17 July 1981

The Ditchley Foundation Annual Lecture XVIII

The Economic Challenges of the 80s

Delivered by: Otmar Emminger, former President of the Deutsche Bundesbank

Editor's Note: This transcript is compiled from the preliminary draft and David Wills' handwritten margin notes which reflect the lecture as delivered.

I. Introduction

II. Looking back to the 70s

What did the 80s inherit from the 70s? It may be useful to throw a glance back at the preceding decade, as a backdrop against which to evaluate present problems and challenges.

The 70s were a truly turbulent decade. Apart from political turmoil - from Viet Nan and Watergate to Iran and Afghanistan - they were struck by currency disturbances, oil shocks and high inflation. It was during the 70s when inflation became firmly entrenched in our system, when the “Age of Inflation” was enthroned. The average inflation rate (measured by consumer prices) in the industrial world was 3.3 per cent in the 60s, a little over 5 per cent in the early 70s, and after peaking at 14 per cent in 1974 finished the decade at 10 per cent, or nearly twice the rate at the beginning of the 70s.  It increased again to nearly 13 per cent in l980, before it subsided to the present 10 per cent.  Only a small group of countries - Germany, Austria, Switzerland, the Benelux countries and Japan - managed to achieve a lower rate of inflation at the end of the 70s than at their beginning. The developing countries finished the decade with a devastating average inflation rate of over 30 per cent.

The 70s witnessed also the temporary decline of the U.S. dollar, and partly as a consequence, a series of exchange crises, the breakdown of the dollar-based Bretton Woods System of fixed exchange rates and the transition to widespread floating. As a sort of defence, regional fixed exchange rate systems were introduced in Europe, at first the modest, but well-functioning ‘snake’ arrangement, thereafter in 1979 the European Monetary System (EMS), the latter with great fanfare and with exaggerated expectations. The dollar entered the decade on weak legs, but left it in a stronger condition; unnoticed by most people, the first signs of restored dollar strength appeared already in 1979, when the previous large payments deficits of the U.S. gave way to an equilibrated current account.

Considering all the financial and political turmoil, the outcome of the 70s in terms of production and trade was not so bad after all: the average annual GNP growth rate of the industrial countries was nearly 3 1/2 per cent, the real growth of world trade over 5 1/2 per cent, and this despite the sharp break during the world recession of 1974/75 (with a decline in world trade of over 4 per cent in 1975).
The fact that in the 70s world trade expanded considerably faster than overall production shows that the forces of protectionism, although quite strong, were successfully held in check.

Non-oil developing countries achieved a significantly better growth rate than the industrial countries, namely a little over 5 per cent - less than in the 60s, but not bad in a decade of oil and other shocks; and a sign that cooperation between the North and the South, and the financial and technical assistance of the former did work reasonably well, in spite of all the lamentations.

The impact of the first oil crisis on the payments balances of the weaker countries - both developed and less developed - was overcome by successful recycling and adjustment. Overall, the adjustment process, aided by several years of stable oil prices, worked so well that by 1978 the net payments surplus of the OPEC countries had nearly disappeared — only to be resuscitated by the second oil shock of 1979/80.

What went badly wrong was unemployment. In the European Community it increased from 2.1 million at the beginning of the decade to 6.1 million in 1979, although this was a year of relatively high economic activity. In the United States it increased during the decade from 4.1 million to 6.0 million.

III. The inheritance from the 70s — the challenges of the 80s

This then is the chief inheritance from the 80s: The explosive mixture of a seemingly intractable unemployment problem and a deeply embedded inflation. This is coupled with the after—effects of the second oil shock of 1979/80, and, as a consequence of all that, stagnation or near- recession in 1980/81. And we have, of course, the long-term energy problem as a continuing challenge on our hands.

