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The political and social uprisings that spread rapidly across the AW in early 2011 surprised many economists. At the end of 2010, Arab countries were seen as having ‘weathered’ the global financial crisis of 2008/2009 and having regained stability. Visible impacts of the global financial crisis in the Arab region were seen in Kuwait (the Gulf Bank of Kuwait suffered a bank run in October 2008) and the UAE (the capital flight and liquidity squeeze which culminated as the ‘Dubai Shock’ of December 2009). The main adverse impact of the global financial crisis over the region was a plunge in crude oil prices, which hit growth rates of GCC countries and weakened wealth spillovers from major energy-exporting countries in the region to other Arab countries. Nevertheless, during the period before the Arab Spring, the economy of net energy-importing countries in the region, which were seen as more vulnerable to negative external shocks, stayed stable without balance-of-payments concerns. IMF country papers on Arab countries in 2010, based on IMF’s Article IV consultations put forward an optimistic view, albeit cautiously, of the economic prospects for Arab countries in 2011. In summation, in the period immediately before the Arab Spring of 2011, Arab countries were believed to be on stable macroeconomic paths.

The inflation of the 1970s brought to the fore the approach opposite to T-B-K-M. That inflation — which continued until 1985 with average annual peaks of 13 per cent in the OECD countries — was ascribed by many, not to the explosion of the relative prices of energy and labour and the fiscal crisis of the State, but to an alleged monetary laxity on the part of the central banks, “distracted” by the multiplicity of duties assigned to them, including financial supervision.1

From the very beginning, the Eurozone was conceived as a new brand of economic governance institutions: a single currency, with a single, independent central bank conducting monetary policy according to a simple — and almost single — objective of price stability; and decentralized fiscal policies, in the hands of national governments of member states, with simple fiscal rules — the Stability and Growth Pact — and a minimal , rather informal, coordination institution : the Eurogroup. Alongside the objective of monetary stability, the ambition was to foster further economic integration, convergence in living standards amongst member states and sustained growth. Indeed, the “Lisbon strategy” adopted by the European Council in March 2000, a little more than one year after the launching of European Monetary Union, bravely stated that the objective was to make the EU “the most competitive and dynamic knowledge-based economy in the world capable of sustainable economic growth with more and better jobs and greater social cohesion” by 2010. The successor strategy, adopted in 2010 — “Europe 2020” — posted similar, yet less precise objectives of “smart and inclusive growth.” In the minds of its founding fathers, the Eurozone was to be the spearhead of this leap forward in economic and social performance; launched with 11 of the then 15 member states, it would act as a shield from the rest of the world instability and disturbances and would eventually become so successful as to attract all EU member states, including those (Denmark and the UK) that had willingly opted out from the beginning, and those (Central and Eastern European Countries) that would join the EU a few years later.

By 2006 one financial truth dominated the world’s advanced economies: the good times are here to stay. In November that year, Ben Bernanke, Chairman of the US Federal Reserve, showed no concern as he looked to the future: I have confidence, therefore, that however events play out in the short term, in the longer term the economy will grow at a healthy pace, raising living standards in the process. The Federal Reserve will continue to play its part by implementing policies designed to achieve its mandate of fostering price stability and maximum sustainable employment.1

In this chapter we will examine the MMT view of inflation and hyperinflation. The usual belief is that budget deficits and full employment are prone to cause inflation, if not hyperinflation. Many critics even argue that following MMT is necessarily inflationary — the path to ruin. Let us first see how inflation is defined. We then turn to hyperinflation, to fears that Quantitative Easing might spark inflation, and finally to MMT’s views on policy to promote price stability.

The bad-asset problem of transition economies had its origin in the system change. Though moral hazard problems were a concern when credible rules and structures had yet to be established, a strong case can be made for a thorough debt cancellation and balance sheet repair in the transition. This chapter reviews different strategies of how to distribute the burden and their impact on investment activity and growth, price stability, the future tax burden, and social security, respectively. It briefly describes how the bad-asset problem has been tackled in Europe, highlighting the role of the banks. Finally, an outlook is given on the recent financial crisis which led to an excessive inter-government lending. This new European ‘bad-asset problem’ calls for shared responsibility in fiscal policy.

