Central banks, amnesia, judgement and the present inflation
Flawed intellectual frameworks, defective forecasting models, recondite distractions and amnesia about effective counter-inflation policy mean that central banks have failed to control inflation
Modern central banks enjoy great institutional independence in setting monetary policy. Yet are handicapped by an intellectual amnesia about the lessons of both monetary theory and monetary and financial history that is not mitigated by a practical purchase on financial markets.
Central banks have faced their first proper monetary challenge since the Great Recession and its financial crisis between 2007 and 2019. Their response to it has been timid, slow, and ineffectual. Confronted with powerful relative price effects and a general likely persistent inflation challenge, they have concentrated on the technical dimension of inflation indices that are likely to exhibit steep falls in reported rates of inflation as the relative price effects fall out. Hence their initial reassurance that the inflation would be transitory.
Need for a counter inflation policy and a non-accommodating monetary stance in 2021
By 2021 it was clear that the emergency fiscal measures taken to stabilise the advanced economies had worked and needed to be offset by a classic counter cyclical macroeconomic policy focused on tightening monetary conditions and raising interest rates. The meat and drink of what a central bank should be doing as its main purpose.
Micro-economic need for a return for more normal interest rates and bond yields
Furthermore, there was an important need for high rates of interest to improve the micro-economic working of money, credit and bond markets. Persistently low interest rates had distorted, saving, borrowing and company balance sheets. This interacted with a feature of most tax systems that the costs of debt could be deducted from profits, so that many firms particularly those that were financed through private equity vehicles were loaded with debt making their balance sheets potentially more fragile. Access to cheap credit for existing firms that had borrowing relationships meant an important process of capitalist accumulation, the ruthless rearrangement of failing firms, their clearing away and reallocation of their resources to other more productive uses, became blunted.
Federal Reserve and international central banks allow themselves to be distracted by recondite debate
Instead of making swift progress in tightening monetary conditions and returning the structure of interest rates to a more normal yield curve, central banks allowed themselves to become distracted. There was a debate led by academic economists, but periodically picked up on by economists who are experienced financial market practitioners, about the merits of relaxing inflation targets. This was ventilated by the habitues of the Federal Reserve Board’s annual Jackson Hole Symposiums. A good example of this thinking was offered by Mohamed A. El-Erian, the President of Queens College, Cambridge in his column in the Financial Times. There was an extensive debate on the role that central banks should have in managing problems that were outside the conventional scope of monetary policy and the remit of a central bank. These included addressing income inequality, structural discrimination of minority communities in labour markets and the role the central banks should play in mitigating climate change. These debates were led by the Federal Reserve but they also occupied other central banks and coloured their thinking.
Federal Reserve changes its Longer-Run Goals and Monetary Policy Strategy
The American thinking culminated in a speech delivered by the present Chair of the Federal Reserve Mr Jay Powell at a virtual gathering of the Jackson Hole Wyoming Symposium in 2020. Mr Powell explained that there was a need for a ‘robust updating’ of the central bank’s formally agreed approach policy. There should be a move towards ‘average inflation targeting’. This would mean allowing inflation to be ‘moderately’ higher than the Federal Reserve’s 2 per cent objective goal for some time’ after periods when inflation has been running below 2 per cent.
The Fed Chair also announced changes to the central bank’s approach to employment. Analysis of the employment position would be informed by its ‘assessments’ of the shortfalls of employment from its maximum level. The previous position was expressed as deviations from the maximum level. While this superficially may appear to be superficial exegesis of central bank speak the change in language was significant. Mr Powell explained that ‘his change reflects our appreciation for the benefits of a strong labour market, particularly for many in low- and moderate-income communities, ….’this change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.’
When the inflationary weather changed, the Federal Reserve was not intellectually equipped to meet it
Mr Powell plainly recognised the significance of the Federal Reserve’s shift in gear, saying that ‘many find it counterintuitive that the Fed would want to push up inflation, however, inflation that is persistently too low can pose serious risks to the economy.’ The difficulty is that as the inflation weather was about to change Mr Powell and his international central bank colleagues were not in a frame of mind to notice the change.
