranks of the unemployed.
When the US Treasury Secretary says that America supports a strong dollar policy, in spite of seeing the dollar lose half its value against the euro over five years, I question whether he means that only a weak dollar can avoid a deep recession in the US by making imports more expensive and exports more competitive.
When the government assured us last autumn that it is keeping the surcharge steady at 50 per cent until June 2008 in spite of actual costs indicating a surcharge of 95 per cent I question (as I in fact did in an article in this series titled Surcharge and Surprise published on 7 December 2007) whether this is mere political convenience for which we will have to pay a posteriori lest public finances will reverse their positive trend. As it happened we have suffered both unpleasant consequences. The surcharge shot up to 95 per cent after June 2008 and our public finances are bleeding as the cost of energy continued to increase making the higher surcharge still inadequate to cover the escalating cost.
There is one breed of professionals in the commercial world who depend crucially on strong credibility credentials for performing effectively. Rather than elected, central bankers are irrevocably appointed for a long term, and this to ensure that they perform independently and do what is needed rather than what is popular. Their mandate is to protect the value of money from fast erosion caused by inflation beyond a small acceptable threshold needed to lubricate economic growth. The former Labour leader once parried criticism about something I had written stating that I tend to view things from a banker’s point of view rather than from a political purview. I felt flattered even though it was not intended.
And of all central banks of the major economies, the European Central Bank (ECB) is clearly winning the prize for the most credible monetary authority in keeping a consistent monetary policy in spite of economic turmoil caused external shocks like exploding energy prices and collapsing real estate values in the US, UK, Ireland and Spain.
While the central banks of the US and UK have dented their inflation fighting credentials by lowering interest rates in the face of rising inflation, the ECB has kept a steady hand and did not succumb to political pressure, mostly from France, to soften their inflation fighting stance in order to safeguard the economy from approaching near recession territory.
The need for a steady hand at the wheel of monetary policy stems from the simple fact that there is no greater evil than when high inflation gets embedded into the economy beyond an acceptable threshold, which in case of the euro area is 2 per cent p.a. Inflation is a spoiler that forces us to fight how to share the misery rather than co-operate on how to grow the economy.
Central Bankers get scared to death when unions make wage demands based on experienced inflation rather than productivity gains. Purely raising wages because of a general increase in prices is the surest mechanism to start an inflation spiral with prices and wage claims chasing each other higher. In the end this benefits no one as wages are always lagging behind inflation and employers withhold the necessary investment for growth as they cannot see profitability through the fog of inflation.
The ECB acknowledges that it can do little to control headline inflation when this is caused by external shocks like rising energy prices. But consistent monetary policy to protect the value of savings can do a lot to ensure that headline inflation does not get transmitted to the rest of the economy resulting in general across the board price increases through accommodative policies to safeguard overall demand and economic growth even in the short term.
Unlike politicians whose fortunes depend on short term objectives, central bankers have to be prepared to sacrifice short term growth for long term price stability. Yet there is ample room for monetary policy to evolve. Central banks cannot be happy with a mandate for controlling inflation at the retail price level and having no obligation for asset price inflation in the property and financial markets. Lax monetary policy inflates asset bubbles which eventually burst to dampen economic growth. This inevitably attracts pressure to protect economic growth by abandoning inflation discipline.
The US Federal Reserve is presently having to go soft on inflation control in order to protect from asset price deflation. This is the consequence of laxity in past evolution of monetary policy which it neglected asset price inflation purely because temporarily retail price inflation was behaving within targets. The problem is that the tools that are needed to control retail price inflation are unsuitable to address asset price inflation.
When the German economy was soft and the ECB reduced rates to 2 per cent it was automatically permitting real asset bubbles to be blown in Spain and Ireland who actually needed a much higher interest rate to avoid inflating a dangerous real estate bubble. But in a monetary union the ECB cannot have different rates for the same currency in different places. It can however co-ordinate different reserve ratios needed for bank lending to areas where asset prices are being inflated.
Inevitable asset price bubbles depend on strong credit growth stimulated by cheap credit which however can be addressed by different tools like reserve ratios. The Chinese are aggressively experimenting with these tools in a bid to avoid having to push their interest rates too high to calm down an overheating economy. If the ECB mandate has to be revisited it is to widen its mandate to control not just retail inflation but also asset price inflation and certainly not to soften its inflation fighting objectives as the French seem to prefer.