Following the prescription of contemporary economic theory to develop rules and institutions to enforce time-consistent policymaking, the European Central Bank (ECB) is a creation of the TEU, which designed it to be the most independent monetary authority in the world. The ECB’s architects sought to insulate it completely from political pressures, both at the national government and at the eurozone level. The position of the ECB under the TEU permits no clear accountability to either national or federal European institutions. It stipulates that the ECB Council’s deliberations remain confidential, whilst the only method of questioning the ECB’s policies is through periodic reports to the European Parliament. Although commentators have concentrated upon criteria denoting initial convergence for eurozone membership, stringent rules restrict national fiscal policies, and the benefits deriving from the eurozone; however, far less attention has been paid to how the eurozone will operate in practice. In particular, the institutional design of the eurozone stipulates a central role for an ECB, established to be independent of government and charged with sustaining the stability of the currency zone in the face of asymmetric external shocks. The ECB is the sole body credited with determining the appropriate monetary and exchange-rate policy for the entire eurozone and as such its ability to fulfil its stated objectives is crucial to its success or failure, as has been demonstrated by the eurozone crisis.

In the first fifteen years of its life the ECB has delivered price stability through an accommodative monetary policy stance. It has played a crucial role during the sovereign crisis. At the start of 2012, the severe liquidity stress, fixed through the L TROs, has signalled that Italian banks have to address their funding gap problem. To do it without hurting credit flows, a resumption of domestic savings is needed. Thus, the real lesson for Italian banks (and for Italy) is that the ultimate way out of the crisis lies in a quantum leap in the capability of generating higher profits (and income).

The enlargements in 2004, 2007 and 2013 brought a total of 13 new countries into the European Union, of which 11 are post-communist countries from Central and Eastern Europe (CEE) and two are Mediterranean island states. When they joined, the new members committed to entering the eurozone and adopting the euro once they had fulfilled the Maastricht convergence criteria. By the beginning of 2014 four of the eleven post-communist countries had entering the eurozone, but this still left seven post-communist EU countries outside the eurozone, of which Poland is the biggest and the most important economically and politically. This chapter discusses what is without doubt the biggest challenge for Poland and the six other CEE countries, that is the Maastricht Treaty’s price stability criterion or inflation criterion as it is more commonly called. The complications of satisfying the criterion are adeptly summarised in the title of a 2006 paper by Ales Bulir and Jaromir Hurnik: ‘The Maastricht inflation criterion: how unpleasant is purgatory?’

Chapter 4 developed an alternative framework of monetary theory to the new neoclassical synthesis. This new framework ostensibly argues that the objective of price stability can lead to economic instability. Empirical data backs this claim up as the recent financial crisis has shown. The neo-Wicksellian framework stipulates that economic instability cannot be eliminated but only minimised. What follows is an attempt to synthesise these ideas into a coherent theory that is able to explain the nature of the business cycle, providing investors with improved market signals in relation to the assets they own. In conjunction with this attempt to construct a macroeconomic theory it is imperative that the theory is general rather than specific to individual cases. As discussed in Chapter 1, many economic theories work well for a certain period of time until the behaviour of the variables change, rendering the theory useless. Such a theory would therefore need to explain the recent financial crisis in terms of why some countries had significant credit bubbles but others did not. It would need to explain the Japanese lost decade, the 1970s period of stagflation, the Great Depression and the deflation of the 1870s. Clearly the amount of data available pre-1980 does shrink considerably; however, there are proxies that can be used to test the validity of the theory.

According to the textbooks of macroeconomic theory, it is axiomatic that, for a perfectly competitive economy in continuously marketclearing equilibrium, there can be no such thing as unemployment. The blind spot of Single-Gear Fundamentalism lies in its failure to recognise the possibility of deficiency of effective demand. When this blind spot is removed, it becomes clear that the economy is a multi-gear machine.

This chapter introduces the relationship between output and inflation, including the role of inflation uncertainty. Friedman (1977) argued that increased inflation uncertainty reduces the information function of price movements and hinders long-term contracting, thus potentially reducing real output growth, and high inflation leads to higher inflation uncertainty. The chapter uses a generalized autoregressive conditional heteroscedasticity-in-mean (GARCH-M) framework to investigate why price stability as a mandate for monetary policy authorities is significant.

The neoclassical synthesis’ inability to explain the behaviour of credit resulted in monetary policy generating false signals for investors. These false signals led to large and unexpected losses for the world’s pension schemes. As Stiglitz and Minsky argued, credit is external to general equilibrium because credit markets do not clear and are inherently unstable. Moreover, their analysis highlighted two of the characteristics of credit bubbles that drive this instability. Excess business profits are a critical factor in driving increased credit expansion as investors look to continue to increase the rate of profit growth. This increased level of business profits then helps to drive down the cost of capital due to lower expected default rates, thus providing the fuel for further credit expansion. However, the models that have been constructed to identify credit bubbles have generally relied on price stability to provide the framework for such an identification. Indeed, Minsky based his model on Fisher, thus requiring a rise in the general price level and deviation from equilibrium to signal the existence of a credit bubble. Furthermore, this model has been widely popularised via Kindleberger in his ground-breaking book on business cycles and bubbles.2 Hence it is perhaps unsurprising that the majority of investors and central bankers in the summer of 2007 did not believe that the rise in asset prices was unsustainable as inflation remained subdued.

