## Mr George outlines monetary and exchange rate policies for sustainable growth
Speech by the Governor of the Bank of England, Mr E A J George, at The Central Policies Conference, Macau, 17 May 1999.
Mr Chairman, Ladies and Gentlemen, let me begin by saying that it is a real pleasu here with you today in Macau and to participate with such distinguished centra colleagues in your conference.
One of the very agreeable things about coming to the other side of the world to par an event like this is that it enables me to step back from the daily hubbub of my financial markets in the City of London, and the media, and reflect in a broader way is we are all actually trying to do. It is in fact much more agreeable than working!
In a broad sense, of course, our ultimate objective as central bankers is clear, and in your conference title when you talk about 'leading the way to sustainable growth' add high rates of employment and rising living standards to that objective.
Very often in the past, certainly in my own country, but not just in my own coun fundamental objective was seen to be largely a matter of demand management - of pum up demand by expansionary fiscal and monetary policies - with too little regard structural, supply-side, capacity of our economies to meet that demand. There is not overall fiscal policy, still less monetary policy, can do directly to affect th capacity of the economy: they operate essentially on the demand side. And our re experience showed that excessive demand growth spilled over into inflation and a wo balance of payments which ultimately had to be corrected - the infamous boom and cycle. This macro-economic instability damaged the supply side of the economy, with a outcome over time in terms of our ultimate policy objective. It is now very widely u that 'stability is a necessary condition for sustainable growth' and that, of course the universal central banker's mantra.
But the question is stability of what? You obviously cannot sensibly aim to everything. The aim has to be sustainable growth of the economy as a whole. But tha mean stable growth for every sector of the economy or for every business ente Consumer demands change over time and so, too, do technologies and production techni Open market competition to identify such changes, and to exploit them to meet socia more efficiently, is a vital driver of improvement on the supply side of the econo micro-economic level, that means that particular sectors and individual busines continually rise and fall; and that is why established producers everywhere often competition, perhaps especially international competition, as an unwelcome threat. B macro-economic level what we have to remember is that every dollar earned is a available to be spent or reinvested back into the economy, whoever earns it. So, at economic level, competition - the driver of economic progress - is a positive sum increases the potentially sustainable growth rate nationally, regionally, and int How far each country individually is able to take advantage of this increased depends upon how flexibly it can adapt to changes in comparative productive advan which in turn depends upon the supply-side characteristics of our separate economi there is no doubt that we all stand to benefit. That is why I have always fundamentally in the principle of free trade and open capital markets which
competition. It is why I have always welcomed the rapid growth we have seen in the emergi market economies - and why incidentally I look forward to China's accession to the WTO.
We cannot then sensibly aim to obstruct structural changes. But nor can we realistically to avoid all shorter-term fluctuations, associated with the business cycle for example result simply of random shocks. What we are looking for is a stable macro-economic framework for the economy as a whole, which will help to moderate rather than aggravat shorter-term fluctuations, and one within which change can occur in response to longer-t real economic factors, undistorted by unnecessary, erratic, movements particularly in nom values.
In a totally closed, national, economy I suspect that the most effective way of achievi would be to aim to stabilise the rate of consumer price inflation - at some very low representing effective price stability. We might, certainly, as an intermediate step stabilise the rate of growth of the money supply, if we were confident that the demand money was sufficiently stable and predictable, but the reason for targeting the growth money supply would ultimately be to stabilise the rate of inflation, so the distinc operational rather than substantive.
But it is important to understand that effective price stability would not be intended s an end in itself. In order to maintain price stability, what in fact we would need to keep overall demand in the economy continuously broadly in line with supply-side capaci so that the actual rate of inflation is really a measure, or barometer if you like, of o in maintaining macro-economic stability in a much wider sense. If we succeed in maintaini such stability, that would also contribute, indirectly, to improving the supply side economy by reducing nominal uncertainty as a factor in spending or saving or investme decisions and thereby improving resource allocation.
Macro-economic stability in this sense can of course be affected by either overall fiscal or by monetary policy. But frequent fiscal policy changes - to tax rates or expend programs - can generate micro-economic uncertainties so that short-run macro-economic stabilisation is normally left primarily to monetary policy. It is important nevertheless two arms of policy pull in the same general direction to avoid unwanted sectoral or re regional distortions.
In a totally closed economy therefore the objective of macro-economic stabilisation and respective roles of fiscal and monetary policy would be reasonably clear.
