Still talking about money

There is one subject that still has the capacity to fill otherwise cool economists with emotion. This is the use of monetary aggregates in monetary policy. It appears at times that this debate has lost none of vigour since the great Keynesian-Monetary controversies of yesteryear, though the proponents of money have become a lot more modest.

 

Monetary analysis is current subject to one of the hottest debates - not just among pundits - but among European central bankers themselves. Christian Noyer, governor of the Bank of France, and former ECB-vice president, can hardly be described as anti-establishment, or as a great revolutionary. But when he recently called into question the reliability of monetary indicators at a time when hedge funds draw in so much global liquidity, he provoked the ire of the Bundesbank, which felt the need to strengthen the ECB's faltering backbone over the monetary pillar. Monetary analysis is the German inheritance of the ECB, and it is there to stay.

 

The issue also came up, perhaps unsurprising, at this year's Konstanz Seminar on Monetary Theory and Policy this week, where a paper by Gunter Beck and Volker Wieland caused an outcry among colleagues, who accused the authors of presenting a Germanic defence of an indefensible system.

 

In contrast to some of the widely-held views on this, our view is relatively moderate. We think there is a case for monetary analysis, but we are not in agreement with the Bundesbank either. Our argument is more subtle. We think that the proponents of monetary analysis over-emphase the point that money can still serve as a reliable indicator of medium-term inflation trends, as long as one chooses the right aggregate. We believe that money may under certain circumstance be a useful indictor, though one that is far from reliable. Despite these shortcoming, money nevertheless carries important information content that central bankers should not ignore, as some do.

 

A lot of work is currently being expanded on trying to prove that demand for money is stable (see some of the reference in Beck's and Wieland's paper, for example Gerlach). One approach has been to clean up aggregates such as M3 into high-frequency and low-frequency components, to the effect that form of stability sudden becomes noticeable. We treat this kind of research with utmost caution, since it is by definition backward looking, it is predominantly a statistical exercise, and probably prone to future adjustments as the rate and type financial innovations change. Even when if we were to accept that the demand for money was relatively stable in the euro area, we have to accept that it is clear unstable in the UK or the US, no matter how much you massage the figures. Since financial innovation in the euro area is going the anglo-saxon way, it should not be surprising if the relation were to become less stable over time.

 

The argument that money could serve as a useful cross-check - as made by the ECB - is also misleading. Most central banks in the world use a variant of Woodford's money-free new Keynesian model to forecast future inflation. The idea of the cross-check is that normally money should not influence policy setting, except in cases where a chosen money aggregate, such as M3, were to deviate from a reference value for a certain period of time. In this case, there should be a mechanism to take account of this deviation. So if money grows at excessive rates for a predefined period, as it certainly has been doing for the last two years, central banks should raise interest rates by more than they would otherwise do under the new Keynesian framework.

 

There are several problems with this mechanistic approach. The first is that it is not clear that money is the best cross-checking indicator. Why not nominal wages or current inflation? The Bank of England appears to place some weight on current inflation as a counter-measure.

 

The second problem is a political economy problem. The ECB, which claims to operate a two-pillar strategy, does in fact not produce a single strategy out of these two pillars. Rather, the new Keynesian pillar one analysts present their case to the governing council, while the pillar-two monetary analysts presents theirs. It is up to the council to decide how to resolve this conflict. There is no such a think as an error-correction formula within the ECB's own framework.

 

Nevertheless, excessive increases in a monetary aggregate over long periods of time can have important meaning to central bankers, especially if the increase in M3, or M4, is accompanied by corresponding increases in the counterparts to M3, notably bank credit to the private sector. Professor Charles Goodhart has recently made this point, when he argued that the current fashion among central banks to ignore money has gone too far. Goodhart does not advocate he return to monetary targets - in fact, nobody does. But he said that central banks need to analyse monetary aggregates very carefully, and include this analysis in their overall decision-making process. The trouble with the two-pillar system is that this integration is not taking place. In fact, the dichotomy behind "economic" (pillar one) and "monetary" (pillar 2) may have in fact enhanced the persistent ideological gap between the two feuding camps, who have conveniently positioned themselves on each of those pillars. You are either pillar one, or a pillar two man.

 

The Bundesbank is right to emphasise the importance of money, but the Bundesbank is wrong when it claims that M3, properly adjusted, is stable. The point is that you do not need the fairy tale of stable money demand to worry about excessive monetary growth.

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