This chapter begins with a critical analysis of the ordo-liberal and neoliberal intellectual traditions. It shows how this neoliberal mindworld gave shape to early efforts at economic and monetary integration. It also explains that the neoliberal project – to re-structure European social relations in favour of capital and insulate policymaking from democratic pressures – was incomplete at the time of the global financial crisis in 2007.

In the United Kingdom, the debate about the making of the ERM of the EMS, the first real step in the process of European monetary integration, had since the beginning been characterized by skepticism and a notable lack of interest in British socio-economic sectors. In particular, the City had on many occasions expressed its preference for autonomous tight monetary policies over joining the ERM of the EMS in 1978 (Talani 2000). The failure of the Thatcher government to deliver price stability and a strong currency convinced many in the City that the time had come to revisit the City’s position on European monetary integration. Thus, the interests underlying the decision to join the ERM have to be traced in the change of macroeconomic policy preferences of the dominant socio-economic group, namely the financial community and the City. On the one hand, these interests were constituted by the need to continue pursuing an anti-inflationary policy in the face of clear signs that the economy was overheating; and on the other, the need to influence the negotiations leading to the definition of the Economic Monetary Union (EMU) process.

The advent of ‘the Swedish Model’ was related to questions of economic crisis and high unemployment levels in the 1920s. New ideas, connecting insufficient demand with unemployment, were embraced by the Social Democratic Party (Blyth 2001). In the 1930s, the Social Democratic gov-ernment took a more pro-active role in stabilizing employment on a high level. New arrangements between state, business and labour were insti-tutionalized through the Saltsjobaden Accord in 1938. At the end of the 1940s, following the government’s requests to moderate wage demands, the Rehn-Meidner Model was launched as an ingenious solution to the diverse aims of economic growth, full employment, price stability, and maintaining union solidarity.

According to Willis, there are two main statistical measures that have been employed in recent research when investigating inflation dynamics. These are Volatility, or how much inflation varies quarter to quarter or year to year; and persistence, or the speed with which inflation returns to baseline after a shock’.1 Furthermore, ‘Other things equal, less persistence leads to less variability. Lower persistence is associated with faster but smaller swings in inflation over time that, in statistical terms, reduce the overall variability of inflation.’2

In his article ‘The Influence of the Rate of Interest on Prices’, Economic Journal XVII (1907), Knut Wicksell argued that the variations in price level during the classical gold standard were not primarily due to variations in gold supply but, rather, to the interest rate policies followed by the central banks (i.e. discount rate adjustment), and the real disturbances affecting the natural rate of interest. According to Wicksell, price stability required keeping the interest rate controlled by the central bank in line with the natural rate of interest determined by factors outside the control of the central bank.

In this chapter we will examine policy that will promote full employment with price stability. Most economists believe that full employment and price stability are inconsistent. Indeed, unemployment is seen as a “tool” to be used to promote price stability. In this chapter we first examine an approach to full employment that is consistent with MMT, that is, with the operation of a sovereign currency. We will argue that it is possible to pursue full employment in a manner that actually enhances price stability. We will conclude the chapter with an examination of high inflation and hyperinflation. Many critiques of MMT argue that if the principles of MMT were followed (in particular those that follow from the functional finance approach of Lerner) the result would be runaway inflation. We will dispel those fears.

Since the early 1990s some industrialised economies have implemented a monetary policy regime known as inflation targeting (IT). This shift was justified by the difficulties posed by targeting the nominal exchange rate, or in some instances money supply. At the same time, the move paved the way to an enhanced record in controlling inflation, and to monetary policies that were more independent, transparent and effective. Given the very encouraging experience of developed countries, a number of Middle Eastern and North African (MENA) countries have decided recently to adopt price stability and IT as either an explicit or an implicit monetary policy objective. One MENA country that has explicitly adopted IT as its main monetary policy goal is Turkey.

The Tunisian authorities have announced that they will liberalise capital flows and move to convertibility of the Tunisian dinar (TND) by 2014 and that they intend to adopt a monetary policy of inflation targeting (IT) when the preconditions for it are met.1 The Tunisian government has also continued to confirm that the goal of its monetary policy is to ensure price stability and to strengthen its reliance on market forces,2 which is essential for the implementation of IT.

