ZEW President Franz on Credibility in Economic Policy Practice

This piece appeared in the November 2004 edition of the ZEWnews.

The Nobel Prize in Economics was awarded this year to Finn E. Kydland and Edward C. Prescott, through which the importance of credibility in the practice of economic policy was emphasised. This lesson is particularly important considering all the confusion in the current debate, such as over attempts to involve the European Central Bank (ECB) in certain “dialogues.” In order to properly understand and classify the achievements of this year’s Nobel laureates, it is helpful to take a brief look back, roughly to the beginning of the 1970s. Back then, the business cycle and growth analysis primarily focused on the role of aggregate demand (i.e. consumption, investment, public consumption, exports) as the driving force of economic development. This approach reflected John M. Keynes’ point of view regarding his experiences during the Great Depression. It is not known, however, if Keynes would have agreed with this interpretation of his work. It was indeed reasonable to emphasise the great importance of aggregate demand. Still, it was wrong to have lost sight of both the problems with a stabilisation policy aiming to control aggregate demand as well as with supply, which was at least equally as relevant. After all, employment losses caused by a supply-side disruption, e.g. due to an oil price shock, cannot be combatted with the help of expansive monetary and fiscal policy alone. Such an attempt would lead to constantly increasing inflation rates, in which case both evils, that is, higher unemployment and inflation, would ultimately need to be confronted. However, even a monetary policy aimed at the goal of price stability could still turn out to be ineffective if it were not deemed to be credible – businesses and wage policy makers would still need to be reassured. Otherwise, they would expect rising prices and adapt their plans accordingly, especially if they had been deceived in the past because monetary policy did not ensure the stability it originally promised. A monetary policy that is not seen as reliable will once again lead to higher inflation and unemployment, even if the cause is something else entirely. There are two ways to avoid the trap of low credibility—fixed rules must be set and monetary policy institutions must remain independent. Credibility can be increased by establishing a formula in monetary policy which is geared towards monetary stability and will not change in the foreseeable future. However, a potential disadvantage of this strategy is that the rules might turn out to be restrictive and too inflexible, as it is hardly ever possible to establish regulations that cover every potential turn of events. The second approach, then, is to focus on the independence of the central bank that is fully committed to price stability. In addition, the central bank needs to aim for transparency in its monetary policy, primarily with the help of stipulated money development. Any attempts to involve the ECB in some form of macroeconomic policy need to be scrutinised carefully. The desire to “exchange ideas” on the matter is rather alarming. If someone really intends to do so, it would be best to nip it in the bud once and for all!