But none of us - very fortunately in any wider context - actually lives in a closed eco We are all vulnerable to external shocks to varying degrees, including of course, increas shocks resulting from international capital flows. Free trade and open capital markets d noted earlier, bring huge benefits in terms of supply-side improvements from which we a potentially, stand to gain. But there is no doubt that economic globalisation can at massively complicate our national efforts at macro-economic stabilisation and it is problem which I should like to address in the rest of my remarks.
A key issue is how far we can protect our internal macro-economic stability through choice of exchange rate regime. My short answer to that question - from the UK's experien - is that there is, sadly, no ideal solution!
The effective options range from floating, through some form of adjustable peg, to fixed exchange rate by way of a currency board or, ultimately, full monetary uni option has its pros and cons.
Let me start with floating. At first blush the idea of allowing the exchange rate strain, as a kind of buffer, insulating the domestic economy from shocks emanating appears very attractive. Unfortunately it does not necessarily work like that. exchange rate may move erratically in response to market news, causing unwarr movements in the real exchange rate. That, of course, may be an important influe domestic costs and prices; it may affect the relative competitiveness of domesti foreign-produced goods and services leading to changes in the net external trade affecting aggregate demand in the domestic economy. So the insulation provided by a exchange rate may prove to be more apparent than real.
The UK has been floating since 1992. For some years we experienced very little between our domestic and external policy needs. But then, from the autumn of 1996 we sudden appreciation of some 20-25% in our Effective Exchange Rate against the European currencies, and seemingly, largely related to uncertainties about th characteristics of the European single currency. Whatever the reason the strengtheni exchange rate had a dampening effect on the domestic price level, and a subs deterioration of our trade balance (accentuated over the past year or so by the glob slowdown) reduced aggregate demand in the economy. Monetary policy accordingly need to be less restrictive than would otherwise have been appropriate to offset these domestic demand. The aim was not to achieve a particular level of the exchange rat compensate for its deflationary impact. When the exchange rate weakens - as we ant that it will in due course - then monetary policy will at some point need to influence in the opposite direction. But in the meantime we have had to manage as can a severe imbalance between different sectors of the economy, with the interna exposed sectors taking a considerable hammering. Despite reasonable macro-econo stability in the economy as a whole, the environment has been anything but stable sectors.
For a period before 1992 we sought to manage the exchange rate, initially by in shadowing the DM and subsequently by pegging sterling within the framework of European Exchange Rate Mechanism. Both these episodes ended in tears, essentially f same reasons: attempting to manage the exchange rate required us to pursue macro-eco policies which were inconsistent with our own domestic macro-economic needs. In th case shadowing the DM involved accentuating a domestic boom; in the second case membership of the ERM, at a time when reunification required abnormally tight mon policy in Germany, involved us in pursuing an unnecessarily restrictive monetary deepening and prolonging recession. In that case, too, the formal commitment made ex difficult, the exchange rate fell very sharply, and we made a very substantial financ result of massive foreign exchange intervention seeking to defend the ultimately ind While they lasted these regimes provided a degree of nominal exchange rate stabili no doubt helped the internationally exposed sectors of the economy. But the price u was substantially increased instability in the economy as a whole.
Of course, some commentators have argued that the problem we had within the ERM was the exchange rate at which we entered rather than the form of the arrangements. I am n convinced. The divergence between our domestic policy needs and those in Germany was such that it seems unlikely to me that any plausible difference in the exchange rate i chosen for the peg would have made very much difference. But in any event the range o uncertainty surrounding the choice of a sustainable peg is an important part of the pr with any pegged or fixed rate regime.
The UK has not recently experienced a fully fixed exchange rate regime - although we rema a potential member of European Monetary Union. But the basic economic pros and cons of a fixed rate regime are somewhat similar. Essentially the very real advantages are nomi exchange rate certainty within the Euro-zone - which accounts for some 50% of our extern trade as well as participation of the domestic economy in broader, more liquid, pan-Euro financial markets. (The City of London is, of course, already a full participant in the E financial markets - indeed it is the major contribution that we can make at this stage development of the new currency.) These are very considerable potential economic benefi which will lead to more efficient resource allocation across the euro area. The pot downside is the risk that at times the single European monetary policy will not meet domestic monetary policy needs in all the individual participating countries - in other that there will be problems of sectoral and regional divergence which are very famili larger economies at the national level, but on a larger, regional European, scale. The still out on this question.