But the 70s have left more than that: Excessive budget deficits in many countries, growing doubts about a welfare state which became not only very costly but also debilitating; aversion and great doubts about the growth of the public sector and government interference in the economy. One of the most important — and depressing — experiences of the 70s was the parallelism of inflation and unemployment in the longer run, so that countries with higher inflation had in the end also relatively higher unemployment. This undermined the naive belief in salvation by deficit und prepared the ground for the demise of Keynesianism. No one expressed the farewell to Keynes (or rather to the neo-Keynesians) better than Mr. Callaghan when he said to a party congress in 1976: ‘We used to think you could just spend your way out of recession and increase employment by cutting taxes and boosting government spending. I tell you in all candour that that option no longer exists and that in so far that it ever did exist, it only worked on each occasion by injecting bigger doses of inflation into the economy, followed by higher levels of unemployment as the next step’. In 1977 the communiqué of the London Economic Summit put it succinctly into the classical sentence: ‘Inflation is no cure for unemployment; it is one of its causes’. The persistence of inflation over such a long period has bred the worst enemy of a sound stable expansion, namely deeply ingrained inflationary expectations. Too late it had been recognised that inflation has this in common with dictatorship, that you have to fight it before it takes over, •and that afterwards it is terribly difficult and costly to get rid of it.

The 70s were also the decade when economic growth began to be more and more questioned, both because of its long-term costs (Club of Rome, etc.) and for its value in principle. At the same time productivity growth came to a standstill for several years in the formerly most progressive western economy, that of the United States, and showed a distinct tendency towards slowing down in most of the other industrial countries, thus making the fight against inflation more difficult.

Inflation has also greatly increased the instability of exchange rates. Although business has learnt how to cope with floating rates and their uncertainties better than many had assumed beforehand, it still remains a challenge for the 80s to provide a more stable framework for world trade; and nothing will probably contribute more to it than a general — and durable! — lowering of inflation.

Another unfinished business in a number of countries is the need to adjust their real incomes to the inevitable transfer of real resources to the oil-exporting countries as a consequence of the oil price jump of 1979/80. While the United States and Japan, the two countries with the largest oil imports, and therefore those most affected by the oil price explosion, achieved this real transfer surprisingly quickly by an astonishing improvement in their non—oil payments balance (for the U.S. between 1978 and 1980 an improvement of over $40 billion !), the majority of the Continental European countries, including in particular Germany, are still labouring under this burden. This unequal performance has contributed to a new line-up of the major currencies as between on the one hand the two (or three) strong currencies, namely the dollar, the yen and potentially the pound sterling as a petro-currency, on the other hand the EMS and other European currencies on the weak side, with the Swiss franc in the middle. Thus it is not just the much-belaboured U.S. interest-rate policy which is responsible for the appreciation of the dollar against EMS currencies but the great divergences in the balances of payment on current account.  Here a number of countries have an enormous adjustment task on their hands. This will put their economic and financial policies as well as the flexibility of their economies to the test.

All this inheritance from the 70s has become part of the challenges of the 80s. Add to this the continuing challenges arising out of the North—South relationship, the economic consequences of the newly aggravated East—West confrontation and the trade frictions and protectionist reactions arising out of the aggressive export expansion of the Japanese, and you have a pretty long list of challenges and worries for those who are responsible for economic, fiscal and monetary policy in our countries.

IV. The general response of economic policy

In the first two years of the 80s, there has already been a partial response to these various challenges. Its foremost example is the monetarist counter-revolution in the two Anglo-Saxon countries. Its well-known watchwords, particularly in the U.S., are monetarism and supply-side economics. But it is more than m4re technical policy prescriptions: namely a strong belief in the free market system and in private initiative, and the will to roll back an inflated public sector and the state’s interference in the economy.

This movement has struck a sympathetic chord in countries like Germany, where the free market system and monetary policy have always been in the centre of economic policy (even though at the same time the welfare state and the public sector as a whole have grown in Germany exuberantly). The revolt against Keynesianism and statism will, however, not remain unchallenged. Shortly after the sweeping political change in the United States, another sweeping change in France has led in the opposite direction. The new French government has clearly opted for Keynesianism — ‘keynesianisme l’échelle mondiale’, as the new French foreign minister has solemnly proclaimed — and is giving priority to full employment over fighting inflation. It is equally clearly in favour of more welfare state, more government intervention and a larger public sector in general. This is in sharp contrast to the new Anglo-Saxon economic philosophy. It will be fascinating to watch the two systems competing with each other and possibly influencing each other. The outcome will quite certainly make a decisive imprint on the 80s.

Before discussing inflation and the new monetarism in more detail, I want to make some remarks on some of the other challenges.

