One of the remarkable phenomena immediately after Black Wednesday last September was the warning about incipient inflation ahead. Now that the markets had firmly ejected Britain from the ERM, many pundits appeared to tell us that it was like letting go of the hand of nurse for, we were warned, we shall get hold of something worse. For example, Professor David Currie appeared on television to tell us that inflationary forces were to be let loose. And ERM groupies such as Samuel Brittan mourned the passing of the peg and warned of inflationary excesses on the way.
Lord Lawson opined that the breakdown in the ERM proved that he had been right all along and, had Britain joined the ERM at DM3.70 in 1985, inflation would have been kept low, interest rates would have been both higher and lower, our present slump avoided, “convergence” well on the way, a sterling fort to rival the franc fort, and, as I read on I wondered perhaps even, our dear Diana and Charles reconciled . . . or perhaps not.
Nominal and real exchange rates
First, a few definitions. An exchange rate is simply the price of one money in terms of another. Thus the price of a pound is (on December 30) Dm2.42, $1.50 etc. A real exchange rate peers behind the veil of money to find the movements in rate of exchange in terms of goods and services that we can buy with these moneys. Thus the ratio of the price of goods in Britain to the price of goods in Germany, when both are expressed in the same currency at the prevailing exchange rate, will measure this real exchange rate. If British prices increase relative to German prices, both expressed in, say, sterling, then we can say that the pound has appreciated in real terms. In short, British goods compared with German goods have become more expensive. Clearly, for the realities of economic performance, the real exchange rates are the ones that matter.
Fixed, pegged and free Governments do not usually control real exchange rates . . . at least not directly. They control the nominal exchange rate, primarily through the central bank buying and selling foreign exchange to keep the nominal exchange rate within rather narrow limits. Governments do not control the day-to-day price level (except in countries that espoused communist control and rationing). In the longer run, through the effects of the operation of monetary policy, central banks do have control of inflation – but it is important to note that the inflationary effects of monetary policy today appear strung out many years later (probably about three to four on average). As one might imagine, this causes some problems to which we return later.
Governments and central banks may pursue broadly three types of policy. First, they may allow free-floating exchange rates. This is when the government does not buy and sell foreign currency in order to influence the rate. Governments, of course, buy and sell foreign currency in the ordinary business of administration. That is OK. Under a free-floating regime the prohibition is on selling or buying solely to influence the rate. Free floating is a pure case. Many regimes do intervene (buy and sell currency) in a modest way in order to “smooth”quirks in the rate or to iron out movements which might be thought unhelpful. These are not pure and are often described as “dirty floats”.
Second, the exchange rate may be fixed – and I mean by that absolutely fixed – to some other currency or, more rarely nowadays, a commodity. This is the stage that the Delors Report (stage III) and the Maastricht Treaty, between 1997 and 1999, will require all participating countries in the monetary union to have achieved. There is to be no change in the exchange rate, nor is it to be allowed to wobble within any band. It is fixed, and that is that. The operating example of a fixed exchange rate is the Hong Kong dollar (at 7.8 to the US dollar) and, we may well add, the Benelux countries, which do not, and are not expected to, deviate from their fixed parity with respect to the deutschmark.
The third regime, pegged exchange rates or sometimes called managed rates, tries, disastrously, to combine both the virtues of floating and fixing. The exchange rate is only temporarily contained within a band – usually a rather wide band such as in the ERM where it was +/-2.25% or +/- 6%. But the band could be shifted if there was thought to be good cause or, more usually, if the market substantially shorted it. The outstanding example of a pegged system, at least until last September, was the ERM, together with currencies such as the Swedish krona, which pegged to the ECU.
Although it is not the subject of my talk today, it is necessary to add a few words about these regimes. With the fixed-rate regime one gives up monetary policy completely; interest rates and monetary growth are simply derived from the exchange rate. In so far as the pegged system constrains exchange rates, that is also true for pegged rates . . . as has been illustrated in the months leading up to last September. While we were pegged, and expected to be pegged, to the deutschmark at about 2.95% +/- 6 %, base rates of interest were determined largely by the Bundesbank. Only under the free-floating regime can a country have an independent monetary policy, determining its own monetary growth.
