Select Committee on European Union Minutes of Evidence

Examination of Witness (Questions 179-190)




  179. Welcome Professor von Hagen. I gather you had a problem with the aeroplane?

  (Professor Dr von Hagen) Yes unfortunately, I apologise for the delay.

  180. We are very pleased to see you anyway. We had Sir Samuel Brittan before you so that was alright. Have you got any general statement that you would like to make to us beforehand?

  A. Yes, if I may, I have prepared a few notes. I would like to start by saying that it is a great pleasure and an honour for me to be here so thank you very much for the invitation. I would just like to say a few brief words on the ECB strategy and then on the structure of ECB decision-making. There was a question in the letter I received about the two-pillar strategy and a general remark that I would like to make is that central bank strategy is probably best understood as a way of organising the use of information, both internally and between the central bank and the general public. In the public debate there is often a question of whether looking at monetary aggregates such as the ECB has done in the past is appropriate in view of economic research, and I think that reflects a bit of a misconception about what a central bank strategy is all about because we should not think about the strategy as a fixed rule where the central bank by all means tries to obtain a monetary target but rather as a framework in which the central bank organises its communication with the public and also its communications internally. I think the great advantage of the two-pillar strategy, especially of the first pillar, in the past has been that it has helped the ECB to focus on the medium-run or long-term consequences of its current policies and in that regard it is not so different as a framework from the inflation targeting framework of the Bank of England, for example. I would be more concerned about the current developments at the ECB where the ECB has now said that they want to downgrade the first pillar and put the second pillar more into the centre of the debate, and I am concerned about that because in the past the second pillar has never had any conceptual structure. So the second pillar, which contains all sorts of short-term information—asset markets, interest rates, exchange rates, labour market developments and so on—is basically a broad collection of views and information with no systematic analysis, and by the central bank saying it will move that more into the forefront, it is really saying it will downgrade its focus on medium-term development, and it makes more room for arbitrary decision-making. The second question I want to briefly speak to is the question of the decision-making structure of the ECB. As you know, there is now a proposal that there should be two types of ECB Council members; Council members with votes and Council members without votes and that that status will rotate among the members. That, of course, is very much a copy of what we have in the Federal Reserve system. I think it is important to keep in mind that this structure will not solve the actual problem that an enlarged ECB has. The problem is that if you have an ECB Council of, let us say, 20 or 22 national central bank presidents plus six board members, everybody wants to speak in the first round about monetary policy actions for about ten minutes and then maybe half of them want to speak for another ten minutes in the second round. That makes the first round of two rounds of exchanging views on monetary policy last for about six and a half hours, which simply says that this is not a manageable central bank Council any more. Of course, if you give these people a different voting status what that really says is that everybody who cannot vote at the current meeting will have an even stronger incentive to speak for longer in order to convince those who have the vote. In other words, this estimate of six and a half hours is probably on the low side rather than on the high side. My own analysis of this problem says it would probably be more adequate to reduce the involvement of the ECB Council in monetary policy decisions. One way one could achieve that is to have the Council set guidelines for interest rate policies, so for example set the floor and the ceiling for the short-term interest rate for the next six months and then let the managing board takes decisions within that floor over an appropriate time horizon. In that way it would not be necessary to actually involve all the members for all decisions and the whole structure would become more manageable. Maybe I will leave it there just as an introduction.

  Chairman: Thank you very much. Lord Sharman?

Lord Sharman

  181. In the first part of your remarks you talked about comparisons with the Fed and the Bank of England. The Fed's mandate is to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates. In contrast to that, my understanding is the ECB, like the Bank of England, has a hierarchy of objectives as opposed to overall objectives where the primary objective is price stability and only then, and without prejudice to that, to promote growth and employment. What is your view as to whether the Treaty should be amended so that economic growth plays a more prominent role in the remit of the ECB?