V. The oil problem

The energy problem is bound to remain one of the major challenges during the 80s. The present oil glut, though an extremely welcome respite, can also become a dangerous temptation to fall back into complacency. We get very contradictory advice and forecasts from the experts: some see a relatively easy oil situation ahead for the next few years, some even forecast a greatly lessened dependence on OPEC oil in the 90s, while other highly respected experts see the next oil crunch already around the corner. My conclusions from all this confusing forecasting are as follows:

First, it would be a near-miracle if over the next ten years no disturbing political upheaval took place in one or more of the major oil-producing countries. This makes oil accident-prone and a high-risk factor also in the future.

Second, the euphoric forecasts for the longer run are all based on very optimistic assumptions concerning conservation and alternative energies which, however, will only come true if strong efforts for lessening our dependence on oil are continued. So don’t let yourselves be lulled into complacency by the oil glut! It is a ‘detente without security’ (Count Lambsdorff, German Minister of Economics).

Third, energy policy will, therefore, also in future have to play a central role in economic policy, including also monetary and financial policies, and - not least - foreign policy.

The one silver lining on the horizon is that demand for oil, and for energy altogether, has responded more strongly to the high cost of oil than most experts had assumed. In the industrial countries oil consumption is now below the level of 1973, although output is nearly 20 per cent higher. In West Germany alone, oil consumption in 1980 was nearly 13 per cent below 1973, with GNP being 18 per cent higher. I am sure that some of the OPEC countries have recognised that there are limits to the increase in oil prices which they can usefully impose.

Let me insert here some considerations concerning the longer- run implications of the energy problem:

First, all long-term scenarios agree that over the next twenty years coal, natural gas and nuclear energy will have to multiply their contributions, even if one assumes very modest increases in energy consumption (about 1 per cent average annual increase for the industrial world). The coal production of the world would have to be increased from the present 2 1/2 billion tons to about 6 billion tons, natural gas production would have to be doubled. This would entail a shift of power - economically speaking, and also in terms of balance of payments - to the chief sites of coal and natural gas: for coal to the United States (with the biggest reserves in the world) and to Australia, for natural gas to Soviet Russia where about 40 per cent of the world’s known reserves are said to be located. Where does that leave Western Europe? Well, if we leave aside the happy beneficiaries of North Sea oil and gas, and partly also the Netherlands, Western Europe belongs to the have-nots in this field. But perhaps we may take some comfort from the example of Japan: it is even more dependent on energy imports than we are - for nearly 90 per cent of its primary energy, as compared to less than 60 per cent in West Germany - and yet it has managed very quickly to equilibrate its balance of payments. The Japanese seem also to work very hard to get some participation in other countries’ energy resources (Australia, etc.), and we might take a leaf from their book.

A second consideration concerns the enormous amount of capital needed for securing the world’s future energy supply and for the structural adjustments in our economies. At last year’s World Energy Conference in Munich experts were talking about the necessity to reserve one third of Europe’s total investment for energy-related purposes. This would portend a chronic capital shortage for many European countries, unless the public sector cuts down its net borrowing requirements.

VI. Payments, international lending, North-South problems

The effect of the oil price explosion of 1979/80 on the global payments situation was of a similar magnitude in real terms as that of the first oil shock of 1973/74. Up to a short time ago it was widely believed that the second jump in oil prices would create more difficulties than the first, partly because OPEC surpluses would this time not decline as after 1975, partly because the financial markets and a number of deficit countries were still burdened with the consequences of the first oil shock. Contrary to all alarmist forecasts, the payments deficits have been financed with relative ease. In part, this was due to the fact that this time the deficits were much more concentrated on countries that were able to finance them without difficulties; in 1980 Germany and Japan together ha current account deficits of $ 26 billion, that is more than one third of the total current account deficit o the OECD countries ($72 billion). Japan was back in equilibrium at the end of 1980; so Germany is now carrying the load alone.

But the non-oil developing countries, too, have up to now coped better with their external deficits than many had expected. In the middle of June there was an International Banking Conference in Lausanne, where the most noteworthy feature was a wave of optimism as concerns international bank lending and the developing countries’ payments problems. .Pre we really out of the wood as concert the balance—of—payments consequences of the last oil shock? For the 3 moment, and in global terms, maybe. But individual countries’ problems remain serious.