While a fixed regime and a floating regime are technically viable systems, the pegged system is not. The basic reason is that, with free movements of capital and credibility in the peg, interest rates will be equalised whether a country is inflating rapidly or has stable prices. Thus real interest rates will be perverse – low when for domestic reasons they should be high, and high when they should be low. It will put the economy on a roller-coaster. Finally, it is bound to end in a scramble of crisis and devaluation and revaluations – so the confidence in the system collapses.
A German anchor – controlling inflation in the long runIgnoring all these transitional difficulties, however, it has often been asserted that a pegged exchange rate, with respect to a currency that has a proven record of stability (such as the deutschmark) will provide a nominal anchor for sterling. The Bundesbank policy shall then be our policy . . . although it is clear that, quite properly, the Bundesbank will have the welfare of Germans rather than Britons in mind, as we have seen all too clearly in the past two years.
The idea is that the United Kingdom cannot be trusted to run its own monetary policy by, for example, expanding the money supply at the same low rate year in, year out. Politicians in power will be tempted to expand monetary growth in order to promote a boom, particularly before an election, and will be unwilling to take unpopular measures to eliminate the inflation. Best to borrow the credibility of the bureaucrats of the Bundesbank. They have a policy of restricting monetary growth to a band which, they reckon, will deliver a low average inflation rate below 2% and which will avoid runaway inflation or deflation. This is a “monetarist policy”*.
The question is, do we thereby borrow the inflation rate of Germany? At first sight it seems the obvious answer is “yes”. And certainly virtually all commentary suggests that this is so. . . but it is not so.
First, let us be assured that a necessary condition is that there be free trade (or conceivably a constant ad valorem tariff and transport costs) between Germany and Britain. But this is not a sufficient condition. Since initial conditions may vary (for example, sterling may enter the ERM at a rate far above its appropriate goods value) the equality of inflation will be established in the long run only after time has eroded these initial distortions. This adjustment may never occur: for example, the reestablishment of the gold standard in 1925 required, according to Keynes, a reduction in British prices of around 10%. It was never achieved and Britain floated six years later in 1931. The long run here tends to be very long indeed. Britain’s experience with the deutschmark peg from 1987 to September 1992 is also moot.
Second, the equality of inflation in the long run will appear only for tradeable goods. It is trade that ensures that a ton of steel (not a happy choice!) will cost approximately the same in Britain as Germany. There is no trade to speak of in haircuts, so there is no obvious reason why the rate of inflation in the price of haircuts should be the same in the long run in both countries. Haircuts are one example of a large number of non-tradeable goods and services. If the costs of tradeable and non-tradeable goods moved in tandem pari passu, then, of course, all rates of inflation would be ultimately equal. But there is no reason why this should be the case, and furthermore there are remarkable examples of massive divergences.
Perhaps the most famous one today is Hong Kong. As mentioned above the Hong Kong dollar has been fixed at $7.8 since October 1983, so clearly we are getting near to the “long run”. But over the past three years the inflation rate of consumer prices in Hong Kong has been about 11%, compared with an inflation rate of about 3.7% in the United States. A little inspection shows that the inflation rate of tradeables in Hong Kong has been about 3%, which is similar to its counterpart in the United States and clearly what we would expect. The price index for Hong Kong non-tradeables is about 16% per annum. Another example is Japan from 1947 to 1972 (and surely 25 years is the long run) when it was on a fixed exchange rate of 360 yen to the US dollar. But during this period the inflation rate of Japan was roughly twice that of the United States. (True, this comparison is confounded by the changing trade regimes over that period).