Inflation targeting (IT) is one of the operational frameworks for monetary policy aimed at attaining price stability. In contrast to alternative strategies, notably money or exchange rate targeting, which seek to achieve low and stable inflation through targeting intermediate variables — for example, the growth rate of monetary aggregates or the level of the exchange rate against an ‘anchor’ currency — IT involves targeting inflation directly (IMF, 2005b). In a wider context, IT is part of a process in which economic policymaking is becoming more transparent and subject to greater accountability and technical rules, and less susceptible to discretionary actions. IT has become an increasingly popular monetary policy strategy. Since New Zealand adopted IT in 1989, twenty-nine countries have introduced IT frameworks (Roger 2010). Other countries are seeking to develop the necessary ‘infrastructure’ to implement an IT framework, Egypt being one. Moreover, according to Roger (2010: 52), TMF discussions with member states in 2006 suggested that the number of inflation targeters in developing and emerging market economies was likely to increase fourfold over the next decade, consistent with the estimate by Husain et al. (2005) that the number of countries with exchange rate pegs may almost halve in the next ten to fifteen years.’ Nonetheless, the 2008 global financial crisis and the preceding boom-and-bubble period pose serious challenges to IT and to the conduct of monetary policy (Schmidt-Hebbel, 2010).

On 18 March 2009 the Federal Reserve (Fed), the central bank of the United States, announced that it would pump an additional 1.15 trillion dollars into the financial markets. The Fed announced that “in the light of increasing economic slack, the Committee1 expects that inflation will remain subdued and sees some risk that inflation could persist for a time below rates that best foster economic growth and price stability in the longer run”.2 To provide greater support to mortgage lending and housing markets, the committee decided to purchase up to $750 billion of agency- and mortgage-backed securities (MBS), bringing its total purchases on these securities up to $1.25 trillion. It would also increase its purchases of agency debt by $100 billion. Moreover, to help improve conditions in private credit markets, the Fed decided to purchase up to $300 billion in longer-term Treasury securities over the next six months.

The global financial crisis has devastated Europe’s economy and greatly damaged its prospects for closer integration. Europe’s plunge into the worst recession since the Second World War abruptly terminated the mood of triumphalism that accompanied the introduction of European Monetary Union (EMU) and the rather modest gains in productivity, growth and employment that had been achieved during the period of 2005–2007 after years of stagnation.1 By demonstrating that Europe remains especially vulnerable to external financial shocks and the contraction of global trade the crisis has shattered dreams of de-coupling from the US. It has also brought into sharper relief a number of underlying problems that have bedeviled the EU throughout its neoliberal phase of development: overemphasis on price stability and flexible labour and capital markets to generate employment and growth; uneven development and mounting financial imbalances; and German mercantilism.

In the 1990s a consensus emerged in the economic literature that price stability should be the primary objective of monetary policy, and the CB should have sufficient independence as a means to attain this goal.1 These conclusions are based on a large body of literature that was developed starting in the late 1970s, and demonstrated that CB independence has undisputable benefits for macroeconomic performance. On average, countries with CBs enjoying significant independence were able to achieve lower average inflation, cushion the impact of political cycles on economic cycles, enhance financial stability, and boost fiscal discipline without any real additional costs or sacrifices in terms of output volatility or reduced economic growth.

Central bankers are used to discussing nominal convergence. It is at the heart of their main task, maintaining price stability. It is also at the heart of the Maastricht criteria on the adoption of the euro. This chapter, however, focuses on the other side of the coin, namely real convergence. There are three reasons for this. First, catching-up is the main goal of all the countries in Central, Eastern and South-Eastern Europe. Second, real convergence has gained momentum in recent years, also in countries where progress had been slower in the 1990s. Third, real convergence has important implications for nominal convergence.

Our assessment of CBs’ governance framework shows that CBs have changed dramatically in the past three decades in ways that would have been inconceivable back in the late 1970s or early 1980s. Building on the literature that highlights their benefits, CBs, irrespective of the country’s income level, have been granted higher independence; have become more accountable to those which have granted them independence; and have significantly boosted the transparency of their operations. Such a framework for CB governance which developed over time is based on the consensus that CBs should be entrusted with the primary mandate to preserve the public good of stability. This broad-based consensus stems from the view, backed by empirical analysis, that price stability is the best contribution that monetary policy can make to help the economy achieve its maximum potential output, and that any attempts to sacrifice the medium-term goal of price stability for efforts to meet other short-term objectives will adversely affect the credibility and effectiveness of the CB and ultimately weaken long-term economic growth. To allow the CB to achieve its delegated responsibility of protecting price stability, it must be made independent from the government so that its decisions are not influenced by short-term political and electoral objectives.1 However, independence does not mean isolation, and the CB must be accountable to those from whom it receives its mandate and independence.