Central bank amnesia forgetting the lesson of the 1970s and 1980s
Not only had central banks in practice started to relegate the first order importance of price stability in the way they exercise their discretion, but they plainly had forgotten the principal practical lessons about conducting an anti-inflation monetary policy. Lessons painfully learnt by their predecessors in the 1970s and 1980s.
These lessons include: the role of positive real interest rates – it is difficult to control inflation when real interest rates remain negative; it is difficult to engineer an end to a persistent inflationary dynamic without short term losses of output and employment, including a recession; that persistent inflation is a monetary phenomenon that will not just fall away without an appropriately tight non-accommodating monetary stance; and a successful disinflation will require tough judgements and strong will power sustained over time.
The inflation of the 1970s
The post-war Keynesian macroeconomic consensus broke down as the persistent creeping inflation in advanced economies threatened to turn into something much more serious, unstable and malign in the 1970s. Lord Rothschild in a long article in London The Times compared Britain’s inflation crisis in 1975 when inflation was over 25 per cent to the position in Weimar Germany in 1923. It was an exaggeration and the very high and unstable inflation in Britain at that time was not in any strict or technical sense hyperinflation, but it was very awkward.
The US also lost control of the price level in the 1970s before the oil price shocks.The Nixon administration’s pressure on Arthur Burns the Chair of the US Federal Reserve was clear : do not tighten domestic monetary conditions and put the electoral prospects of the Republican Party at risk in either the mid-term Congressional elections or in the Presidential election in 1972. That domestic monetary incontinence was magnified by the international monetary policies of the Nixon administration. This culminated in closing the dollar gold window. The Smithsonian Agreement effectively ended the post-War Bretton Windows fixed parity foreign exchange regime. This allowed all the major advanced economies to run independent monetary policies determined by their preferred perceived trade-off between economic growth and domestic inflation. This was made possible by a flexible or floating exchange rate allowing the balance of payments to adjust to the preferred resulting domestic inflation. The result was a generalised world inflation, a synchronised economic cycle where industrial economies and commodity agricultural economies all boomed in sync matched by a commodity price super cycle. This was then further complicated by the oil price shock in 1973 from OPEC following the Arab-Israeli War.
Stagflation
This inflation took policy makers by surprise, and they were even more surprised in 1974 when high inflation began to be accompanied by rising rates of unemployment not seen since the depression years of the 1930s. They experienced stagflation: high inflation, slow growth and higher unemployment. In the following two decades, economists and policy makers roughly worked out what to do to stabilise prices and lower unemployment
The rough rules of thumb that policy makers painfully learned
These rough workable rules of thumb were :
persistent high inflation was principally a monetary phenomenon that would require monetary tools to bring it down and control it;
the rate of unemployment over the economic cycle was the determined by labour market institutions, that there is a connection between real wages and non-wage costs arising from regulation, such as payroll social security taxes and regulation framing employment including redundancy, these influence the demand for labour, while social security benefits, the replacement ratio of benefits to wages and the rate of income tax and social security contributions influence the supply of labour;
while demand management could bring about a short term increase in economic activity in the medium and long-term the effects of monetary induced increased demand is neutral given the neutrality of money;
and the long-term trend rate of growth was determined by the evolution of an economy’s stock of physical and human capital, saving investment, long-term technical progress and the efficient functioning of product and labour markets.
Need for price stability for markets, particularly labour markets to work smoothly
There was a further practical observation. In market economies resources are allocated through the price mechanism. Markets exhibit friction. There are transaction costs and information costs. Inflation blunts the information yielded from prices making changes in relative costs opaque. Inflation plays havoc with long-term saving and investment decisions and particularly messes up prices signals in labour markets. Therefore, a commitment to price stability or having no more inflation than about 2 per cent so that households and businesses do not have to take it into consideration should be the objective of central bank policy.