  A. I think you are absolutely right, the Fed has an explicit legal mandate to promote those three goals that you have mentioned, but I think in practice everybody would agree that the Fed actually cares most about price stability de facto, and the reason why that can happen despite the legal mandate is that there is a broad agreement, both among monetary policy makers and among members of Congress in the United States today, that monetary policy is not an appropriate tool to promote full employment. It can support full employment but to use monetary policy systematically to reach full employment will always undermine price stability. That consensus makes it possible for the Fed to act very much like the ECB or Bank of England do today although the legal mandate is different. In the ECB's case, the principal mandate is price stability, the subordinate mandate is that as long as price stability is not in danger the ECB should promote the general economic policies in the euro area, which does not amount to a concrete constraint because there are 15 economic policies plus the economic policy of the Commission, so that is much more vague than full employment or adequate real economic growth. Having said that, I think in practice the ECB is now showing its readiness to care for promoting real economic growth when price stability is not a problem and so in terms of actual economic policies or monetary policies I think there is virtually no difference today between the three major central banks—the ECB, the Bank of England and the Fed. I think changing the Treaty and actually giving the ECB an explicit mandate for full employment or economic growth could be dangerous because it could undermine the credibility of a very young institution because it would be a very visible action for the European governments to take. I think as long as a compromise or a consensus has emerged that makes the ECB pursue the policies it does, I would rather not touch the Treaty because that will arouse lots of suspicions in the public whether the governments want the ECB to become more activist or more inflation prone.


  182. You said in your introduction that you thought that it was a mistake to downgrade the first pillar of monetary policy. We note that but perhaps you would like to say a bit more about that. Secondly, you thought it was also a mistake to put more emphasis on the short term. Do you not think that the changes that have been introduced by the Bank have been helpful because it has brought the Bank closer to an inflation target which is perhaps clearer than in its present second pillar?

  A. Maybe I should clarify my view on that a little bit. First of all, I never thought that the two-pillar structure was a very fortunate one. It is not a fortunate one because it is very difficult to communicate or to clarify how the elements of the two pillars are actually connected or combined into one decision-making process. What was and what still is useful about this structure is that it has put medium to longer-run developments into the first line of the debate. In other words, it has made the European Central Bank concentrate on the question what will be the consequences of our policies two or three years down the road in terms of price stability? That has never kept them from looking at more short-term developments in addition to that. I think this is very similar to what happens at the Bank of England today. When the Bank of England targets the annual inflation rate two years down the road that is very much like asking the question what will be the price stability consequences of what we are doing today two years down the road? So in terms of content I do not think there is much of a difference between the first pillar of the ECB and the idea of an explicit inflation target. What has always been unfortunate about the first pillar is, first of all, the business about the reference value for the growth rate of M3, which the ECB itself has never taken seriously. At least we know that for most of the time since the start of EMU money growth has been much above the reference value and the ECB has never taken any consequence in order to solve that issue. The second unfortunate element is that there was not even an attempt to clarify how the two pillars would be combined into a consistent decision-making process. So what I think is risky right now in terms of future developments is that the ECB has said that they want to downgrade the more long-term orientation, by implication they will look at fore-term developments more. That still leaves all the other issues open and it just signals that ECB monetary policy could very well become less forward thinking and more activist in the future.

Lord Taverne

  183. Most of our witnesses have come to the conclusion or have suggested that the ECB itself has not really made any major mistakes and has not been responsible for the relatively sluggish growth and high unemployment in the European Union in the euro zone. First of all, do you agree with that general judgment? Secondly, is this something which may change with the accession of the new members because is it not the case that many of new members would require for their purposes a rather higher inflation rate than has been the kind of inflation rate that the ECB has managed to achieve so far?

