Journal Issue
Finance & Development, December 1979

The anguish of central banking

International Monetary Fund. External Relations Dept.
Published Date:
December 1979
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Gordon Williams

The tasks faced by central banks in dealing with inflation and problems of international monetary coordination were the main issues at the Per Jacobsson Lecture this year. Mr. Burns focused largely on experience in the United States in his attempts to identify the philosophical as well as the economic factors that have led to today’s chronic inflationary pressures. Noting that international stability depends on reasonably good control by the major industrial nations, and especially the United States, over domestic inflationary pressures, Mr. Burns outlined a strategy for drastic therapy in the United States. Professor Cirovic saw the recent distortions in the world economy as a result not only of inflation but also of falling economic growth rates. He outlined a general program for international action that would achieve both a sufficiently stable international environment and a faster expansion of world output in a period of deflationary as well as inflationary trends. The need to look ahead toward action to promote the better functioning of the international monetary system was Mr. Polak’s main subject. He commented on a number of its new and emerging features in the interrelated areas of exchange rate developments, coordination of adjustment policy, and control of reserve assets. He agreed with Mr. Burns’ statement that he does not expect a return to stability until reasonably good control over inflationary forces has been achieved in the major industrial nations, especially in the United States.

Bias toward inflation

Mr. Burns began his lecture by noting that the re-emergence of inflation in the major economies had created doubts about the stability and effectiveness of the international monetary system. Despite their anti-inflationary traditions and the powerful weapons at their command, central banks have not been effective in fighting inflation. The purpose of his talk was to consider the causes and implications of this paradox, from which he derived his title—“The Anguish of Central Banking.”

He noted that for roughly two decades after World War II economic and financial developments had been reasonably satisfactory but that inflation had begun to accelerate in the mid-1960s, both in the United States and in other industrial countries.

Purely economic analyses of inflation in the United States, he believed, overlook the fundamental inflationary bias that has emerged from the philosophic and political currents that have been transforming economic life in the United States and elsewhere since the 1930s. The essence of the unique inflation of our times and the reason that central bankers have been ineffective in dealing with it can be understood only in terms of these currents,

During the greater part of U.S. history, government intervention in economic life was only peripheral. But less than a decade after the cataclysmic events of the 1930s and 1940s, the U.S. Government had become a leading actor on the economic stage. The experiences of the Great Depression and of World War II had persuaded people that the Government should both help the unemployed and prevent unemployment in the first place. The Employment Act of 1946 explicitly stated the Federal Government’s responsibility to promote “maximum employment,” which came to mean “full employment” as a matter of law as well as popular usage.

The period from World War II to the mid-1960s was marked, not only by a dampening of the business cycle but also by persistent increases in the prosperity of American families. “This experience of economic progress strengthened the public’s expectation of progress,” Mr. Burns said, to the point of a feeling of entitlement to annual increases in real income and a belief that all newly-discovered ills of society should be addressed promptly by the Federal Government. And the administration in power attempted to respond. The interplaying demands and government action had an internal dynamic that led to their concurrent escalation, and their cumulative effect was to impart a strong inflationary bias to the American economy. Since the willingness of the Government to levy taxes fell far short of its propensity to spend, budget deficits became a chronic condition of federal finance.

“Much of the expanding range of government spending was prompted by the commitment to full employment,” Mr. Burns reminded his audience. “Fear of immediate unemployment—rather than fear of current or eventual inflation—thus came to dominate economic policymaking.”

This emphasis inevitably gave an inflationary twist to the economy; so too did the expanding role of government regulation, much of which reduced the amounts of capital that might have gone into productivity-enhancing investments by private industry. Additional forces on the side of supply contributed to the inflationary bias. As the income-maintenance programs established by the Government were liberalized, the number of individuals counted as unemployed could rise even at times when job vacancies, wages, and the consumer price level were rising.

These philosophic and political currents inevitably affected the attitudes and actions of central bankers. In addition to these influences, the Federal Reserve was also subject to provisions of the Employment Act of 1946 “to promote maximum employment,” which limited its scope for controlling prices through limiting the money supply. In Mr. Burns’ judgment, the Federal Reserve did not maintain restrictive policies long enough to end inflation. He continued: “By and large, monetary policy came to be governed by the principle of undernourishing the inflationary process, while still accommodating a good part of the pressures in the marketplace. The central banks of other industrial countries, functioning as they did in a basically similar political environment, appear to have behaved in much the same fashion.”