An independent central bank: avoiding political temptation ahead of an election
The combination of the understanding that price stability should be the central object of policy with the recognition that artificial monetary stimulus could only offer a short-term boost to economic activity that would then be followed by unhelpful inflation, led to a further broadly agreed proposition. Decisions on monetary policy and short-term interest rates should be removed from finance ministers controlled by politicians constrained by an electoral cycle where they may have an incentive to engineer a short-term boom that coincides with an election. It was also considered possible neatly to separate fiscal policy from monetary policy. Elected governments are responsible for decisions about fiscal policy because they directly involve taxation and spending has little or no role in short term demand management. Indeed, fiscal policy, and the details of taxation and benefits and public expenditure should be directed at shaping the structure of incentives, the functioning of the economy and its long-term supply performance. Hence the case for making central banks operationally independent.
Inflation targets achieved through central bank discretion
The question of how central banks should operate was left to them. They were given policy goals – price stability and employment in the USA, price stability in the Euro-zone and an inflation target in many countries such as the remit given to the Bank of England of an inflation target of 2 per cent. How they chose to go about this was pretty much up to the people appointed to run the central banks. There are a variety of approaches and interest rates: intermediate targets and rules versus complete discretion, monetary targets, foreign exchange targets, open market operations, interest rate policies and minimum reserve requirements. Each has merits and demerits. Led by the Federal Reserve Board in the US, central banks tended to choose discretion. Where they inherited rules, they watered them down and eventually abandoned them. A good example is the ECB. Bundesbank’s broad money M3 target was part of the intellectual legacy that exerted it after the creation of the euro-zone 1999 that had a long half-life.
Under the leadership of Ben Bernanke, the Federal Reserve introduced an explicit inflation target for the Consumer Expenditure Prices Index. His predecessor Alan Greenspan had eschewed an inflation target because as he sardonically observed it was like steering a car using the rear-view mirror. Yet the Federal Reserve under Dr Bernanke’s leadership offered no explanation about how the inflation target would be achieved. Members of the Bank of England’s Monetary Policy Committee created to set interest rates after the central bank was given operational independence in the early years often made speeches about the MPC’s approach. The rhetorical device they constructed was that the MPC had ‘constrained discretion’. They had an inflation target but enjoyed full discretion over how they achieved it. These speeches by members of the MPC at that time often borrowed the Oxford philosopher Sir Isier Berlin’s metaphor about the difference in approach between the Fox and the Hedgehog to explain their approach. This was like explaining monetary policy in an Oxbridge high table riddle that further contributed to the opaque quality of central bank communications.
Keynesian general equilibrium model, focusing on trend growth and the output gap
Led by the Federal Reserve after 2000, a central bank consensus emerged. There was no need for any proper rules or loadstar to guide policy. Policy should be wholly discretionary. Central banks following the lead of the Federal Reserve approached this discretion using Dynamic Stochastic General Equilibrium DSGE output in relation to the trend rate of growth and estimates of the scale of any negative or positive output gaps to inform policy. There was no role for a monetary sector and prices effectively passively returned to trend in the event of a shock. At its best the DSGE approach was more suited to modelling a large significantly closed economy rather than smaller open medium sized economies, but given the difficulty of ever measuring either trend growth or the output gap, it is not clear how useful in practice it is even for a larger more closed economy. This tendency for forecasts of inflation to return to trend is helpfully illustrated by the evolving Bank of England inflation forecasts both in this episode of inflation that started in 2021 and in the episode of above target inflation between 2009 and 2011.
Monetary policy should be used to ensure that economies operated at their full capacity so that there was no negative output gap. There was at the Federal Reserve among officials an increasing belief that the central bank could not only control inflationary expectations but inflation itself, no matter what overall monetary conditions may be, through announcement effects.
