Current Issues in Monetary Economics

The question how monetary institutions should be designed attracted considerable attention during the past years. In the context of the Maastricht Treaty, there has been a surge of papers on the adequate design of the European Central Bank; the breakdown of the Rouble-zone created a strong demand for policy advice about what kind of monetary institutions should be adapted in Eastern European countries; finally, after the breakdown of stability of money demand in many countries, there was a need to redesign monetary policy instruments.

The time inconsistency of optimal policy plans is today’s most popular theoretical explanation for the existence of positive inflation rates. Among academics, incentive mechanisms for central bankers are becoming a very popular solution concept for this particular problem. The appealing feature of incentive mechanisms is that they solve the credibility problem of the central bank without reducing monetary policy flexibility. Gerhard Illing has provided an insightful survey of this recent literature. And he raises a couple of interesting questions for further research. In my comment I want to make some additional skeptical remarks.

Since a couple of years central bank independence is a very popular topic in economic literature as well as in the political discussion. There are several reasons for this actual interest:

Dietmar Kath gives an excellent digest of the arguments in favor of an independent central bank exercising its responsibilities without being subject to direction by government. Taking the Deutsche Bundesbank as an example he then points out deficiencies in the extent of its autonomy, for instance with respect to international currency agreements and in connection with monetary union between the two German states before reunification. However, intolerably high inflation in Germany — which is the concern of all those who, like Dietmar Kath, favor a central bank with unrestricted autonomy — did not result from this event. In the run-up to European Monetary Union, which is due to come into force in 1999, Kath pleads for a future European Central Bank which will have a greater degree of independence than the Deutsche Bundesbank currently has. He argues his case above all on the basis of the theories of Public Choice and of Institutional Economics. Both of these concepts are able to offer interpretations of the actions of bureaucracies; but to the analysis of developments in the economy as a whole they scarcely make any useful direct contribution. This requires macroeconomic paradigms. And so this article, on the basis of Keynesian elements of macroeconomics such as sluggish price adjustment and incomplete information, pleads for a future European Central Bank with conditional independence, which will be required to pay due regard not only to monetary stability but also to economic growth and employment.

The vigorous debate between proponents of a fixed exchange rate system and proponents of a flexible exchange rate system has not decreased over the past 30 years. New theoretical and empirical research and new reform proposals have continued to fuel the dispute which regime is the best for an individual country and which serves best the task of an international monetary system, which is to provide a stable environment for international trade and investment. The experience with fixed exchange rates under the Bretton Woods system, in which the adjustment process to external imbalances was too slow in many countries and in which the central banks were eventually unable and unwilling to defend the fixed rates, most economists in the late 1960s and the 1970s advocated flexible exchange rates. The decision to let the Bretton Woods system collapse and to implement a flexible exchange rate regime between major international currencies reflected the firm belief in the superiority of flexible exchange rates at the time. However, with the strong rise in the value of the U.S. dollar in the early 1980s and its subsequent decline, doubts arose about the advantages of flexible rates. As a result, the 1980s were characterized by a growing disenchantment with flexible exchange rates, which led to an increasing support for limitations on the flexibility of exchange rates.

All exchange rate systems ever implemented are imperfect. Fixed exchange rate systems typically lead to delayed adjustments while flexible systems can produce highly volatile and misaligned exchange rates. Therefore, both systems might cause economic losses. Numerous economists have tried to measure these effects and to make suggestions for more stable and more efficient systems.

On January 1, 1999 the conversion rates of the euro into the national currencies of the EMU-countries will be fixed irrevocably. Two conditions have been attached to this conversion process. First, the Maastricht Treaty stipulates that the adoption of the irrevocably fixed conversion rates should not modify the external value of the ecu. Second, at the Madrid Summit Meeting of December 1995 it was decided that at conversion time one euro should be equal to one ecu. These two conditions severely constrain the choices about how to set these conversion rates for stage three. In a nutshell, the constraint is that the euro conversion rates used on January 1, 1999 will have to be the market rates of the ecu observed at the end of the previous day. In addition, it will not be possible to announce in advance the euro conversion rates that will be applied on January 1, 1999. The reason is that the ecu rates of the participating currencies will continue to fluctuate until the last day because the ecu contains non-participating currencies (e.g. the pound sterling). This will create problems. In particular, if the authorities rely on the market to decide about these conversion rates an indeterminacy problem will arise (see Begg, et al. (1997) and De Grauwe & Spaventa (1997)). This can be described as follows. The ecu rate of say the DM before conversion time will be determined by the expectations the market has about the future euro conversion rate of the DM. The latter, however, will be equal to the last day’s ecu rate of the DM.

At their Mondorf (Luxembourg)-meeting on 14 September 1997, the EU ministers of finance and heads of central banks agreed upon fixing bilateral exchange rates of their currencies in May 1998, that is to say, in advance of stage three of European Monetary Union (EMU). In a recent strand of papers, De Grauwe and coauthors turn their focus on problems of different proposals of how to set these conversion rates for the third stage of EMU. Different proposals take EMS central rates, market rates at the date of announcement or on the last day of stage two, an average of past or past and future market rates (which is frequently called the Lamfalussy rule though the latter mentioned it only a few times) and forward rates as their basis. By his current paper, De Grauwe convincingly contributes to a significant reduction in this large number of possible options how to set the irrevocable conversion rates of the currencies of the EMU member states.¹ Moreover, he is absolutely right in paying special attention to credibility-enhancing announcement solutions, as setting the final conversion factors no sooner than the last trading moments in 1998 will probably lead to serious problems after EMU will have been started. Since he deserves great merits for both jobs, critical comments should only concern some minor points. These points are actually intended to be possible suggestions for further discussions.

The aim of this paper is to discuss issues that relate to the recent exchange rate and capital market crises in developing countries. The body of existing literature on the basics of money and exchange rate reform in developing countries — and increasingly transformation economies as well — is extremely large. I believe, however, that by now it is possible to find a certain number of essentials, i.e. elements that are conditions of sine qua non character for monetary and exchange rate reform in those countries. About the essentials there is either a wide-spread consensus or the differences in opinion have already been comprehensively identified.² Little value would be added if one was to try to list these essentials again. I consider it a much more rewarding task to analyze those developments that despite extensive existing research „routinely“ surprise national as well as international policymakers, in spite of the dramatic experience with Mexico in 1994/95. As a matter of fact, these developments have shakened a group of newly industrializing countries in East and Southeast Asia which were treated before as the most challenging competitors for the OECD group. By now, it is less than clear what their growth prospects in the future really are.

There is no such thing as a general theory of the currency board (CB). Hitherto, there is no generally accepted definition of a currency board. Additionally the term is increasingly being used in political discussions, and thereby it is becoming increasingly meaningless.

Since its implementation in Argentina and Estonia, the currency board idea celebrates a revival which comes quite as a surprise. With the exceptions of Hongkong and Singapore, all currency boards in former colonies were substituted by central banks when colonial times ended (see Schwartz (1993)). Hence, the abolition of currency boards in the past marked the beginning of an institutional reform. It is highly interesting that the recent introduction of currency boards were exactly motivated by full-scale institutional reforms starting either from scratch (transformation countries: Estonia) or chaos (developing countries: Argentina). Have the former colonies made a mistake when abolishing currency boards? What is the role of a currency board in institutional reforms? Fuhrmann touched this issues in his introduction but rather as a motivation for his interesting approach to formalize the currency board idea in terms of exchange rate policy.