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From Crises to Targeting Inflation

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From Crises to Targeting Inflation FROM CRISES TO TARGETING INFLATION an international upheaval y the early 1980s the situation for monetary policy had changed 397 completely. Previously, the dollar was formally valued in terms of B gold and the currencies in the Bretton Woods system were therefore based on gold. The collapse of that system put an end to the age of standards in terms of precious metals. A currency’s value now depended entirely on confidence. Monetary policy had a new outlook. After the oil-price shocks, cross-border capital flows rose rapidly. Vari- ous mutually reinforcing factors contributed to this. With new information technologies, large, complex long-distance transactions could be settled more The global economy is transformed. 1980 –1 Dollar interest rates rise. Cross-border capital flows are stronger and 1982 The krona is devalued by 16 per cent. previously regulated economies are drawn Bengt Dennis is appointed Riksbank into international trade. Economists recon - governor. sider the Keynesian approach behind early 1985 Former finance minister Gunnar post-war monetary policy. Germany gives Sträng steps down as chairman of the combating inflation precedence over Riksbank’s governing board. employment; the United States and Britain Interest controls are abolished. set about deregulating financial markets. 1986–90 Exchange controls are dismantled. The reassessment reaches Sweden later than 1992 The Maastricht Treaty. The EEA many other countries – deregulation here agreement comes into force. does not begin until the mid-1980s, followed International currency unrest. Bank by measures to lower inflation in the early crisis in Sweden. The Riksbank 1990s. The latter coincide with a financial abandons the fixed exchange rate. crisis when deregulation results in rapid 1993 The Riksbank changes to targeting credit growth. In November 1992 the inflation. Riksbank abandons the fixed exchange rate 1994 Urban Bäckström is appointed and monetary policy switches to targeting Riksbank governor. inflation. In 1999 a new Riksbank Act makes 1999 Amended Riksbank Act increases the the Bank markedly more independent. In Bank’s independence. Eva Srejber and 2003, a referendum rejects a changeover to Kerstin Hessius are the first women the euro and Sweden’s currency continues on the Riksbank’s Executive Board. to be the krona. The Riksbank’s task of en - 2002 Euro notes and coins are introduced. suring the stability of payment systems 2003 Lars Heikensten is appointed attracts more attention. Riksbank governor. Sweden’s referendum rejects the euro. 1970s The Bretton Woods system collapses. 2005 Stefan Ingves is appointed 1970s–80s Some central banks adopt a tight Riksbank governor. monetary policy to break inflation. from crises to targeting inflation 398 or less instantaneously. Financial market participants invented instruments tries with large dollar loans became heavier, particularly as the slump among 399 and procedures for increasingly sophisticated purposes. Greater possibilities OECD countries was reducing their export income. Led by Paul Volcker at of operating across borders encouraged companies and investors to look the Federal Reserve and Gordon Richardson at the Bank of England, the further afield. central banks managed to prevent what could have been a major threat to the In the early 1970s, cross-border transactions were still strictly controlled. international banking system. Much of the adjustment was left to the debtor As the decade proceeded, more and more ways were found of evading the countries, though many banks did have to write off claims. The ensuing restrictions. An unregulated financial market grew up alongside the market negotiations were in the hands of Jacques de Larosière, managing director of which governments controlled. For the Bretton Woods system, this was a the IMF. The World Bank finally sounded the all clear for the major debtors growing problem. At the same time, the two markets were so intertwined that in 1994. disruptions outside government control could have serious repercussions in More and more governments concluded they must strengthen their hold the regulated systems. on the financial system. Fewer regulations would make financial institutions An indication of what could happen occurred in 1974, when Bankhaus more willing to submit to government supervision; standards for reserves and Herstatt in West Germany collapsed. The bank had built up large future coverage could then be imposed to reduce the risk of default. Following the positions in foreign currencies and misjudged the course of events; the losses example of West Germany and the Benelux countries, Margaret Thatcher’s totalled more than a billion German marks. The Bundesbank could not government