The question is: What should monetary policy do and not do?
Should the central bank set specific economic outcomes as its targets, e.g., production, employment and trade? Or should it concentrate only on monetary/financial objectives, such as prices, the exchange rate and financial sector performance?
Most economists agree that monetary policy cannot achieve economic outcomes directly, and that setting such targets may even worsen a country’s economic performance (Tobin, 1983). The point is that aggregate output is primarily determined by the supply and productivity of labor and capital, which are not under the direct control of the central bank. Moreover, the transmission of monetary policy is uncertain. Shocks from both the demand and supply sides will affect it. The effects of monetary measures could take a few months – or 1-2 years, or even longer – to manifest themselves.
Finally, since various economic factors and the actions of other authorities obscure the effects of central bank measures on aggregate output, the central bank itself has both little incentive and little capacity to establish and pursue an output target.
It is not surprising, therefore, that central banks tend to select price stability as the sole objective of their policy. This can be seen from Table 1, which presents central bank objectives in several transition countries.
Table 1
Objectives of central bank policy in selected transition countries Country Legislated prime objectives
Bulgaria Czech Republic Hungary Latvia Lithuania
Poland Russia Slovenia
Slovak Republic Ukraine
Currency stability Currency stability
Internal and external currency stability
Price stability, and facilitation of the circulation and allocation of financial assets
Currency stability, and support for government policy
Price stability and banking sector stability Currency stability
Currency stability Currency stability Currency stability Sources: Web sites of countries’ central banks
A possibly even more powerful factor that influenced the selection of target choices has been the insistence of the IMF, in line with the Washington Consensus, to single out monetary stabilization as a top priority. Thus, governments of countries that cooperated with the IMF were strongly advised to set this as the main target of their monetary policy. Such a policy, however, could be costly for an economy, especially for one in transition (Kamin, Turner, and Van’tdack, 1998). Price stability as the sole target of monetary policy reduces economic flexibility without producing important growth benefits (Stiglitz, 1998). Moreover, there is no evidence that this approach helps economic growth (Alesina and Summers, 1993).
In politically unstable countries with a high level of corruption, and particularly in ex-USSR countries, price stability as the sole target of monetary policy provides the authorities with greater freedom to achieve short-term objectives and pursue personal interests. It also enables a government to justify financial repression and to subsidize enterprises favored by particular officials. Moreover, there is no evidence of gains from very low inflation, especially in transition economies. In fact, the opposite seems to be the case. A policy enforcing “artificial” stability, not supported by economic and institutional fundamentals, could result in missed opportunities to pursue other goals, while gaining little from stable prices. After all, in transition economies, price stability is not the main factor in investment decision-making: there are other, much more serious problems related to the tax system, contract enforcement, corruption, etc.
A question naturally arising is, why some countries are unable, or unwilling to develop their financial systems. The existence of inequalities in the initial conditions is not a sufficient explanation.
The point is that the authorities in some countries, especially where the political situation is unstable, use the financial sector for their short-term purposes, intervene excessively, and obtain cheap money to finance current needs. As a result, banks are hampered by high reserve requirements, interest rate ceilings, credit controls, foreign exchange market regulations, heavy taxation, and government-directed credits. Governments that apply financially repressive measures justify them by stressing that their financial controls help avert market failures, lower the cost of credit, and improve the quality of loans by excluding risky projects (Denizer, Desai, and Gueorguiev, 1998). Moreover, financially repressive governments may support output and exports in some areas of the economy and encourage the flow of capital to those sectors (Stiglitz, 1989 and 1998).
Most economists agree that financial repression is used to finance a budget deficit where the financial sector is characterized by an oligopolistic market structure, directed credit schemes, the
obligatory holding of government bonds, and suppressed security markets. The weak markets enable the transfer of funds to public borrowers. In addition, the development of a sound and competitive financial sector is not supported in politically unstable countries where policymakers frequently pursue their own financial goals.