Based on our experience it seems clear, as I say, that there is no clear best solution, a at all times for all currencies, to reconciling the inherent problem of potential conflic the needs of domestic and external stability.
The choice depends very much upon the country's particular circumstances.
Floating may be more attractive to a country which has a small tradeable sector relative size of its domestic economy, but in that case it will need an effective nominal dom anchor, such as a money supply or inflation target; and it will need an institutional st typically an independent central bank - to reinforce the credibility of the commitment t nominal anchor.
At the other extreme a fixed rate regime may be more attractive to smaller, more op economies or where a credible domestic macro-economic framework is difficult to establis for example, for historical or political reasons. But in this case it is crucial to rec domestic policy must be totally and unreservedly committed to maintaining the fixe exchange rate. It is an extremely demanding regime but one which can work well - as w have seen in Hong Kong - where there is a high degree of supply-side flexibility to act alternative external shock absorber.
It has become increasingly fashionable recently to exclude anything between these t extreme positions - an actively managed float or a pegged rate regime - as an unviable mi ground. It is argued essentially that because they do not exert a sufficient discipline in either direction, or therefore represent a sufficiently clear policy framework, they intensify market tensions when a divergence between the policy needs of domestic an external stability does in fact arise.
I am reluctant to accept that so-called 'corner' view in any absolute sense. When te arise between external and domestic objectives, you cannot avoid the impact on d policy altogether even with a floating exchange rate regime - as I explained in the our own recent experience. It may help to reduce that tension to attempt to manage t some degree, by supporting appropriate domestic policy action with exchange m intervention, though I agree that such intervention may serve as little more than a s a currency is internationally widely traded and held. Similarly there can, I b circumstances in which domestic discipline may be reinforced by an exchange rate peg is vital in that case that the authorities should identify a clear exit strategy tensions are allowed to emerge. That - I know from our own experience - is much easi than done!
Mr Chairman, these dilemmas are certainly not new. But clearly they are liable accentuated by the massive increase in global capital flows over recent years, whic only complicated the choice between alternative possible exchange rate regimes but al the management of any of those regimes substantially more difficult.
So there is a further question we need to address which is whether there is anything to reduce the volatility of these massive capital flows beyond pursuing disciplin economic policies. That of course is the subject of a whole series of conferences o and there is certainly a good deal that we can do. Let me conclude by mentioning som items on my own shopping list in this context.
First, at the recipient end, a crucial condition for living with financial gl improvement of market structures to ensure that capital inflows are productively e That involves attention to structural issues, such as accountancy standards, bankru and governance questions. It involves appropriate sequencing of capital account libe - and arrangements to ensure that the particular risks to the borrowing country, fo attaching to volatile short-term inflows are properly recognised - and reflected i paid by the borrower. That in turn involves effective management of foreign currenc and liabilities in particular, including management of their relative liquidity, public and private sectors. It involves, also, ensuring that borrowers, and their unambiguously clear as to who is ultimately responsible for the liability at the tim on. It involves increased attention more generally to the soundness of financial which is to be the subject of our discussion this afternoon. And perhaps above all improved transparency - of policies, of standards, and of financial and economic enable investors and lenders to make informed assessments of risks.
But there is a great deal too that the international financial community can do, as the provider end. This includes the intensive efforts being made, particularly by t encourage sound macro-economic and structural policies - and greater transparency IMF member countries. It includes intensified efforts by financial regulators parti the national level but also working collectively through the new Financial Stability Basle Committee and IOSCO for example - to improve prudential standards of finan behaviour. And it includes the provision of official financial support to countri pursuing sound policies - in parallel with continuing private finance, on which would have been reduced both through the parallel official finance itself and throu international endorsement of the borrowing country' s policies. In this context I
the official sector may have placed too much emphasis in international discussions on 'ba in' the private sector - which can sound ominous, even threatening - where what we real need is recognition of our mutual interest in public-private sector partnership.
It is a heavy and complex agenda which is being very actively pursued in many differe international groupings, involving both the industrial and emerging countries, across a front. We are I believe steadily moving towards consensus or many of the issues and thi 'leading the way towards sustainable economic growth' into the next millennium. In th meantime we are collectively having to manage the consequences of the recent globa financial disturbances and their economic after-effects. Happily we have recently been ma progress on that too, particularly in many of the emerging countries here in Asia.