Select Committee on European Union Minutes of Evidence

Examination of Witnesses (Questions 35-39)




  35. Good morning, Professor Buiter and Professor Goodhart. It is very good to see you. I have seen you in another guise when you were members of the MPC and I was Chairman of the Treasury Select Committee. It is very good of you to come and help us on our ECB inquiry. It might be of interest perhaps if both of you could give a short statement on your views about the ECB and how it operates and performs, to get us going; or you might want to take into account the latest ECB statement about the monetary target and, indeed, their inflation target?

  (Professor Buiter) I was not planning to make an opening statement. I was rather looking forward to answering questions. In two words I can say something about the two sets of changes going through in the ECB at the moment. The first, you refer to, which is the recent reorientation, rephrasing, of the operational objectives; the second one being the institutional reorganisation dealing with voting rights and the problems of dealing with an ever-enlarging Union and Governing Council. In a nutshell, I think that the ECB is gradually moving towards speaking the name of the inflation target (that dare not speak its name thus far) which they have been avoiding for the first four years of their existence. They have maintained that they had a price stability target and that the inflation rate on the HICP basis, of between zero and 2 per cent, was consistent with the target. The move now to a statement that 2 per cent is still the ceiling, but they will try and stick close to it, represents a gradual move towards a proper inflation target. We are not there yet. It is not clear whether it is a one-sided target or whether, in due course, it will become a two-sided target. It is clear, I think, they have recognised that for communicating their future decisions more clearly, the market has to have a better idea about the tolerance thresholds for inflation. Part of the problem here is semantic. You cannot get any continental European central banker to admit that he or she has an inflation target, because inflation is a bad thing. It is price stability, and the operational definition of that is that inflation is in a certain range. We should not ever expect the formal admission of an inflation target, at least not in our lifetime, but we will gradually move closer to it. As regards the organisational changes, the ECB is stuck between a rock and a hard place. It is clear that if and when the full set of current EU members also become full EMU members, we would have a Governing Council of 21. The proposed changes intend to cap the size of the future voting members of the Council at 21, even though it anticipates an increase in the total number of Council members of up to 33. We would have 27 National Governors present plus six executive board members, 33 members in total through the discussion with 21 voting. That is three football teams for the discussion, and two with one man sent off for the voting! It is too large. It is an incredibly complicated scheme. You literally have to use a formula to figure out who is going to vote how often and what the rotation scheme is. This is the unavoidable result of an internal contradiction, which is that you have the ECB whose mandate is EU-wide price stability and whose only legitimate considerations are EU-wide considerations, yet the majority of the members of the Council, and of those voting, are selected for nationality reasons. You cannot have it both ways. As long as nationality considerations in appointments and the EU-wide mandate have to be accommodated in the same body we are going to have something that looks like an inelegant mess. Finally, the Executive Board consists of six members and it is already too small relative to the governors, the external members. It will be too small in the future and I consider that to be a dangerous development.

  36. Why should it be a dangerous development?
  (Professor Buiter) Again you have 12 people who are there because of their national background now, and in the future up to 27 present and up to 15 voting who have a weight greater than the full-time non-nationally partisan members.
  (Professor Goodhart) I agree very largely with what Willem has said. Let me start with the organisation's institutional side. I think that the ECB has actually handled the problem of enlargement and how it will make decisions and run the committees on an incorrect model. They have followed the Federal Reserve model, where everyone turns up and only a limited number can vote. I think they would have been much better advised if they had followed the IMF-type model in which Executive Directors will represent groups of countries. The fact that everyone can turn up at the Governing Council means that, at present, there would be 28 people; and if each person was given ten minutes to present their own initial position that would last five hours before you actually got started with the discussion at all. As Willem has already said, the size of the Governing Council is actually going to become totally unwieldy, not only with the people present but with all the various other people which can attend. Again as Willem says, it gives a huge preponderance of votes to national central bank governors, frequently from really very, very small countries. In my view, a much better approach would have been to group the countries into smaller groups. My own preference would be to have the President and the Deputy President elected by the politicians through the European Council, and then have the other members of the Board, say there were five groups, each of them electing one member of the Board. Then I would try and reduce the number of either voting or attending members of the ECB from the national central banks to, say, five. I would prefer to have a situation in which the Board had a larger number of those voting, and the national central banks had a smaller number. The only way that one could do that is by grouping them into a set of four, five or six groups. It is perfectly possible. I think they have taken the wrong model. One issue which Willem did not touch on was the change in the first pillar, the monetary side and the reference value. If you look at the decisions of the ECB you will see that, in fact, the relationship between monetary growth and the decisions of the ECB is actually inverse. When M3 or M2 was growing faster than the reference value, the ECB was cutting interest rates. What they have done, in a sense, reflects reality; but what they have done is to move towards a greater realism by looking at a range of monetary variables and credit variables as well. It is right that they should; but now if you ask what does the first pillar consist of, I think it would be very difficult for anyone to give a clear answer and would consist probably of what Dr Issing and the other key economists at the ECB wish it to consist of.