The reason for the long-run divergence, not convergence, of inflation rates is to be found in the relative productivity gains in tradeables and non-tradeables. We all know that the fabulous productivity performance of Hong Kong and Japan in manufacturing industry (the principle tradeables) is not matched by a similar performance in their service sectors. Since the productivity gains in tradeables cannot be reflected in falls in their price (since that is pegged by big brother the USA), the only way the economy can adjust to the relative productivity movements is by increasing the price of non-tradeables and generating the stable state inflation of 10% in Hong Kong and 6% in Japan.
The interesting point is that the Maastricht conditions for inflation convergence specify that a country must have its inflation rate no greater than 1.5% of the average (they do not specify whether it is a weighted average) of the three ERM countries with the lowest inflation rate. The odd result is that high productivity in manufacturing, such as Britain enjoyed in much of the 1980s, would require a higher inflation rate – and this would preclude Britain from joining the monetary union! Success, like that of Hong Kong or Japan, appears to be damned in Delorsland.
Inflation in the medium termIn true communautaire spirit let us ignore this little difficulty, and examine the association of the rate of inflation and the exchange rate in the medium term (which we can take as being the maximum life of a government, five years). The simple argument is that a reduction in the deutschmark value of sterling will give rise to a corresponding increase in the sterling price of imports and exports. This assumes that the UK is a relatively small part of the world market and can exert virtually no market power to contain the sterling price of tradeables. (Of course there is some market power for many of our traded goods and one would expect a somewhat smaller “pass through” of the exchange rate change into prices. But let us assume that there is “full pass through”.)
In order to get the wage-price spiral going, let us suppose that all wages are indexed to the consumer price index. Then the increase in prices of tradeables will translate into a somewhat smaller increase in money wages and so into higher prices, which will in turn increase the real exchange rate. So in order again to achieve the original devaluation of the real exchange rate, another devaluation of the nominal exchange rate must take place. This is the much promoted downward spiral of exchange rate and the value of the currency.
I have a problem with this version of the downward spiral or slippery slope. One of the generally accepted principles of economics is that it is the rate of growth of the money supply that determines the rate of increase of the general level of prices. Yet in this explanation the money supply does not put in an appearance. It is Rosencrantz and Gildenstern without the Prince. More technically, the description of the slide in the exchange rate causing an increase in the price of tradeables should strictly have talked about only the change in the relative price of tradeables (that is, relative to non-tradeables). The general level of prices is determined, with a long and variable lag, by the money supply.
Yet we can put the two pieces together if we say that, first, there is some external force, such as a rampaging socialist government, which causes an increase in the rate of growth of the money supply, which will in turn cause a devaluation, which then gives rise to the increase in the rate of inflation consistent with the increase in the money supply. This argument is now all of a piece. It avers that the price of one money in terms of another is largely determined by the relative supplies of those moneys. Increase the quantity of pounds, holding the quantity of deutschmark constant, and the value of the pound relative to the mark will fall*.
But, with a pegged exchange rate system, as we said above, the quantity of money is determined not by politicians but rather by the need to maintain the peg. This leads to our interest rates being somewhat above those of Germany. And the money supply must be whatever the market wants at those German-determined, short-term interest rates.
Now, not only is there no reason for supposing that the monetary growth induced by this interest rate parity will be just right to deliver a British rateof inflation about the same as that of Germany, but there is also every reason for believing that, granted the peg is credible, the monetary growth will be diametrically the opposite of what is required for convergence to the supposedly low rate of inflation of Germany. This is the perverse roller-coaster type policy in the ERM.
The result is that, with a pegged exchange regime with open trade and capital markets, one would expect that the pegged-induced expansions (and contractions) of monetary growth would lead to periodic devaluations (and revaluations) when the effects of monetary growth have worked their way through into pressure on prices. We should note that, since tradeables are in lock step, the main effect is on the price of non-tradeables. (Those who have recently stayed in a hotel in Italy or Spain will testify to this effect!) Thus resources are sucked out ofthe tradeable sector to the high-priced nontradeables.