Changes under way

But, Mr. Burns noted, central bankers are not free from some responsibility for the inflation that is our common inheritance. “Central bankers can make errors—or encounter surprises—at practically every stage in the process of making monetary policy. In some respects, their capacity to err has become larger in our age of inflation,” which has “often taken the sting out of interest rates,” he remarked. Recent financial innovations, moreover, have raised doubts about the meaning of particular growth rates of the monetary aggregates. Thus, not only has central banking been unable to exercise restraint on credit by keeping interest rates high enough to affect inflation but also, to a large extent, with new alternatives to bank demand deposits emerging all the time, it is not clear how to measure changes in aggregate transactions.

Delays in recognizing some of these developments would tend to bias policy toward monetary ease. Moreover, the common assumption that inflation will continue indefinitely in the future has imparted an asymmetry to the consequences of monetary errors. As a result, the influence of a central bank error that intensifies inflation may stretch out over years, while the unintended effects of central bank actions of a restrictive type do not.

This does not mean, Mr. Burns emphasized, that central banks are incapable of stabilizing actions. It means simply that their practical capacity for curbing an inflation that is continually driven by political forces is very limited. “The persistent inflation that plagues the industrial democracies will not be vanquished—or even substantially curbed—until new currents of thought create a political environment in which the difficult adjustments required to end inflation can be undertaken.”

Such a change in the intellectual and political climate of democracies may be under way, Mr. Burns pointed out. Growing feelings of resentment and frustration are largely responsible for the conservative political trend that has developed of late in the United States and other industrial countries. This widespread concern about inflation in the United States is an encouraging development, but no one can be sure how far it will go or how lasting it will prove. Economic life is subject to all sorts of surprises and disturbances that could readily overwhelm and topple a gradualist timetable for curbing inflation.

Mr. Burns said that if the United States is to make real headway in the fight against inflation, he had reluctantly come to believe that the following drastic four-point therapy would be needed: (1) legislative revision of the federal budgetary process that would make it more difficult to run budget deficits and that would serve as the initial step toward a constitutional amendment directed to the same end; (2) a commitment to a comprehensive plan for dismantling regulations that have been impeding the competitive process and modifying others that have been running up costs and prices unnecessarily; (3) a binding endorsement of restrictive monetary policies until the rate of inflation has become substantially lower; and (4) a reduction of business taxes in each of the next five to seven years.

Mr. Burns said that he could not express confidence that such a program, or any other constructive and forceful program for dealing with inflation, will be undertaken in the United States or elsewhere in the near future. He said he was not even sure that many of the central bankers of the world, having by now become accustomed to gradualism, would be willing to risk the painful adjustments that he fears are ultimately unavoidable. While, therefore, the return to reasonable price stability in the industrial democracies and thereby to an orderly international monetary system is likely to be postponed by more false starts, he believed the conservative trend that now appears to be under way in many of the industrial democracies may continue to gather strength.

Inflation and growth

Professor Milutin Cirovic, the first commentator, stressed that, as a result of the interdependence of national economies, internal developments are increasingly influenced by world developments. The severe recession in industrialized market economies over the period 1974–75 and their now accelerating rates of inflation, their high balance of payments (BOP) disequilibria, and the deceleration of fixed investment all had negative implications for the developing countries. While the recycling of part of the BOP surpluses of some countries to developing countries, carried out through the international credit market, had had a positive effect, a negative effect was the excessive accumulation of foreign indebtedness by developing countries.

In analyzing these recent distortions of the world economy, Professor Cirovic said he thought that placing emphasis on inflation as the main causal factor was onesided. His view was that the deteriorating functioning of the world economy reflects not only disturbances experienced in a certain number of national economies but also interaction of adjustment processes in national economies and in groups of them. From this it follows, Professor Cirovic noted, that an effective economic strategy “must simultaneously act towards stabilization … and towards strengthening the expansionary forces that will lead to further expansion of the world economy … carried out through … international coordination.” The formulation of such a strategy must recognize that economic growth rates and inflation rates—though interrelated—are essentially distinct. In an optimal policy mix, monetary policy, assisted by other instruments (above all by fiscal and income policies), would bear the brunt of the fight against inflationary expectations and forces. These would operate only if some other forces in the economic system, exerting a long-term upward influence on the economy, are set in motion; market mechanisms can no longer be seriously relied upon to create an environment assuring sufficient economic propulsion.