  A. The question of whether the ECB has made major mistakes or not depends on what you call "major". There is at least one very clear policy mistake that the ECB has made. If you go back to early 1999 that was a period when inflation was generally low in the euro area. The euro area was coming out of the consequences of the Asian crisis and the Russian crisis but there were plenty of signs that growth was picking up in the euro area. Then Germany had a change of government and some very unfortunate domestic policies that kept Germany from joining the train and having a faster growing economy again. In that situation the ECB said, "Let's cut interest rates." So they were cutting interest rates right in the face of a beginning up turn in the euro economy. Two years later when the signs were very clear that Europe was marching into a slowdown (which later on turned into a real recession) it would have been quite appropriate to lower interest rates in April or May of 2001 but at that time the ECB found itself trapped because inflation was running significantly above two per cent which was a consequence of the too easy monetary policy in 1999/2000. Whether we call that a major mistake or minor mistake, I do not know. What it shows, I think, is that the timing of monetary policy action was not always appropriate in the past. In terms of the accession countries, first of all, I think we have to recognise that even though these are many countries they are very small relative to the euro area economy and I do not think they can make a significant impact on euro area inflation significant enough so that the ECB would be forced to take a restrictive stance which would damage the other economies in the euro area. So just by a matter of size I do not think that there is a very serious risk. Secondly, of course, we will all have to learn better than in the past that by definition a common currency area can only have one inflation rate. There can be local deviations from that inflation rate but this is not an Irish inflation rate versus a German inflation rate, it is a general inflation rate, and then there are adjustments in the price level. This is very different from inflation because a) it does not have anything to do with monetary policy and b) it was equivalent to what were in the past exchange rate movements, so these are not very long-lasting trends and they are the adjustments in the price level that should occur if economies are growing at a different pace.

Lord Marlesford

  184. You said that the Fed normally keeps stable prices in the forefront of its mind. I can see that that is the case when economic growth is satisfactory but when that does not look good its policy seems in practice to be very much focused on attempting to correct a growth or, if you like using the Congressional mandate, to create employment, and certainly the Fed seems to have been doing that since fairly early in 2002 where its monetary policy has almost entirely been aimed at reviving the economy, particularly in recent months. The mistake which you attributed to the ECB, which I totally agree with, has been made but now that Europe is facing very serious deflation, do you see the ECB as being able to face up to the need for really major use of monetary policy to attempt to perhaps counter the effects of the exchange rate change and falling output?

  A. First of all, I do not think that Europe is, and the euro area in particular is really facing the risk of deflation. After all, inflation is still running right around two per cent. Secondly, I think one really has to be a bit precise about the notion of deflation. In economic analysis when we say deflation what we mean is a lasting negative growth rate in the price level where "lasting" means two, three, even more years. We certainly do not mean a period where, let's say, the average rate of inflation is around one or 1.5 per cent and every once in a while there is a quarter where on average the price level falls. We have had that in the past in Germany and it certainly did not do the economy any harm. In the mid-1980s and before in the 1960s you can find periods where the CPI fell from quarter to quarter while on average the trend inflation rate was still well above one per cent. I do not think we are really facing a risk of deflation in the euro area right now, even if we believe the projections of some people that the inflation outlook is more in the range of one to 1.5 per cent than 1.5 to two per cent. Having said that, I think two other considerations come into play. One is that the ECB has made it very clear in statements recently that if there were a real risk of deflation they would counteract it as aggressively as the Fed has done recently. Number two, the big problem that everyone is thinking about is of course the situation in Japan. But the Japanese situation is very different, I think, from both the United States and Europe. The Japanese situation has a lot to do with a financial system which is very weak and a banking system which ought to have been cleaned up ten years ago and never was. In the presence of such a situation where low interest rates pose a problem of cash flow to banks and therefore threaten the stability of the banking system, one would have to be really worried about deflation, but I do not think that is a serious risk neither to Europe nor in the United States currently.

Lord Lamont of Lerwick

  185. Just going back to your reply to Lord Taverne about the application of an overall inflation target for the euro zone now and after enlargement you said it is not a question of Ireland versus Germany. Well I understand what you mean of course but one of the points that was made by one of the witnesses here, Mr Bootle, although I was not here when he made it, was that when you have an overall monetary area with an average target rate of inflation and you have a contrast between the high inflation catch-up countries, not just Ireland but also Spain, some of the other southern countries as well, that imposes a greater burden of relative disinflation on Germany. You rather implied that will not become a worse burden on Germany because the accession countries are not that big an addition. I wonder whether that really is right when you add all the countries together, Poland with the population of 30 million, Hungary and the Czech Republic ten million and then the other very small candidates together, it is quite a lot put together, and the relative disinflation burden on Germany with all these high inflation/high growth economies will surely make the position of Germany much more difficult?