But the lags in this process are long. Much of the research suggests that money has its effect on prices with a half-life of three or four years. So a pegged exchange rate system can stagger along for some years without the pressure becoming so marked as to force a realignment. (Proponents of the ERM always argue strongly that, until September last, there had not been a significant realignment in the central values of exchange rates. One can see why.)
Now for the final chapter of this story, let us return to the world of free exchange rates, where the international values of currencies are not artificially set by government intervention.
Does devaluation cause inflation?Your immediate reaction is to say: “Of course it does!” The effect of a devaluation is to increase the domestic prices of tradeable goods, relative to non-tradeables. (Unless you are a large country such as the United States, it is doubtful whether your devaluation will have much effect on world prices.) Such rises in the domestic price of tradeable goods cause increases in the prices of imports, as well as exports, and this generates mark-ups in domestic prices. QED.
But first, as a small matter of logic, if the devaluation is one-off and is not repeated, the increase in prices is simply a one-off phenomenon. There is none of the persistent increases in price which is characteristic of inflation.
More fundamentally, it is widely agreed that inflation is a monetary phenomenon and high inflation is caused by high monetary growth. So, if devaluation causes inflation, we must somehow argue that a devaluation causes an expansion of monetary growth. How come? Here, I fear, the argument becomes rather mushy. If there is an increase in domestic prices, then it is argued that, with the prevailing tendency to index, money wages would be increased. This would largely nullify much of the devaluation. So yet another devaluation would be needed to boost the relative prices of tradeables. And so on. Then you do have an inflation. But the important point is that there must be an accommodating monetary policy to allow the inflation to proceed.
Most of the things we can say with certainty about inflation and the exchange rate apply to the very long run. There have been quite long periods (up to seven years) when there have been substantial depreciations associated with a marked fall in the rate of inflation. For example, Britain’s inflation in 1980 was in excess of 20%, whereas in 1986 it was about 3.5%. One would have expected an appreciation in sterling over this period, and one would have been so wrong. In dollar terms, sterling fell from $2.40 at the end of 1980 to $1.43 at the end of 1986. Similarly the sharp decline of the dollar after February 1985 did not generate any comparable inflation in the United States – for example, 2% in 1986. This year we have also seen a sharp fall of 8% (trade weighted index) in the Australian dollar; yet inflation has subsided to about 2% and all the signs suggest a further decline.
One may suspect that the explanation for the association of falling currencies and inflation is the dominance of monetary policy. In a monetary squeeze, interest rates generally increase and this attracts capital which, in turn, tends to push up the exchange rate. The lag in monetary policy ensures that the effect on inflation begins to occur 18 months to two years after the onset of the squeeze and to be spread out over the next three or four years. Thus, by the time that the rate of inflation is subsiding, the government decides to ease its squeeze. So interest rates fall, bringing about a fall in the exchange rate. Thus we observe simultaneously disinflation and devaluation.
Of course, it cannot go on for ever . . . but, on reflection, very little, even this lecture, can.
*Samuel Brittan has frequently derided the idea of a monetarist policy for Britain almost as vigorously condemning monetarists such as Patrick Minford, Tim Congdon and me. But he has enormous admiration for the monetarist policies of Germany. Although I have invited him to explain this apparent inconsistency, so far as I know he has not done so.
*There is yet another variation on this original theme which asserts that variations in the money supply may be due not to government policies to stimulate or dampen the economy, but are the result merely of the central banks’ response to changes in the demand for money. For example sterling may become fashionable, and portfolio holders switch from marks to sterling. But the expansion of sterling would have no effect on inflation and this demand can be easily and, without fear of promoting inflation, accommodated. This, however, is a very different accommodation from that discussed in the text. There the government accommodates by enabling an exogenous wage increase to be validated in nominal terms by increasing the money supply. In this footnote the accommodation is really ensuring that variation in tastes for different currencies does not affect interest rates or exchange rates or, indeed, nominal wages and prices.