The costs of excessive intervention can be demonstrated by examining directed credit schemes in Ukraine. The central and local authorities have the power to influence Ukrainian financial institutions and direct credits to selected enterprises. The government guarantees some loans, and in many cases they are not paid back. In this way, financial intermediaries transfer to loss-making state companies and corrupt officials funds that could have been lent to productive enterprises. Directed credits are considered to be one of the main reasons for the poor structure of assets in Ukraine. According to official statistics, approximately 18 percent of all credits are problem credits (December, 2000).
Excessive government intervention results in low saving account balances, low bank profitability, low resource-allocation efficiency, and low direct investment. Moreover, if the financial sector is repressed, undeveloped and riddled with obstacles, the central bank’s monetary policy could be both inefficient and ineffective, producing unpredictable results because the necessary policy transmission mechanism is lacking. All these factors constitute obstacles to growth and lead to losses in the economy.
There is no doubt that high inflation distorts market signals and prevents the economy from developing. Indeed, if there is a threat of high inflation, the government must develop special policies to keep prices from skyrocketing. However, if inflation is not very high, is price stability still so crucial a factor, and if it is, does it make sense to make it the sole target of monetary policy? There is no evidence in support of this hypothesis. Bruno and Easterly (1996) estimated that no significant costs are incurred if inflation is less than 40 percent. Stiglitz (1997) confirms this and argues that only with a very high inflation rate does the economy fall into a high-inflation-low-growth trap. Fischer (1993) and Barro (1997) also state that there is no evidence supporting the assertion that moderately high inflation is costly.
Nonetheless, it should be emphasized that control of inflation, under any circumstances, should remain a very important policy objective. The point is that it should not be the sole target of central bank policy.
A major problem is that too much weight attached to price stability could stimulate efforts to achieve it, not by means of reforms and the strengthening economic fundamentals, but through administrative
measures – price controls, subsidies, etc. As Stiglitz (1998) wrote:
“The single-minded focus on inflation may not only distort economic policies – preventing the economy from living up to its full growth and output potentials – but also lead to institutional arrangements that reduce economic flexibility without gaining important growth benefits.”
This thesis can be illustrated by the 1998 financial crisis in Ukraine. By 1998, after several years of hyperinflation, Ukraine had achieved relative price stability. Inflation was only 10 percent in 1997, and the exchange rate was stable. This currency stability, however, was achieved mainly through T-bill operations, and not through structural reforms. The government started to issue T-bills in late 1995, which by 1997 became the main method for financing the budget deficit and for maintaining currency stability. Monthly T-bill issues rose constantly, leading to a rapid increase in public debt while nominal and real yields skyrocketed. At the same time, GDP kept declining, the fiscal deficit remained large, and financial intermediaries remained undeveloped. In the second half of 1998, after the Russian financial crisis, the Ukrainian government announced that it was not able to service its debt, which had to be restructured. As the result of the crisis, the economy in general, and the financial system in particular, experienced severe shocks:
• The NBU spent most of its foreign reserves attempting to protect the national currency and repay the debt.
• The hryvnia lost approximately half of its value by the end of the year.
• Government credibility declined further, as was made evident in, among other things, the collapse of the T-bill market.
• The banks had serious problems – in particular, a loss of liquidity, followed by excessive liquidity – and foreign exchange risks became a major issue.
• Bank deposits fell abruptly if expressed in dollar terms (while remained almost stable when expressed in hryvnia terms).
To summarize:
– Current monetary policy and maintaining price stability as the central bank’s sole target enables the government to manipulate the financial system and finance the fiscal deficit.
– Directed credits permit corrupt officials to siphon off funds to selected enterprises and to their own pockets.
– There is no evidence that maintaining currency stability fosters economic growth when the inflation rate is less than 40 percent.
– Focusing on currency stability could cause the policymakers to lose the flexibility to pursue other economic goals.
– If the authorities are obliged to achieve currency stability, they could attempt to do so, not through real reforms, but by administrative measures, often at the expense of other sectors, especially the financial sector.