US interest rates, announcement effects and no need for then usual open market operations
In the 1990s the Federal Reserve noticed that when Federal Open Market Committee, FOMC announced a new interest rate target for the Federal Funds Market, the markets would adjust to the new policy rate because they knew that the Federal Open Market Desk at the Federal Reserve Bank in New York would impose its new policy rate on the private Fed Funds market. The market would adjust itself to the new target without the central bank having any need to carry out the normal open market operations needed to accomplish the policy. From the mid-1990s onwards the US central bank increasingly passively relied on the market to carry out its policy. The Federal Reserve and its regional reserve banks used to publish primers on how open market operations work and the mechanics of how the Federal Reserve manages its interest rate policy tools. These primers ceased to be produced in the 1990s, because they no longer offered a mechanical account of what the Federal Reserve was doing and the central bank was reticent about explicitly explaining how it simply relied on expectations that pulled the money market into line. The central bank explained a practice that did not seem to have enough gravitas and authority and there was also a feeling that given that expectations worked to the convenience of the Federal Reserve, why expose it to the light of day and the danger that markets may call the central bank’s bluff.
Could the same thing work for inflationary expectations
The success of this announcement effect in relation to interest rates and the Fed Funds market made Federal Reserve economists and officials wonder if the same device could not be used in relation to inflation control. The central proposition being if the US central bank could exert such influence over the money market could it also try to do the same with inflation expectations. Instead of controlling a potential inflation problem with active and decisive policy measures, perhaps inflation control could be pulled off by the central bank managing the expectations of economic agents about inflation.
Led by the Federal Reserve, central banks thought that inflation could be managed not through the discretionary exercise of monetary control but through guidance. Disturbing shocks could be accommodated and would pass out of the price indices measuring. Central banks should see through temporary events and inflation would return to the undisturbed inflationary expectations of households and business. A central objective of this direction was to avoid any measures that tighten monetary conditions and result in either a recession or an identifiable negative output gap. This post-Keynesian discretionary policy focused on estimates of economies' trend rates of growth and forecasts of about the rate of economic activity in relation to them. In this approach a great store was placed on the economic models that central banks used to buttress their discretion in pursuit of their inflation targets. An inflation target may be a lagging or backward-looking indicator, but the forward looking economic forecast by the central banks’ economic models was the protection against making an error of judgement. In all it represents a highly sophisticated exercise in designing optimal policy practice.
Limits of economic models and economic forecasts and trying permanently to expand an economy with nom output gap
The difficulty was that it was both intellectually naïve and conducted in a manner that is institutionally arrogant. Naïve in the sense that economies can be accurately measured in terms of their full productive capacity and their trend rate of growth in a timely manner and that economic forecasts can generate reliable models that can be used to override other sources of judgement. At any given time, there is huge uncertainty about trend growth and the precise size of an output gap. Moreover, by keeping the foot permanently on the accelerator to ensure continuous full employment of all the economy's potential capacity it resulted in treating the risks of inflation and a recession in an asymmetric manner where inflationary risks were down played and risks of recession were given greater priority.
This Federal Reserve international consensus on the practice of monetary policy led to the very loose monetary conditions in the years leading up to 2007. They would have resulted in a sharp rise in inflation. Except that instead they facilitated an expansion of bank balance sheets that was so great that banks and financial market practitioners simply lost confidence in the credibility of their counterparties and credit markets and financial institutions collapsed. This implosion of bank balance sheets and the serial adverse wealth effects created deflation rather than inflation between 2007 and 2009, the result was the credit crunch and the Great Recession. There were many facets to the crisis: bank fraud, inadequate bank and financial market failure, but here was one consistent artefact that made it all possible: comprehensively loose monetary conditions created by the central banks.
Monetary policy and fiscal policy become fused after 2008
The crisis between 2007 and 2009 showed that monetary policy could not be neatly separated from fiscal policy. A point amply demonstrated when the Federal Reserve was unable to rescue Lehman Bros in 2008 without the US Treasury and the sanction of Congress, because as Anna Schwartz – Milton Friedman’s distinguished co-author had warned ahead of the crisis the Federal Reserve did not have in a marked to market world a mandate to take a margin call on a bankrupt bank with taxpayers’ money. In the crisis in 2008 it was clear that monetary policy had lost all traction and fiscal policy had to be used to stabilise the international economy, rescuing and restructuring bank balance sheets and stimulating demand.