When the US Treasury Secretary says that America supports a strong dollar policy, in spite of seeing the dollar lose half its value against the euro over five years, I question whether he means that only a weak dollar can avoid a deep recession in the US by making imports more expensive and exports more competitive.
When the government assured us last autumn that it is keeping the surcharge steady at 50 per cent until June 2008 in spite of actual costs indicating a surcharge of 95 per cent I question (as I in fact did in an article in this series titled Surcharge and Surprise published on 7 December 2007) whether this is mere political convenience for which we will have to pay a posteriori lest public finances will reverse their positive trend. As it happened we have suffered both unpleasant consequences. The surcharge shot up to 95 per cent after June 2008 and our public finances are bleeding as the cost of energy continued to increase making the higher surcharge still inadequate to cover the escalating cost.
There is one breed of professionals in the commercial world who depend crucially on strong credibility credentials for performing effectively. Rather than elected, central bankers are irrevocably appointed for a long term, and this to ensure that they perform independently and do what is needed rather than what is popular. Their mandate is to protect the value of money from fast erosion caused by inflation beyond a small acceptable threshold needed to lubricate economic growth. The former Labour leader once parried criticism about something I had written stating that I tend to view things from a banker’s point of view rather than from a political purview. I felt flattered even though it was not intended.
And of all central banks of the major economies, the European Central Bank (ECB) is clearly winning the prize for the most credible monetary authority in keeping a consistent monetary policy in spite of economic turmoil caused external shocks like exploding energy prices and collapsing real estate values in the US, UK, Ireland and Spain.
While the central banks of the US and UK have dented their inflation fighting credentials by lowering interest rates in the face of rising inflation, the ECB has kept a steady hand and did not succumb to political pressure, mostly from France, to soften their inflation fighting stance in order to safeguard the economy from approaching near recession territory.
The need for a steady hand at the wheel of monetary policy stems from the simple fact that there is no greater evil than when high inflation gets embedded into the economy beyond an acceptable threshold, which in case of the euro area is 2 per cent p.a. Inflation is a spoiler that forces us to fight how to share the misery rather than co-operate on how to grow the economy.
Central Bankers get scared to death when unions make wage demands based on experienced inflation rather than productivity gains. Purely raising wages because of a general increase in prices is the surest mechanism to start an inflation spiral with prices and wage claims chasing each other higher. In the end this benefits no one as wages are always lagging behind inflation and employers withhold the necessary investment for growth as they cannot see profitability through the fog of inflation.
The ECB acknowledges that it can do little to control headline inflation when this is caused by external shocks like rising energy prices. But consistent monetary policy to protect the value of savings can do a lot to ensure that headline inflation does not get transmitted to the rest of the economy resulting in general across the board price increases through accommodative policies to safeguard overall demand and economic growth even in the short term.
Unlike politicians whose fortunes depend on short term objectives, central bankers have to be prepared to sacrifice short term growth for long term price stability. Yet there is ample room for monetary policy to evolve. Central banks cannot be happy with a mandate for controlling inflation at the retail price level and having no obligation for asset price inflation in the property and financial markets. Lax monetary policy inflates asset bubbles which eventually burst to dampen economic growth. This inevitably attracts pressure to protect economic growth by abandoning inflation discipline.
The US Federal Reserve is presently having to go soft on inflation control in order to protect from asset price deflation. This is the consequence of laxity in past evolution of monetary policy which it neglected asset price inflation purely because temporarily retail price inflation was behaving within targets. The problem is that the tools that are needed to control retail price inflation are unsuitable to address asset price inflation.
When the German economy was soft and the ECB reduced rates to 2 per cent it was automatically permitting real asset bubbles to be blown in Spain and Ireland who actually needed a much higher interest rate to avoid inflating a dangerous real estate bubble. But in a monetary union the ECB cannot have different rates for the same currency in different places. It can however co-ordinate different reserve ratios needed for bank lending to areas where asset prices are being inflated.
Inevitable asset price bubbles depend on strong credit growth stimulated by cheap credit which however can be addressed by different tools like reserve ratios. The Chinese are aggressively experimenting with these tools in a bid to avoid having to push their interest rates too high to calm down an overheating economy. If the ECB mandate has to be revisited it is to widen its mandate to control not just retail inflation but also asset price inflation and certainly not to soften its inflation fighting objectives as the French seem to prefer.
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