As discussed in Chapter 1, the standard policy response to the inflationary bias caused by discretionary monetary policy-making is the delegation of monetary policy to an independent institution. Directly linked and complementary to independence is the concept of accountability. Research on CB accountability is relatively recent and the literature is still evolving. Relatively few authors have focused on empirical measures of accountability, including Briault, Haldane, and King (1996), de Haan, Amtenbrink, and Eijffinger (1998), Bini-Smaghi and Gros (2000 and 2001), Stasavage (2003), and Siklos (2002). The literature we survey spans eight years, a period during which accountability indices have been refined. While there is still a lack of consensus among academics and practitioners, progress has been made in understanding the contributions of the different variables to a measure of CB accountability.

In October 2003, a Goldman Sachs report (Purushothaman and Wilson, 2003), using the demographic projections and a model of capital accumulation and productivity growth, mapped out GDP growth, income per capita and currency movements of the BRICs countries (Brazil, Russia, India and China) until 2050. Based on some assumptions, the report forecast that in less than 40 years the BRICs countries together could be larger than the G6 in US dollar terms and by 2025 they could account for over half the size of the G6 (currently they are worth less than 15 per cent). However, as the report recognizes, there is no guarantee that the economic growth of these countries will reach what is forecast by the study, as such behaviour depends on a set of factors, which includes macro stability (understood as price stability), development of good institutions (legal system, functioning markets, educational systems, financial institutions, etc.), openness to trade and FDI, and improvement in education level of the population — all known development policies supported by multilateral institutions, such as the World Bank.

The preceding chapter has laid down the agenda designed to restructure, refocus and strengthen the Democratic Republic of the Congo’s financial system. This chapter is devoted to an important part of our ‘vision for a strong currency’. The chapter provides additional elements of the reform agenda designed to position the Congolese franc to become a credible currency. In this light, the agenda would be complemented by reforms designed to stabilize the exchange rate, reduce inflation, restructure the overall denominations of the national currency and introduce coins, as well as to promote the efficiency of the payments system.

This chapter examines the issues facing the Bank of Japan’s (BoJ’s) Policy Board in implementing a new post-deflationary framework for monetary policy. The chapter provides an overview of the new framework and the ramifications of the Policy Board’s “understanding of price stability” as a range of inflation (over the medium term) from zero to 2 percent. While lower than the benchmarks used at other central banks, this chapter shows that the range may be appropriate because inflation has indeed been more subdued in Japan than in most industrial countries. This said, inflation expectations could be better anchored in positive territory if BoJ communications emphasized that most Policy Board members assess price stability as ranges for CPI inflation with medians close to 1 percent. Finally, while the Policy Board’s range focuses on headline CPI inflation, other price indicators could also be useful in assessing—and communicating—incipient inflationary pressures.1 In particular, the traditional measure of core inflation performs well in describing the medium-term inflation outlook. However, there is also a broader class of price indices, derived to correct some of the shortcomings of core inflation, that also perform well.

‘The good news … was that the loan from the International Monetary Fund will be doled out in instalments up to some time in 1978, with audits to check whether Britain is fulfilling the loan’s terms’, The Economist observed in late 1976. ‘This period of rule by IMF Inspectorate General should give the country better government than successive teams of British politicians have done.’1 British experience had shown that the State could not, at one and the same time, perennially increase real incomes, attain price stability, sustain full employment, and continually expand the social services, as the Keynesian dispensation had led people to believe. Yet such a role for the State had become an integral part of Britain’s liberal democracy,2 and it was only obvious and regularly displayed excess on the part of the British trade unions together with a succession of external blows culminating in the Oil Crisis of 1973 and the IMF loan conditions of 1976 that eventually created the political climate in which the Governments of Margaret Thatcher could pursue their programmes of radical change.

As in many other developing economies, establishing a low inflation environment has been a challenge in Nigeria; and ways to improve the formulation and implementation of monetary policy have been at the forefront of the policy debate. An array of institutional reforms expected to foster the credibility of a commitment to price stability could potentially be envisaged. In this chapter, we focus on two alternative reform paths currently under discussion, namely the formation of a monetary union with neighbouring countries, and strengthening the independence of the Central Bank while keeping a national currency. In contrast to most of the existing literature, our analysis is based on a model that incorporates two types of distortions leading to excessive inflation: the desire to stimulate out-put and the need to finance government spending. The model clarifies how the two specific policy frameworks considered here might remedy those problems. While both options can potentially yield significant credibility gains, the analysis points to the importance of capitalizing on the recent record of improved fiscal discipline. Specifically, structural fiscal reforms that would improve expenditure efficiency, and preclude interference between the conduct of monetary policy and public finances, appear to deliver significant credibility gains.