Lord Lamont of Lerwick

  37. Thank you very much for those very interesting statements. I wonder if I could switch to monetary policy. Could I just ask a double-barrelled question which I think is important about the future. The first is whether you think there is any risk of deflation in Europe? It seems to have been generally thought that the risk of deflation in European was minimal. Most people discounted it. Yet last week we had a statement from the Fed that openly referred to it. The alteration of the ECB's inflation target was thought to reflect fears of deflation as well. Last week the Financial Times in an editorial said: "The risk of deflation in Germany is increasing each week". A lot of people think and it is accepted that the ECB's interest rate for Germany is too high compared with what it had under a national bank. Do you think that there is a significant risk of deflation in Germany and, therefore, in the euro zone? The second point is whether the present set-up of the ECB, if this situation did materialise, would be appropriate to deal with it. I do not know whether you saw an article by Sir Samuel Brittan in the Financial Times last Friday? As you know, he has been a great supporter of bank independence. He doubted whether the ECB could cope with this. If I could just quote from what he said: "The relevant point is that nearly all such novel policies . . .", and "novel polices" refers to novel policies to do with deflation, ". . . involve close co-operation between governments and the central bank. An example is the issue of new public debt financed by money creation. This would require delicate co-ordination between the European Central Bank and the 12 or more governments, some already struggling with structural budget deficits and all with different objectives, priorities and operational theories. Apportioning the permitted rise in deficits would be just one point of contention." He was using this as an argument for not joining the euro, which is not my point in any way. He was saying that actually the way in which independence operates for the Bank would not place it in a good position to deal with this situation if it arose?
  (Professor Goodhart) I do not myself think that the ECB will allow deflation to occur in the euro zone. I think they will take sufficient action to prevent that. The problem is that that is not inconsistent with the possibility that deflation could take over in Germany, which is a different matter. The ECB's remit is to be concerned with price stability and avoiding deflation in Europe as a whole. That leads to the second question of what could Germany do and what you do about asymmetries—noting, of course, that there are asymmetries within any European country; so that the monetary policy which is suitable for the tradeable goods sector in the UK, (before sterling started to decline) is not necessarily the monetary policy best adapted to the housing sector. You can get asymmetries within a country as well as between countries. My view is that it is perfectly proper for the ECB to aim for the achievement of price stability within the euro zone as a whole, which is after all what they are required to do by Treaty. What should Germany do? The answer is that it is very difficult, other than structural changes which are pressed upon them. If you want to say what is wrong with the set-up, I would tend to go back to the area of discussion which you have just had recently which relates to the Stability and Growth Pact. One of the factors within a large single currency union like the US, which enables there to be adjustment between regions, is of course fiscal policy. The difficulty is that the Stability and Growth Pact has very largely cut that out in conditions that Germany is now facing.
  (Professor Buiter) Deflation in Europe, I interpret it as meaning sustained deflation—price movements are always random, so there could be a little blip for various reasons — is unlikely, and it is also completely avoidable. Deflation at some level reflects a policy choice or, in the case of Europe, the inability to coordinate policy choices, should it happen. Germany is not the euro zone. It is about 30 per cent, a third of the euro zone. Deflation in Germany is certainly consistent with inflation in the euro zone as a whole, just as Britain has a deflation in the manufacturing zone. I do not think that mild deflation in Germany creates great economic problems. I think that Germany suffers from real rigidities more than from nominal rigidities. While it would be desirable, and easier, if no country had deflation, if an overall inflation rate of about two per cent is to be achieved over a large economic area, some countries inevitably are going to have negative inflation. That of itself is not worrying, if it is anticipated. Sharp deflation caused by sudden contractions in demand are catastrophic, because of debt deflation and financial stress. Sustained deflation is always a policy choice, in the sense that the combined monetary and fiscal authorities can always stop it. The state has always known how to make inflation and has not forgotten it. You just run budget deficits and finance them by printing money. In the EU setting, including Britain, at the moment, the central bank is independent, and this ability to coordinate monetary and fiscal policy is not automatic. The ECB, in fact, by treaty is prevented from directly financing national governments in the primary debt markets. That does not stop them, of course, if both the fiscal authorities (12 at the moment) and the ECB were willing to do so, from monetising the deficit. They would simply have the national governments borrowing in the capital markets, and the central bank buying up the debt in the secondary markets. It can be done, but it requires coordination. That coordination is hard in a single country like the US or the UK. It is very, very hard if you have 12 national authorities. It could be done, sure. What could be done effectively is that the central bank could send every European, man, woman and child, a cheque drawn on the central bank for a thousand euros, or whatever. If that does not work they send another one until people start spending. Clearly you cannot do that, because it would involve the central bank acting as a fiscal agent — it would be a tax cut or gift by the central bank, financed by printing base money. The economic equivalent can be done by the fiscal authorities cutting taxes, making transfer payments and then the bank refinancing that. That always works whether the interest rates are zero or positive. It is harder in euro land but is not impossible. I think the risks of deflation as it is are also quite limited. The ECB still has 250 base points to go, which is 125 more than the US. The risks of deflation, if anything, are slightly greater in the US at the moment than in euro land.

