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In the recent book, “Volker, or the triumph of perseverance”, one can read how, during the confrontation that pitted the Federal Reserve Bank against the Reagan administration, the refusal of the Central Bank to monetise the federal debt forced the hand of Congress to adopt legislation imposing a return to a balanced budget by no later than 1991.
This situation is reminiscent of conditions prevailing at present within the eurozone, where the ECB is conditioning its intervention, aiming at relieving the burden of punitive interest rates imposed by the market on the most debt-ridden Member States, on the entry into force of the European Stability Mechanism (ESM), itself dependant on the ratification of the TSCG.
In 1985, Paul Volker had re-established the badly damaged international credibility of the Central Bank, having succeeded in reducing significantly the rate of inflation and, as a result, lowering the price of gold and increasing the external value of the dollar. The main remaining “black spot” was the persistent high level of long-term interest rates which was inhibiting the strength of the economic recovery. Absent other “culprits”, it became evident that the principal cause was the excessive deficit of the federal budget. It is the convergence of all these factors that forced the passage of the G-R-H Act which ran flagrantly counter the electoral promises of President Reagan; similar constraints will force, in the coming days, the adoption by France of the TSCG, flying in the face of President Hollande’s own electoral promises.
The first lesson to draw from this episode is the absolute necessity of coherence between monetary policy enforced by the central bank and the economic, fiscal and budgetary policies decided by the government(s). On its own, the Central Bank is not able to guarantee the simultaneous optimisation of the conditions necessary to stimulate the economy, fight unemployment, control inflationary expectations and defend the external value of the currency. That is essentially the message that Mario Draghi addressed to EMU governments when he revealed, early September, the new orientations of ECB policies and in particular the prior conditions for activating the new “Outright Monetary Transactions” (OMT).
The parallelism between the two situations is striking: indeed, both in 1985 and today budgetary deficits and public indebtedness reached unsustainable levels; similarly, inflation was not, then or now, a major cause of concern; however, in 2012 the price of gold and questions surrounding the dollar – two indicators to which Paul Volker was particularly sensitive – are apt to make markets nervous and reinforce inflationary expectations. On the other hand, there are also marked differences: interest rates remained stubbornly high in the US in the mid 80’s while today they are at historical lows both for American treasury securities and for the highest quality European borrowers. Furthermore, through unwavering perseverance, Volker had succeeded in giving strong credibility to his policies, in particular by daring to increase rates early on in the economic recovery cycle; today a great question mark hangs over the intentions of Central Banks, be it in the US where Ben Bernanke has recently prolonged, once again, the guidance on maintaining interest rates at their present floor level until 2015 (for which he has been criticised by Paul Volker) or in Europe. The ECB must still demonstrate its capacity to impose an increase in interest rates, in the case of a sustained recovery, in order to maintain “price stability” by draining the excess liquidity with which it flooded the market to prevent the implosion of the banking sector.
There are also other differentiating factors that influence significantly current outcomes: the fast increasing globalisation of the world economy since the 1980’s with the emergence of new major economic powers has reinforced the interdependence of national economies and, consequently, the impact through contagion of decisions taken at national (or European) level. This state of affairs puts into question the legitimacy of the dollar’s role as reserve currency of choice which confers on it certain privileges (that are more and more contested) but also imposes obligations (that are more and more ignored).
But it is in the field of the institutional architecture that the differences between the situation in the US and the eurozone are set to create the greatest difficulties and restrict severely the capacity of the EMU to deal with the necessary force determination and flexibility to overcome the challenges of the financial crisis.
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Paul N Goldschmidt, Director, European Commission (ret.); Member of the Advisory Board of the Thomas More Institute
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