Neglect of fiscal policy after 2009 and the flogging of the dead horse of monetary policy
After the initial and successful effort at stabilisation in the eye of the Great Recession when active use was made of fiscal policy, in the years that followed fiscal policy took a back seat. Central banks took the lead in stimulating their economies with novel unorthodox policies: quantitative easing, credit easing and forward guidance. These had little impact as effective sources of demand stimulus. For all practical purposes when nominal interest rates are around zero, the ‘zero rate boundary’, monetary policy is dead. And the central banks were flogging a dead horse to little effect. Ten years after the great crisis in 2019 there was increasing evidence of a sort of approximation of a stationary state or secular stagnation. Moreover, the permanent very low rates of interest resulted in complex micro-economic distortion of the pricing of credit and money markets. The combination of low interest rates and long periods of albeit very slow but long uninterrupted periods of economic activity combined to vitiate the normal processes of creative destruction that Joseph Schumpeter had observed in successful market economies. A stasis had been created. And central banks and the interest rate they had created were at the heart of it.
A higher inflation target?
While this was going on central bankers and academic economists pursued two unhelpful and distracting themes. The first was a debate about whether central banks should pursue a higher inflation target of say 4 per cent. In parallel there were debates about how the central banks could extend their role into managing income inequality, the response to climate change and de-carbonisation of the economy and mitigating the labour market consequences of structural racism in relation to minority communities. Central banks are technocratic institutions that are not immediately accountable to the electorate, policy decisions of this sort that involve trade-offs are highly contested and are not appropriate for a central bank to decide. The principal tools needed to get traction in relation to them involved taxation, expenditure and regulation that are outside a central bank’s tool kit. These excursions into policy questions outside of their mandate distracted central bankers from their principal task of inflation control.
Central banks join the Fabians: the baby step approach to an inflation problem
In response to the economic consequences of the covid public health crisis governments made full use of fiscal policy to protect the economic welfare of households, sustain business and employment and to stimulate a recovery in output. Fiscal policy showed that it worked, economies were stabilised and output did recover. Moreover, its potency as a demand stimulus was demonstrated as demand began to outstrip the capacity of disrupted economies supply chains. Faced with an immediate inflation challenge, central banks in 2021 hesitated to act, considered the inflation to be transitory and when they finally began to tighten policy moved in ‘Fabian’ baby steps. A Fabian approach worthy of the Roman general in the Punic wars famous for delay, Fabius Cunctator, the Delayer.
Janet Yellen, the US Treasury Secretary when asked whether she had concerns about inflation was confident that a generalised inflation should not be a problem and that if it were, central banks had the tools to deal with it. Her judgement about that was right in the sense that once inflation emerged the central banks did possess the monetary tools to control it. The question is whether they had the willpower to use those tools. Janet Yellen’s answer implies that she both thought that central banks had the tools and not unreasonably she expected them to be used. Lawrence Summers, one of the Harvard economists who established the proposition that low inflation was central to the proper functioning of market economies and their growth and went on to serve as President Clinton’s Treasury Secretary was clear that ‘team transitory’ should have stepped aside some time ago.
Central banks do not have the information for optimal policies that are directed at always avoiding recession while maintaining price stability.
Among the practical lessons learnt following the 1970s inflation are several awkward truths about real interest rates, short term losses of output and the role of exchange rates as part of disinflation in small and medium sized open economies.
Successful disinflation is likely to require not just a rise in nominal or cash interest rates but positive real interest rates. The real rate of interest is the nominal rate of interest minus the expected rate of inflation. Now, as the charts for the US and UK show real rates of interest are negative, the rate of inflation is higher than the nominal rate. It is very difficult to get a proper purchase on future expected inflation, but higher nominal rates that overtake the rate of inflation are likely to be needed.
Monetary policy operates with long and variable lags. Central bankers work with imperfect information and economic forecasts that are unreliable. Therefore, to know reliably how much policy has to be tightened to precisely slow the economy without a recession and still reduce inflation is very difficult to achieve. Normally it is not possible to disinflate an economy without a short-term loss of output and employment. Moreover, the premature easing of tightening or relaxation of policy risks failure to get inflation down. To take the necessary measures requires audacity and willpower.