First, the assumption that this time OPEC surpluses would remain near $100 billion for several years has been corrected downwards. The global current account surpluses of the OPEC countries were $103 billion in 1980. They are now forecast around $75 to $80 billion for this year and lower next year. Several important oil exporters, like Venezuela, Nigeria and the non-OPEC country Mexico, are already on the borrowing side of the international financial markets. In overall terms, the reduced global OPEC surplus now appears more manageable.

Second, as concerns the deficit side one should not be too much impressed by the widely-quoted ‘horror’ figures of the total deficits on current account of the non-oil developing countries — according to IMF estimates $80 billion in 1980 and nearly $100 billion in 1981. These figures are misleading because they don’t take account of official transfers. On a more normal (OECD) definition the collective deficit of this group is probably around $ 60 billion;as a proportion of their GNP this is less than in 19,5 after the first oil shock. About one half of this global deficit will have to be financed by the international banking system. Up to now this has proved manageable. The total exposure of banks to country risks in the Third World has not been extravagant as yet — although it may be so in individual cases. The chief problem is not the global deficit and debt figure. It is the problem of a handful of heavily-indebted individual countries. The 10 or 12 main debtors account for the main part of the total. Their problems and risks differ greatly. So one has to assess the payments and debt problems on a case-by-case basis. This is similar to the external debt problem of Comecon countries. There, too, it is not the global debt figure, but individual countries’ position which may give rise to concern.

Most of the debtor countries have, of course, been hard hit by the world—wide rise in interest rates. According to Morgan Guaranty bank, gross interest payments for the 12 major non-oil developing countries in 1981 were likely to be $ 26 billion or about 17 per cent of their export proceeds, double the average in the years from 1975 to 1979. In extreme cases, oil imports plus debt service together pre-empt more than half of export proceeds. In view of this, it is remarkable that production in the developing countries, and also their imports, have up to now held up better than in the industrial countries (and also better than in the recession of 1975 after the first oil shock); for 1980 their GNP rose on average by about 5 per cent, and for 1981 it will probably be only slightly less. There may be individual difficulties ahead, including unavoidable debt-rescheduling. But it does not look as if a general breakdown of the recycling process and of debt financing in general were likely. This relatively positive assessment is dependent on the debtor countries playing their own role appropriately, viz, that they continue to make the necessary adjustments with a view to reducing their external deficits. The deficit financing will only function if it goes hand in hand with a reduction of the deficits. This is what the ‘conditionality’ of IMF lending is all about.

We can draw from all this the conclusion that both the international financial system and the economies of many developing countries have been more resilient under the oil—shock than one had assumed. This should, however, not lead to the illusion that there won’t be problems ahead. I have no doubt in my mind that for instance to keep the international banking system on a sound basis will require the closest attention of the national prudential authorities and also close international cooperation among the monetary authorities. Moreover, the system would not have functioned so relatively well, had it not been for the crucial role played by the international financial institutions, in particular the IMF and the World Bank with its affiliates. They are crucial not only as providers of funds. In my view their role as guardians of financial discipline, as advisors on necessary structural adjustments, and as giving their seal of creditworthiness to debtor countries, may be much more important than the actual amounts provided, since this helps the adjustment process and facilitates the lending of the banks. These international institutions are also particularly useful as lenders to the poorer LDCs which have no access to financial markets.

You probably know that a critical evaluation of the role and policies of some of these international institutions is at present under way. Having watched them from near for many years, I can only hope that they will be enabled not only to continue, but to expand their vital role for the world economy, and in particular for the Third and Fourth Worlds.