As a guide for the management of the short period, Robertson made the important distinction between ‘actual’ changes in output, resulting in a new ‘actual’ scale or rate of output and ‘justifiable’ changes in output resulting in a new ‘optimal’ scale or rate of output. The latter are defined in terms of a standard non-cooperative, non-monetary case in which producers vary output by reference not only to familiar criteria (lowered costs due to invention or greater efficiency induced by prolonged depression; increased desire for the products of others which leads to increased output of own product; a fall in the real cost of obtaining other products and where the effort-elasticity of demand is greater than unity) but now also to include the enlightened self-interest of employers, both because of their control over the ‘forces of technical progress’ and because the ultimate divergence between the interest of employer and employee may not be as great as the immediate divergence (Robertson, 1926: pp. 8–23).

The primary goal of a central bank is to develop and maintain an efficient monetary system whose primary goal is price stability, but it remains an open question as to what an ideal central bank should look like. The answer to this question is important, but it would be a bad mistake to believe that there is only one best way to organize a central bank in an emerging democracy. Most high-income countries, and many low-and middle-income countries, have achieved success in maintaining low inflation and price stability, even though there are substantial differences in the organization, structure and functioning of their central banks. We need to think out of the box about the design of the central bank and recognize that there are different ways to achieve the same end. Success in achieving low and stable inflation – price stability – is relatively recent in a number of countries. We may well discover that some institutional arrangements are more robust over time than others, as we observe how various arrangements stand up to stresses not yet observed.

The purpose of this chapter is to prepare the ground for the chapter that follows immediately. We assess the empirical evidence on Inflation Targeting (IT), a new policy framework designed to tame inflation, and consider whether the assessment can be helpful in studying the experience in Brazil with such strategy. This policy framework has been with us since the early 1990s and given that IT was introduced in Brazil in 1999, lessons for the latter can be ascertained. Recent work makes the point that a significant number of countries adopted this strategy, and the number is growing. For example, Sterne (2002) suggests that 54 countries pursued one form of IT or another by 1998, compared with only 6 in 1990. A more recent study (IMF, 2005) suggests that 21 countries (8 developed and 13 emerging) are now clear inflation targeters, pursuing a full-fledged IT strategy (FFIT in short). IMF (2006) has recently reported that there are 17 countries that have sought technical assistance to be able to introduce it. A number of studies have attempted to examine empirically the degree and extent of the impact of IT on inflation. We review this literature in what follows and conclude that the available empirical evidence produces mixed results. In pursuing an IT strategy, countries commit themselves to price stability as the main objective of monetary policy, along with stipulating that medium-to-long-term inflation is the nominal anchor where an inflation target is set.

Two aspects in the performance of the German Bundesbank stand out: first, its remarkable success when measured against its main goal — price stability. Second, that since 1974 up to the takeover of its mandate by the Eurosystem in 1999 it almost exclusively (apart from the Swiss National Bank — SNB) stuck to what has been labelled ‘monetary targeting’. Do these two aspects bear any relationship to each other? This is the question I will try to answer in this chapter. To put it briefly: I think that such a relationship indeed exists, but it is far more complex than is usually perceived. In particular, there seems to be a mutual causality. While monetary targeting was probably one important reason for the Bundesbank’s success, especially in the first ten years, it was this success in turn which allowed the Bank to retain its specific monetary targeting framework, even in periods when almost all central banks abandoned it. Monetary targeting by the Bundesbank survived not only two oil shocks and a period of high turbulence in the world economy and the international financial system, but also what appears to be the greatest shock for the German economy after the Second World War — reunification of East and West Germany.