Medium sized economies and the exchange rate
In smaller and medium sized economies where there is a strong passthrough from international prices to the domestic price level there is a further challenge in the context of an inflation target. Disinflation in the UK after the 1970s and in the late 1980s was associated with a strong exchange rate that reflected relatively tight domestic monetary conditions and explicit decisions made in relation to the exchange rate, including an exchange rate target between 1990 and 1992. While interest rates as a policy instrument are in the hands of the central bank, foreign exchange policy is the preserve of the finance ministry, in the UK and US it is an area where the Treasury departments take the lead. A successful and swift disinflation may require an explicit collaboration between the Treasury and the central bank to take advantage of a rising exchange rate in disinflating the economy.
Judgement and willpower
In the 1970s and 1980s several economies that had lost control of inflation in the 1970s successfully disinflated their economies. They included the US, the UK and France. Each episode of disinflation was different in character. In America he was a technocratic central banker in charge. In the UK the policy was executed as part of a wider counter-reformation in the political economy brought about by a Conservative politician. Mrs Margaret Thatcher’s purpose was to break with the post-war Keynesian consensus. In France it was the story of socialist finance ministers restoring financial order after a brief attempt at neo-Keynesian reflation. Yet there was a common thread in each episode: the determination to restore price stability in the face of political, economic and social costs.
Paul Volker’s new approach – monetary targets and limits on supply of minimum reserves
In the US inflation was brought about by an exceptionally determined central banker, Paul Volker, who chaired the Federal Reserve Board and announced a new framework of minimum reserve requirements to do it in October 1979. Interest rates rose to 20 per cent and there was a recession. The policy was very controversial in Congress but was sustained.
Mrs Thatcher’s Right Approach to the Economy and TINA
In the UK monetary policy and interest rates were under the control of the Treasury that directed the Bank of England in a master/servant relationship. Mrs Margaret Thatcher’s Conservative Government was elected on a monetarist approach to inflation control that had been set out in the Right Approach to the Economy. Targets for broad money, £M3, were laid out in a Medium-Term Financial Strategy MTFS published in March 1980. Interest rates were raised to 17 per cent The policy was maintained by the will power of the Prime Minister and that of her Chancellor of the Exchequer Sir Geoffrey Howe and the Financial Secretary to the Treasury, the author of the MTFS. It resulted in very high interest rates, a rising exchange rate, the longest and deepest recession since the 1930’s and a return to mass unemployment aggravated by labour market institutions that had yet to be reformed. The policy was maintained because as the Prime Minister said, in 1981 at a banquet for City of London bankers, hosted by the Lord Mayor of London at his official residence Mansion House : ‘ there is no alternative’ TINA.
Nigel Lawson’s boom and the return of inflation
In the mid-1980s after getting inflation down, the British Treasury under the direction of the Chancellor of the Exchequer Nigel Lawson, lost control of inflation and ended up with it peaking close to 10 per cent in 1990. In 1985 in his Mansion House speech Nigel Lawson ended the framework of monetary targets. The focus on broad money £M3 was dropped reflecting institutional changes that made the demand for money unstable. Nigel Lawson’s Mansion House speech emphasised that inflation would be the judge and jury of the new arrangements. Policy returned to being discretionary, albeit distorted by a period when the exchange rate was targeted against the deutschemark. Unfortunately this involved a clash between the need to control domestic inflation, which at the time implied an increase in interest rates and the informal external exchange rate target, where at that time sterling was rising against the deutschemark. The interpretation of policy was hindered by defective statistics, a flawed Treasury economic forecast and by mistaking a fall in the rate of inflation arising from the powerful relative price effect of the fall in oil prices and a genuine fall in inflation in the mid 198Os. Monetary policy also suffered from simply relying on inflation being its judge and jury , because it is a lagging indicator and without any intermediate warning targets it took off.
How Nigel Lawson and John Major reduced inflation through high interest rates and a strong exchange rate between 1988 and 1992
Having created the inflation problem Nigel Lawson directed the Treasury to deal with it decisively. Interests were swiftly raised to 15 per cent. The exchange rate rose and Negel Lawson’s successor as Chancellor persuaded the Prime Minister in September to take sterling into the Exchange Rate Mechanism ERM of the EMS at a high rate against the deutschemark, to ensure that inflation fell, which it did between 1990 and 1992, not least because the scope for easing domestic monetary conditions while sterling was in the ERM was highly constrained.