  A. You seem to assume that Germany will always be in the country with the lowest inflation rate or the lowest rate of price increase in the euro area. I do not necessarily see why that would be the case.

  186. I do not mean forever, I mean in the next few years, the next decade maybe.

  A. Hopefully we will manage to revive economic growth and employment in Germany before that. But still having said that, I think the principle is pretty clear that Germany right now needs an improvement in its competitiveness, and the way it gets that is by having prices rising currently below one per cent when the average price increase in the euro area is more like two per cent, so we have a gain in average competitiveness of about one per cent per year. Given the very high tax burden and regulatory burden of the economy, that is exactly what we need in order to revive economic growth. Even with Poland and other countries in the euro area I do not think that will change very much for Germany. You could ask yourself, of course, is it preferable both for the euro area and for the accession countries to postpone euro area membership of the new EU members for a few years. I think the judgment must be on a case-by-case basis. I would say yes for a country like Poland which can reasonably have its own monetary policy. I would say no for a country like Latvia which is so small that thinking or conceiving of a monetary policy that is able to control the domestic price level does not make much sense. There are certainly good reasons to think that the larger accession countries, in their own interests, might think about postponing EU membership for a few years.

  187. In defence of my premise I read the other day a Goldman Sachs report forecasting that Germany actually did face for ten years the same sort of prospects it faces now. You drew a contrast between Japan and the situation in Europe. Even if the precise problems are different, would you not say that the weakness that is now being exposed and the controversy over a lot of the German banks means there are a lot of serious causes for worry in the German banking system?

  A. There are certainly reasons to worry about parts of the German banking system, in particular those parts which used to be, and partly still are, public banks, which for a long time have operated under the umbrella of municipalities or state governments and which now have to face stiffer competition, partly because the European Commission does not accept the implicit subsidy coming out of state guarantees any more. But then again, first of all, in the euro area now we have a pretty unified financial system, so even if some German banks got into trouble that would not be as disruptive for the European financial system as it is in Japan simply because a business that sees its banks having problems can turn to banks in other parts of the euro area and get finance.

  188. Is that really realistic? One or two other witnesses, notably Professor Goodhart, suggested that, but if you had a serious contracting in lending from the German lending system do you really think banks outside Germany would in reality take up that slack?

  A. I think at least in part they should and I do not see a reason why they would not. The question is how that actually takes place, and I think you have a point when you think it is pretty unlikely that, let's says, a French bank would actually get into contact with a local business somewhere in Duisburg. But that is not necessarily the mechanism that one has to think of. There is the mechanism of bank mergers of course, there is the mechanism that we already see a lot more inter-bank lending across national borders in the euro area, and so I think there are indirect channels of financing where effectively what happens is French banks or non-German banks support the German financial system without actually having banks come in and do the customary relationships.

  Chairman: Any further questions?

Lord Marlesford

  189. Can I just go back to exchange rates for a moment. On the competitiveness of euro land, presumably you would agree, and you have already indicated the high labour costs particularly in the case of Germany and you refer to unfortunate economic policies after the change of government in Germany, that has been made more serious by the depreciation of the dollar against the euro? Presumably you do not feel the ECB has any particular role on exchange rate policy, but do you think at any rate it has to take into account the economic effect of how the exchange rate moved in its monetary policy?

  A. I think it already does because part of the reason why CPI inflation has come down in the euro area is precisely the appreciation of the euro against the dollar which makes imports cheaper, so the imported goods part of the CPI has contributed quite a bit in the reduction in the inflation rate to the extent that now the ECB says the risk of inflation has pretty much vanished and therefore we have been willing to reduce interest rates there taking account of that fact. I would be much more worried about a scenario where the ECB said directly, "We now want to manipulate the euro/dollar exchange rate", because that would immediately call the attention of the United States government and the Fed and I do not think we want to have central banks engaged in wars of competitive devaluation.


  190. Perhaps that is a good note to end off on because Sir Samuel Brittan said exactly the same before you came in. Anyway, thank you very much, Professor von Hagen, for coming all this way. We are very grateful to you, thank you.

  A. My pleasure.

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