There is another challenge ahead of us. in connection with the developing countries, which I can, however, only touch upon very briefly. I mean the never-ending North-South dialogue. Some of you may have read the Report of the Brandt Commission (North-South Commission), entitled ‘A Program for Survival’. You probably know that there will be a Summit Conference on these problems in Mexico in the late autumn. This meeting may be useful in order to get to know, and to understand, each other’s views at the highest level; perhaps also to convince the new American administration that development assistance is more than just a bilateral political give-and-take, and to overcome what has been called ‘aid fatigue’. But I do not believe in such high-sounding concepts as ‘a new international economic order’, especially if at closer view they just boil down to getting (directly or indirectly) more SDR allocations, loans and grants, plus higher guaranteed prices for some export products. In my view the best thing the industrialised countries can do, is to put their own house in order, so as to achieve steady growth and stability, and to grant the developing countries the freest possible access to their (expanding) domestic markets. The developing countries should also have access to the technology of the more developed countries. We have a number of successful developing countries, the NICs or newly-industrialised countries, which in reality are just as developed or even more, as some of the poorer OECD countries. In each case their take-off into successful development began when they took their fate into their own hands, sent their young people to industrialised countries of their own choice, provided for a high rate of capital formation, invited foreign firms to invest in their countries, and established their credit standing in the international markets. When I read reports that not only South Korea, but also India, Pakistan, Indonesia, etc., are actively competing for large projects in some OPEC countries, I have the impression that the industrialisation of leading Third World countries is well under way. However, a footnote seems to me appropriate here. It would not be helpful if developing countries would, in the rush to industrialise, neglect their agricultural development. Food imports into developing countries have risen very fast over the last 20 years. In 1980 they cost the non-oil developing countries about one half as much in foreign exchange as their inflated oil bill. If this trend continues, those may prove right who prophesy that in the second half of the 80s we will have international food shortages with strongly rising prices.

VII. Inflation and monetary policy

Now let me return to our problems and challenges nearer home. As I said in the beginning, the most difficult one is inflation. It is not always realised that the chronic inflation which we have experienced in the post-war period - at first creeping, then trotting, finally rampant - is unprecedented in the history of the modern world, at least in normal peace times. Over the last few years most governments in the industrial world have come to accept the fight against inflation as their economic policy priority. For good reasons: they have seen that with inflation and inflation expectations rampant, they are unable to solve other urgent problems, e.g. to get at the root of unemployment, to get steady, long-sustained economic expansion, to achieve stability of exchange rates (as general inflation inevitably breeds large inflation differentials among countries).

They have also seen what damage inflation can do to capital formation, efficient economic planning and productivity.  What chronic inflation can do, was best summarised by John Maynard Keynes (in: The Economic Consequences of the Peace):

‘There is no subtler, no surer means of overturning the existing basis of society than to debauch the currency. The process engages all the hidden forces of economic law on the side of destruction, and does it in a manner which not one in a million is able to diagnose.’ Footnote: This passage gives support to a remark of Professor von Hayek (the arch-enemy of Keynes) a few years ago: ‘I have good reason to believe that Keynes would have disapproved of what his followers did in the post-war period. If he had not died so soon, he would have become one of the leaders in the fight against inflation’.

This is reminiscent of the well-known saying of Lenin that in order to destroy capitalist society one must debauch its currency.

I do not need to describe how the revolt against chronic inflation has finally led to the adoption of monetarist policies. It is remarkable that monetary policy which in the heyday of Keynesianism had been relegated to the sidelines is now in a number of countries in the centre of economic policy. The U.K. is, of course, a prime example. I come from a country where the fight against inflation and monetary policy as its main tool, have always held a central place. My own experience with monetary targets goes back to 1972 when we tried to organise coordinated monetary targets for a common E.E.C. policy, which, however, fell victim to the currency turmoil of the time. The Deutsche Bundesbank was the first central bank which, at the end of 1974, published a monetary target for the following year. So we can claim to have been in the vanguard of practical monetarism.

Our version was, and still is, in some ways different from the present Anglo-Saxon monetarism. Ours has always been a pragmatic monetarism (and I don’t hesitate to call it so, although ‘pragmatic’ seems to have become a bad word with one school of monetarists). Our monetarism is pragmatic in its operational procedures: we have never believed that it would be technically possible to keep the money volume precisely on track from month to month; nor do we think this is necessary, provided the money supply is firmly kept on track in the medium-term. In 1979 and 1980 the Bundesbank succeeded very well in that latter aim, although there were month—to—month fluctuations between zero and 15 per cent on an annualised basis. We were never under pressure of public opinion (as the Federal Reserve seems to be) to react immediately to such monthly fluctuations in order to maintain our credibility. Our version of monetarism is also pragmatic in the sense that we have never believed that monetary control by itself is a cure-all or a magic incantation, which guaranteed success irrespective of what was happening in fiscal policy, or wage developments, or the exchange rates. When publishing our monetary targets, we emphasised in the communiqué that their desired effect could only be reached if the other participants in the economic process, in particular fiscal policy and the ‘social partners’ in their price and wage policy, paid due regard to the constraints implied in the monetary target. (But this had nothing to do with a formal incomes policy, as it has occasionally been misunderstood abroad).