Looking for alternatives, Professor Cirovic noted that a growth strategy based on expansion of exports, and hence on expansion of fixed investment, would be a strong stimulus to economic development, leaving to monetary and incomes policy the responsibility for monetary stabilization. But world exports are not likely to grow at a rapid pace in the foreseeable future unless a mechanism is established to spur the international economic system. An acceleration of the purchasing power of non-oil developing countries would induce a corresponding acceleration in world economic activity. Such an acceleration could be accomplished by three actions: stabilization of the terms of trade between primary and industrial products on the world market; a gradual reduction of protectionism in the industrial countries; and an expansion of concessional capital to non-oil developing countries.

In all this, the International Monetary Fund has an important role, both in regard to BOP financing and to the creation of special drawing rights (SDRs). A link between the creation of SDRs and development financing in the developing countries would increase the purchasing power of developing countries, thus creating an increased demand for imports and an impetus to new fixed investment. Professor Cirovic concluded that “the International Monetary Fund could develop into a world institution ensuring adequate adjustments of national economic and balance of payments policies which would, at the international level, result in … an environment conducive to both a faster expansion of the world trade and production and a gradual reduction of inflation rates and balance of payments deficits.”

International arrangements

The second commentator was Mr. J. J. Polak, Economic Counsellor of the Fund, who noted, in the beginning, that some developments in the world economy seemed to inject rays of light in what could otherwise appear as unmitigated secular gloom: the 15 years of price stability in the United States between the Korean and the Viet Nam conflicts; the remarkable success in some European countries in curbing the post-1974 inflation; and the experience of reasonable price stability in much of the Far East. Nonetheless, he agreed with Mr. Burns’ fundamental view, that a return to stability in the international monetary system could not be expected until reasonably good control over inflationary forces had been achieved in the major industrial countries, especially in the United States.

But this fact does not mean that the international monetary system “must be left sitting quietly in a corner” until the campaign to subdue inflation is won. On the contrary, work to be done on the international side now could involve in his view: (1) deepening our understanding of the workings of the system as it exists; (2) attempting to discover certain tendencies for change in the system; and (3) seeking to steer the system in directions believed to be beneficial. The work to be done thus requires not only a climate of political will but, equally, the design of structures that can continue to function under the pressures and in the turbulence that characterize even a favorable climate.

Starting with the exchange rate aspect of the system, Mr. Polak commented that, while under the Fund’s new Article IV exchange rate arrangements are left to each member’s choice, exchange rate policies are made subject to the Fund’s firm surveillance. While one provision of the new Article IV states that “orderly underlying conditions … are necessary for financial and economic stability,” Article IV also enjoins Fund members, whether or not they have been successful in establishing orderly underlying conditions, not to have an exchange rate that is economically wrong. It is to this, Mr. Polak said, that the Fund’s surveillance is most directly addressed, and he quoted one of the general purposes of the Fund: “to shorten the duration and lessen the degree of disequilibrium in the international balance of payments of members.” Although exchange rate surveillance encounters its difficulties—as manifold rationalizations are advanced to delay changes in exchange rates whose disequilibrium character is not denied—Mr. Polak emphasized that “no country has an advantage in sticking to a disequilibrium rate for its currency, and no country in the end manages to do so.”

Mr. Polak added that the Fund is increasingly using its surveillance authority in a broader sense, paying attention to the fact that the domestic economic policies in the largest industrial countries and their coordination have a major impact on the economic activity and the payments position of all countries.

Turning to the reserve assets of the system, Mr. Polak noted that an important move toward making the SDR the principal reserve asset in the international monetary system, as called for in the Fund’s new Articles of Agreement, seems attainable. This could happen given the recent interest among members in replacing a large amount of dollars in their reserves with SDR-denominated claims on a substitution account administered by the Fund, if a technically workable scheme is developed for doing so. He pointed out that no one can be sure how much of a difference to the system would result from the creation of a substitution account, but it is clear that it could contribute to the stability and symmetry of the system and that it is the only major avenue of reform that seems currently within the realm of the attainable.

In concluding, Mr. Polak said that “however well it may be designed, no system will produce satisfactory results in the absence of sensible policies, most particularly on the part of the main countries.”

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