This chapter utilizes the Markov regime-switching modelling framework to study the credibility of monetary policy, with respect to the objective of price stability, in some member countries of the EMS throughout its life (i.e., 1979–98). Eight countries are examined for this purpose: Austria, Belgium, Finland, France, Italy, the Netherlands, Portugal and Spain. In addition, Germany is used as a benchmark case.1 A number of other studies have investigated the issue of credibility during the EMS period (see for example, Dahlquist and Gray, 2000; Arestis and Mouratidis, 2004a). One of the main conclusions of this body of literature is that monetary policy may go through different stages of credibility through time, in such a way that it is perceived to be credible in some circumstances and may lack credibility on other occasions. It is, thus, appropriate to use the Markov regime-switching modelling framework to study this phenomenon. Moreover, some of these studies allow the probability of switching between regimes to be a function of macroeconomic variables (see Engels and Hakkio, 1996; Gray, 1996; Dahlquist and Gray, 2000; Sarantis and Piard, 2000). In particular, most of these studies attempt to explain the currency crises of 1992 and 1993 using as information variables in the transition probabilities a number of alternatives: the exchange rate within a band (i.e., a target zone model framework), real exchange rates, budget deficits, interest rate differentials, and other variables. None of these studies includes in the transition probability the two main variables that determine the loss function of monetary authorities, namely domestic output-gap variability and inflation variability (the exception is Arestis and Mouratidis, 2004a).2

Over the course of the last fifty years, four monetary policy regimes succeeded each other. A particular view of governance corresponds to each monetary policy regime. First, until 1974, for the Keynesian regime founded on the Keynesian synthesis, the government exercised direct management of economic policy. During this time, monetary policy was only one element of the global policy and under the full discretion of the government.

What would a Post Keynesian economist see as being the appropriate macroeconomic policy goals of the state? If we polled macroeconomists of all ideological persuasions, and asked them to outline the major macroeconomic policy objectives then the following consensus would probably emerge: (a) full employment; (b) price stability; (c) a robustly sustainable rate of economic growth; and (d) maintaining an equilibrium balance of payments. While these goals are so general that they lack clarity and are regularly used by different economists in ways that do not permit meaningful dialogue, we can use them to motivate our discussion.

A reliable monetary system is indispensable to an extended division of labour, which is the basis for economic advance. In facilitating exchange, money releases man from a close dependence upon nature and upon the narrow confines of local markets; but it forces an individual to rely upon the entrepreneurial success of other individuals: upon ‘human effort that we cannot know about or control’ (Hayek, 1988, p. 90). This is indeed ‘unnerving’. Price signals are the means of communication for billions of interactive participants within an extended economic order, whereby the delicate balance between over- and under-production is maintained by continuous readjustments. It is vital that those signals should not be corrupted by extraneous influences or swamped by the inflationary impact of monetary expansion. It might appear curious, therefore, that Hayek should remain true to his early conviction of the wrongness of the (widely held) view that price stability should be the objective of monetary policy.

Monetary targeting adopted by central banks has the objective of anchoring the expectation of economic agents. Central banks usually announce a growth rule for what they consider to be a sustainable and proper monetary aggregate with the ultimate goal of controlling inflation in the long run and possibly influencing the level of output and employment in the short run. Central banks have these ultimate goals, but they only have direct control over a set of tools that will influence some operating and intermediate targets, and then have an impact on the economic goals. It is important to note that emphasizing the transparency and communication of the economic agents are important elements contributing to the success of monetary targeting. It is argued by Mishkin (2001) that transparency can help to improve the time-inconsistency trap in which central bankers try to expand output and employment in the short run by pursuing overly expansionary monetary policy, and to achieve price stability in the long term. It was argued by Friedman (1968) that economic agents have to decide whether to rely on these official projections, or whether to form their own expectations. Economic agents usually consider the credibility of the central bank and the accuracy of the stated targets compared to the alternative monetary information available when they depend on the monetary target announcement to meet their expectations. However, the monetary targeting approach depends to a large extent on the choice of the monetary target, where this operating or intermediate target has to have a direct impact on the goal and that it should be highly correlated with it; furthermore the intermediate target has to be easier to control than the goal.

Greece has recently entered a period of rapid increase of bank loans to the private sector, an episode that leads to a significant transformation of financial institutions’ asset structure and an increase in the indebtedness of enterprises and, in particular, households. Rapid credit expansion is of particular interest to the central bank because of the implications this may have, both for price stability, and for the overall credit risk assumed by banks.