We have had relatively good experiences in Germany with this kind of monetary policy. Sometimes the influence of exchange rate movements on the inflation rate was underestimated, both as a positive and a negative factor. At present, the effect of pretty tight money control in Germany on the inflation rate is partly undercut by the inflationary effects of a depreciated Deutschemark rate.

The Anglo-Saxon versions of monetarism are different in several respects. As the British version is well known to you anyway, let me take the American version as an example.

One crucial point is credibility. The chief enemy is inflationary expectations. They can be broken only by a very credible stabilisation policy. German monetary policy has an initial advantage here. It can build on a certain credibility acquired over many years of effort. It is easier to wind down inflation from 5 1/2 per cent than from 10 per cent. The leading American monetarists are — rightly — concerned about establishing the credibility of their anti-inflationary policy. It seems to me that the sometimes hectic reaction of the Federal Reserve to the technical swings in the money supply figures is dictated by the need to gain, and to maintain, credibility. This may also lead to the reaction being preferably on the stronger rather than the weaker side. There are a number of other reasons why the real rate of interest rate in the United States, necessary to achieve a desired effect, must be significantly higher than formerly. The effect of all this has been that American interest rates

  • are completely unpredictable, at least on the short-term side,
  • are extremely volatile,
  • are sometimes very high, and this is true not only of nominal, but also of real rates of interest.

There has never been as much volatility in interest rates in modern economic history as in the United States over the last 18 months (the range for the gyrations of the short-term rates being between 10 and 21 per cent), nor have we ever seen such high interest rates. As relative interest rates have a strong effect, at least in the short run, on certain exchange rates, we have during the same period also seen very volatile exchange—rate movements. This has hit above all the DMark/dollar rate, as the DMark, as a sort of antipole of the dollar, is particularly sensitive to changing interest rate differences; and the differences between American and German short—term rates have been jumping up and down between zero and 10 per cent since the beginning of 1980.

There have been, as you know, foreign complaints against the so called ‘high interest-rate policy’ of the Americans, especially by Europeans. They find their own interest rates being forced up if they do not want their exchange rate against the dollar to tumble down too fast. One European minister of finance likened the effect of the high dollar exchange rate — which he ascribed mainly to high American interest rates — as comparable to a third oil shock. For the Americans the answer to such complaints is simple:

It is true that American interest rates, nominal as well as ‘real’ rates, i.e. inflation-adjusted rates, are historically very high; but so is inflation and are inflationary expectations. Moreover: how can one change one’s interest rate policy if one doesn’t have one? For the Americans have only a money supply policy, and leave interest rates to the play of the markets, as a residual outcome. As concerns the disruptive volatility of interest rates, American monetarists, including those in the government, complain about it themselves, but blame it on the techniques used by the Federal Reserve, or on the as yet insufficient credibility of Federal Reserve policy. Once full credibility is established, so they claim, the inflationary expectations will be broken and interest rates will both fall and stabilise. So their final consolation is: the more the Federal Reserve sticks to its tight money policy, the sooner interest rates will turn down, and for good. The reverse is certainly true, too, namely that a premature loosening of monetary policy would in the end lead to higher interest rates.

A quick and full success of the American fight against inflation is quite certainly the most important precondition for more stability worldwide, including more stability in exchange markets. Thus I am sure that nobody would suggest a slackening of the American efforts; and nobody would probably dare to criticise the methods held necessary by the American authorities, even though one might have doubts whether hectic reactions to short-term money changes of a purely technical nature were really necessary. My conclusion is that we have to live with the inconveniences of the American monetarist policies, and consider them as the price to be paid for better stability in future - in the hope that this better future will arrive soon.

Some European critics have suggested a change in the American policy mix, i.e. to reduce budget deficits in order to relieve the undue burden on monetary policy. This is certainly a sound advice, but a sort of counsel of perfection. It is equally applicable to most other countries, especially those where the public sector deficit represents a higher proportion of the gross national product than in the United States. The advice has been given in my own country, too, where the public sector borrowing requirement is far too high, and is also pushing up interest rates. In view of the threatening chronic capital shortage in the years ahead, I would register the lowering of unduly high budget deficits as one of the challenges of the 80s.