France: Keynesianism in one country and the Programme Commun in 1981
In many respects the French episode of disinflation between 1983 and 1987 is the most remarkable. President François Mitterrand was elected in May 1981 on the Programme Commun agreed between his Socialist Party and its coalition allies the Communist Party. It was an ambitious programme of nationalisation, a shorter working week, increased transfer payments and a higher minimum wage. In short a programme of neo-Keynesian expansion constructed to expedite the recovery of the sluggish French economy President Mitterrand had inherited from Valery Giscard d’Estaing. Its purpose was to insulate the French economy from the international recession. The French government budget balance swung from a surplus of 0.3 per cent of GDP In 1980 to a deficit of 2.9 per cent tin 1982. A consumption driven economic expansion where investment stagnated resulted in severe balance of payments difficulties aggravated by high relative inflation compared to other economies. French inflation fell but not by as much as other economies. Wage growth increased in double digits and the growth rate real wages roughly doubled. This resulted in unemployment rising. In May 1979 France had entered the European Monetary System EMS and fixed its currency to the deutschemark. A fixed exchange rate further complicated France’s balance of payments difficulties. France was forced to devalue twice within the EMS between 1981 and 1982. These realignments within the EMS offset France’s adverse inflation performance but they were not accompanied by the necessary fiscal measures needed to curb domestic consumption. This led to a further devaluation in March 1983. This was accompanied by the severe domestic austerity that was needed. Discretionary tax increases and spending cuts equivalent to 2 per cent of GDP were announced. This ended France’s experiment with neo-Keynesian demand management in one country.
Jacques Delors and Pierre Bérégovoy and the franc-fort after 1983: the French Treasury out Germans the Bundesbank
In many respects what is fascinating in this French episode is what happened next. The finance minister Jacque Delors supervised a policy of macro-economic monetary and fiscal caution. This policy was maintained by his successor Pierre Bérégovoy. Over the next seven years a policy that became known as the’ franc fort’ transformed France into Europe’s strongest financial economy. Orthodox monetary policies based around tight adherence to German monetary conditions, within the EMS, resulted in low inflation and a strong balance of payments. High public expenditure and taxation along with inflexible labour and product markets resulted in disappointing employment and growth. The micro-economic damage of the Programme Commun was not abandoned. The high unemployment and sclerotic performance of the French economy in a context of low inflation and strong public finances also offer a lesson. This is that financial orthodoxy without measures that ensure properly functioning product and labour markets will not alone yield prosperity and jobs, although they lay the necessary basis for a properly functioning supply side. In the Trente Glorieuses France had a trend rate of growth of around 5 per cent, the Programme Commun contributed to reducing it to something closer to 2 per cent .
Conclusion : the plain fact has become the harsh truth for central banks
A practical understanding of these hard lessons has been lost by central banks during decades when they have acquired independence and increased authority. Their technocrats have allowed themselves to become absorbed by recondite considerations that are beyond the policy tools that central banks have. The result is that persistent inflation has been recreated that is significantly above their targets. The position will not be corrected without a determined, expeditious exercise in creating a non-accommodating monetary policy environment. This is likely to involve positive real interest rates, losses of output and employment and will, once the inflation problem is dealt with, require a more normal structure of interest rates that will be much higher than the rates that had prevailed in the decade following 2009. When Nigel Lawson lost control of inflation in 1989, one of his witty Treasury officials quipped, playing on a comfort phrase that Nigel Lawson used to like to use in his speeches that ‘plain fact’ had become ‘the harsh truth’. Much could be said of the leadership of the principal central banks in the advanced economies of the OECD.
Warwick Lightfoot
20 June 2023
Warwick Lightfoot is an economist with specialist interest in monetary economics, public finances and labour markets and was Special Adviser to the Chancellor of Exchequer 1989-92.