While the European summit at Lisbon in the spring of 2000, in the euphoria of a relatively sustained period of growth, proclaimed ambitious objectives for employment rates and promised to make the EU ‘the most competitive knowledge-based economy …’, the five years that followed unfortunately recorded economic performance well below these ambitions. Harsh diagnoses on the state of the European economy and its chief members have multiplied in recent years (Camdessus et al., 2004; Kok et al., 2004; Sapir et al., 2004; Blanchard et al., 2005). They concur in identifying some serious slack in the European economy in comparison with the United States and in the emphasis placed on the dangers that the prospects of lasting weak growth would pose for the financing of European systems of social protection in particular, which would not be supported by demographic change (because of the rapid ageing of European populations) or by technical progress since efforts in research and development in Europe are inadequate. All blame the ‘rigidities’ that are characteristic of European economies, especially in the labour markets, the inertia of public sectors and the too heavy tax burden on the net return from the efforts and savings for financing them and social protection. All seem to agree on the idea that the macroeconomic policies are globally good, or at any rate that the ‘stability culture’ shared by the chief leaders at the heart of the European economic and monetary union — the famous ‘Brussels-Frankfurt consensus’ (Sapir et al., 2004) — and the institutions that are inspired by and support it (the independent central bank, pursuing a primary objective of price stability, and the SGP framing the national budgetary policies) are all in no way responsible for the poor economic performance of the eurozone, and that only ‘structural reforms’ radically transforming the European welfare states and drastically lightening their financial burden are likely to encourage a salutary ‘rebound’ (Camdessus et al., 2004).

A constitution has two key functions: structurally it defines the institutions and the powers that they can exercise and substantively, it sets out key values and goals according to which those powers are exercised (Walker, 1996: 270). The articulation of values and goals institutionalises the underlying normative vision, but that vision alone cannot control and constrain the way power is exercised. It is the structural elements of the constitution that both allocate powers and control their exercise, and it is these structural elements that are the focus of this chapter.

Our focus in this chapter and the next shifts to the impact of European integration on the outcomes of industrial relations. Singling out wages for special attention needs little justification. The levels of wages, and the wages structures they are embedded in, lie at the heart of the employment relationship and the negotiations that surround its governance. Following Brown and Walsh (1994: 437), being quantifiable, and thus generalizable across all manner of jobs and employees, wages are the common focus and language of policy makers and negotiators alike, albeit their interests may differ. For policy makers, as Chapters 4 and 5 have shown, wages are a key element in the macroeconomic policy mix, with links to employment, social security and taxation; changes in the levels of wages are fundamentally important in maintaining price stability. The wage structure shapes the distribution of employment between skills, employers and regions. For negotiators, the interests of their constituents are paramount. For workers, the level of wages is both the means to livelihood and a measure of self-esteem, explaining the focus on both real wages and relative wage levels or differentials. For employers, the levels of wages (both absolute and relative) are not only a key component of costs, but also instruments of motivation, performance and productivity.

The issue of financial system procyclicality is tricky. In a way, central bankers like myself have mixed feelings on the procyclical nature of financial forces. We love it, because it is the very source of leverage of our monetary policy. We hate it, because it amplifies economic swings, sometimes triggering economic and financial crises. Lowe and Stevens are right when they caution us that the outgrowth of financial resources over real economic resources makes the well-known issue of procyclicality increasingly important for today’s policy considerations.

The monetary policy of the European Central Bank (ECB) was in many ways supposed to be different than the policies pursued by national central banks. As the Financial Times noted, ‘It was not meant to be like this’.78 From the ECB’s first days in office in June 1998, the ECB’s policies were extremely politicized, its independence questioned, and its credibility doubted. What is immediately and abundantly clear is that the institutional and policy dilemmas faced by the ECB are quite similar to the dilemmas faced by other national central banks over the last 50 years. Exchange rate fluctuations, to say nothing of internal political pressure from the Euro-Zone governments, act as a direct constraint on the ability of the ECB to pursue an independent monetary policy. The early efforts of the ECB to prop up the sagging euro — which lost over 20 per cent of its value between January 1999 and January 2002 illustrated the dilemmas the bank faces. While the weak euro boosted exports from and employment within the Euro-Zone, the euro’s value demonstrated in part the power of the markets over the ECB, contributed to the credibility problems of the bank, complicated trade relationships with non-euro members and the US, and undermined public support and confidence in the euro. The first years were difficult ones for the ECB.

The treaty of Maastricht signed by twelve member-states in 1992 established the Economic and Monetary Union (EMU) with a single currency controlled by an independent European Central Bank (ECB) and the exclusive aim of price stability. It established strict convergence criteria for membership in terms of national rates of inflation, budgetary deficits and debt. The stability and growth pact of 1996 set a deficit limit of 3 percent sanctioned by a fine of up to 0.5 percent of GDP in order to preserve the value of the Euro. The statutes of the ECB were modeled on those of the Bundesbank with an assured majority of German monetary satellites and prohibition of attempts of national governments or politicians to influence it from the outside.

There are some things that I shall not be discussing in this lecture. I shall not try to assess the quality of the monetary policy followed by the European Central Bank (ECB), the quality of its policy-making framework, or the merits of the rigorous way it quantifies price stability. I shall not explain why I believe that Britain should adopt the euro, although some of the issues raised in this lecture bear directly on that issue.