  38. Surely deflation in Germany alone would be a very serious development? The dangers of deflation are if combined with indebtedness. Germany is a highly indebted country in terms of corporate structures and, of course, it has quite a weak banking system?
  (Professor Buiter) Unanticipated deflation, serious deflation, is indeed costly because unanticipated deflation, by definition, is not priced into non-index linked contracts and you get a major distribution of wealth and income from debtors to creditors, and that creates debt deflation problems. If deflation happens in Germany it will have been pretty well anticipated. Longer dated debt may create some transitional problems, but new debt will simply price expected deflation into nominal interest rates. If there is deflation in Germany it will be very gradual and should not create any problems. Low deflation, anticipated and stable deflation, creates no more problems than low inflation. The notion that there is some big discontinuity at zero in the damage caused by price movements is not correct. There are some technical problems of zero nominal interest rates but, as I have said, we are still some distance away from that. I would not start panicking simply because there might be deflation in Germany for the next two years. You can have deflation with growth. The UK had it for 50 years in the nineteenth century.

Lord St John of Bletso

  39. With inflation rates differing in euro land from under 2 per cent to 4 per cent, surely one of the long-term problems with the stability of euro zone is the speed with which national inflation rates will or can convert?
  (Professor Goodhart) Again that can happen within a country. I remember looking, when I was on the MPC, at data showing the rate of inflation in the service sector which at that time was something like 4.5 per cent as compared with manufacturing, which is for goods compared with services. Services were going up 4.5 per cent and goods were negative. I knew you could get this kind of asymmetry within a country as well as between countries. This is something that will always have to be handled. Monetary policy, by definition, can only aim at one objective and that raises the question of when you face asymmetries either within or between countries of what other mechanisms you have for dealing with it. That goes back to the issues about fiscal policy, about the ease and speed of adjusting within the sectors, and so on.
  (Professor Buiter) As long as there are asymmetric shocks, of course, you would hope that national cost and price inflation rates would differ; that is the adjustment mechanism. You can only expect convergence of national inflation rates if there was commonality rather than asymmetry in the shocks and if the underlying productivity growth trends were the same between countries.
  (Professor Goodhart) That goes back to one of the issues I am sure you will come on to, which is that with the accession of the transition countries we expect them to have a much higher rate of growth of productivity. There is some expectation that they will naturally have higher inflation rates in Eastern Europe consistent with equilibrium, and whether there should be any forward-looking adjustment to the "inflation target which dare not speak its name".

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