abolished Britain’s exchange controls in October 1979. As more achieve a reconstruction, so the German inspectorate closed the bank on 26 and more countries deregulated, it became increasingly difficult for others not June. The failure undermined confidence in the entire banking system; to follow suit. insurance companies and foundations withdrew their deposits from smaller The new order gave governments less discretion. In 1981 in France, the private banks (Franke, 1998). Other financial institutions also ran into incoming socialist government lost no time in providing fiscal stimuli: under trouble in the 1970s – American mortgage institutions, Franklin National President Mitterrand’s budget minister, Laurent Fabius, the budget deficit Bank and institutions in Japan. grew by a quarter while economic growth picked up from 1.2 per cent of Rapidly expanding international financial markets gave many deve- GDP in 1981 to 2.6 per cent the following year. However, as the stimuli could loping countries a chance of borrowing much more than before. Interna - not be directed, the fixed exchange rate and a global recession led to a weaker tional banks were flooded with deposits from the OPEC countries; non-oil balance of payments. The franc came under pressure and its interest rate countries obtained loans to avoid cutting imports. South Korea, the Philip - in London rose above 20 per cent, signalling expectations of devaluation. pines, Mexico, Brazil and other countries rapidly accumulated large debts. In March 1983 the French socialists did an about-turn – they could not go Goodhart (1988) considers that, prior to the crisis in 1982, creditors had un - on swimming against the economic tide. Belief in what Keynesian fiscal derestimated the risk of lending to sovereign states, which had traditionally policy could achieve was shaken. been seen as ‘safe’ debtors. Opinions about monetary policy were changing. OPEC had effected For a long time the issue at international conferences was not how to a second oil-price shock in 1979. Contributors to the international eco - check borrowing but how to get banks to lend even more (Pringle, 1995). nomic debate began to talk of stagflation, a combination of stagnation, high The banks relied on the United States assisting large debtor countries and on unemployment and high inflation. Looking back on thirty years as gover - West Germany safeguarding its banks’ interests in Eastern Europe. The BIS nor of Denmark’s central bank, Erik Hoffmeyer (1993) wrote, ‘[T]he full was still undecided in June 1982, calling for stricter banking guidelines yet employment policy was shipwrecked in the 1970s in virtually every western warning that undue caution in lending to the Third World might spread ‘too country.’ widely and too indiscriminately to whole groups of countries’. The instigators of the new insights included two economists. In his ad - When dollar interest rates rose in 1980–1, the burden of debt in coun - dress as chairman of the American Economic Association, Milton Friedman from crises to targeting inflation 400 (1968) discussed the role of monetary policy and rejected the notion that The overheating of the British and Japanese economies is at least partly 401 inflation could help maintain employment. Some years later came Robert attributable to monetary policy not being sufficiently restrictive in 1987–8 Lucas’ (1976) influential assessment of economic policy’s potential and (Pringle, 1995). effects. Economic agents are influenced by what they expect government will do. Households and firms behave rationally and adapt to new conditions. the 1982 devaluation The fact that a particular tax system induces people to behave in a certain way does not mean they will continue to do so if the system is changed. Up to 1980, interest rates in Sweden had largely followed the international Earlier models for economic analyses were therefore incapable of calculating path. However, Sweden took longer to focus economic policy on combating and predicting what was happening in the 1970s. New models would have to inflation. Deregulation also came later. Problems with stabilisation were be developed, based on the view that people’s expectations are rational. handled with the exchange rate rather than with interest rates. Combating inflation became the goal for more and more OECD Social democrat policy was gradually reconsidered during the years in countries, even if it meant higher unemployment. Opinion elsewhere was opposition (1976–82). One issue was how industry could be expanded in influenced by the Bundesbank’s decision, in connection with the oil crises, order to finance welfare. The traditional recipe had been Myrdal’s from 1944 to defend the value of money rather than stimulate the economy. The – by setting taxes, subsidies and write-offs to promote investment. In the stabilisation
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