With the problem of the fiscal-monetary policy mix I have already touched upon the main question: will Anglo-Saxon monetarism succeed, without being supplemented by other policies? The ‘purist’ or dogmatic monetarists will have no doubt in their hearts. I had a classical experience of that kind when, about 13 years ago, I raised the question at an international meeting whether the growing American budget deficit as a consequence of Viet. Nam would not represent an inflationary danger. Professor Milton Friedman, the arch-priest of the ‘purist’ monetarists, answered coolly: the size of the budget deficit does not matter, as long as the Federal Reserve keeps the money supply under tight control. And what about interest rates? The answer of the ‘purists’ would be: the medium and long-term rates are mainly determined by inflationary expectations; as long as these are kept down by a strict Federal Reserve policy, interest rates will be kept down, too. I would not contest this as a long-run proposition. In the longer run, only sound money policies can produce sustainable low interest rates. But that does not do away with the harsh fact that capital which is eaten up by budget deficits, is no longer available for investment in the economy. There can be no doubt that sound fiscal policies will make a stabilisation effort more effective and shorten the transition period with its often high costs. If I am not mistaken, the role of budget deficits in the stabilisation process and as an influence on the level of interest rates is much more acknowledged in the British version of monetarism than in the American one dimensional version.

Even more crucial may be the contribution of wage and other cost developments to the stabilisation process. Final and durable victory over inflation will only be won if not only prices but also costs have become stabilised. Otherwise, any improvement of demand will immediately be seized upon to push up prices in order to restore profit margins. The sooner wages are brought in line with the money target, the less time and production will be lost in the transition process. This is not a call for formal incomes policies (which in their former applications have left a bad image in both Britain and the USA). But it is an appeal to shorten the costly adjustment period in every conceivable informal way, including through pressure of public opinion, through information campaigns, through informal ‘concerted action’, etc. Such efforts can never be a substitute for appropriate monetary policies, but only a supplement. They can, however, be decisive for the transition costs and therefore for the political acceptance of a monetary stabilisation policy. In Germany, even ‘purist’ monetarists have at the beginning of this year taken a very active part in a campaign for moderation in wage increases, or for a wage pause. In the United States this would probably be anathema. The American monetarists are for a “hands off” policy in this field; they obviously expect an ‘invisible hand’ to bring wage developments in line with the monetary target. It may, however, turn out that in the United States the many 3-year wage contracts for annual increases between 9 and 10 % will be one of the greatest obstacles on the way to a lower inflation rate. In the United Kingdom the government, instead of using its influence as the largest single employer to slow down wage inflation, felt compelled by circumstances to contribute massively to the wage and salary explosion of about 20 per cent in 1980; this made the achievement of the money target virtually impossible in 1980, and. the clash between incomes inflation and the (diluted) money target helped to cause great production losses, and was evidently a great setback for the stabilisation policy. If I am correctly informed, this mistake is now being remedied by a deliberate effort to get wage and salary developments in line with overall stabilisation policies.

At a time, when progress in productivity is slowing down and when the jump in oil prices enforces an unrequited transfer of real resources to the oil-exporting countries, it is doubly difficult to bring wages and salaries in line with the realities, which at present often mean a temporary period of zero or even negative real wage increases.

Overcoming inflation is also largely a psychological task. People have so long become accustomed to inflation ‘as a way of life’ that it will take time and great effort to wean them away from the idea of large annual wage and price increases as a matter of course. The same is true of governments and their budget planning. A steady and credible monetary policy, with gradually declining targets for money expansion can contribute to influence psychology. It can, however, not work miracles.

The Keynesian recipes have foundered because of the neglect of monetary policy, but also because of ‘real wage resistance’, and because money illusion was replaced by the illusion of steadily increasing entitlements (“Anspruchs—Inflation”). It would be a disaster if monetarist stabilisation policies would founder on similar rocks.

This leads me to the conclusion that under present circumstances a stabilisation policy requires more than just to steer the money supply correctly along the predetermined track — which can be difficult enough, to be sure. To break the deeply ingrained inflationary habits and expectations, and to restore a flexible market economy also in the labour market, may be the two most important and most difficult challenges of the 80s.

© The Ditchley Foundation, 1981.  All rights reserved.  Queries concerning permission to translate or reprint should be addressed to the Communications Officer, The Ditchley Foundation, Ditchley Park, Enstone, Chipping Norton, Oxfordshire OX7 4ER, England.