Political economy of Bundesbank Monetary Targeting

I was reading this interesting paper by Jurgen Von Hagen. It was written in 1998.The paper reviews Bundesbank’s monetary targeting strategy from a political economy angle. Bundesbank and its successful monetary targeting strategy has always been a mystery for me. Bundesbank and Swiss National Bank were the only central banks that succeeded in adopting a monetary targeting strategy. Rest all failed. Mishkin in his paper points to this memorable quote:

 Gerald Bouey, the Governor of the Bank of Canada describing the situation by saying, “We didn’t abandon monetary aggregates, they abandoned us.”

 Coming back to the paper, it says:

The recent debate over monetary strategies concludes that monetary and inflation targeting lead to very similar patterns of central bank behavior. Why, then, do central banks insist on the strategies they use. In this paper, we develop an answer from political economy, arguing that monetary strategies are helpful in solving internal and external coordination problems for the central bank. We illustrate the point by reviewing the Bundesbank’s experience with money growth targeting in the mid-1970s. Monetary targeting was a signal that the previous monetary regime had been overcome, and a means to define the role of monetary policy vis-a-vis other players in the macro economic policy game, and to structure the internal monetary policy debate.

The main idea behind the paper is:

Today’s discussion about monetary strategies raises an interesting puzzle. On one side of the debate, macro economists continue to follow the tradition of Poole (1970) and analyze the performance of alternative monetary strategies in the framework of stochastic macro models; see e.g. Svensson (1997, 1998). They regard the choice of a monetary strategy as part of an optimal control problem that depends on issues such as the stability of the demand for money and the relative variances of shocks to the real and the financial sector.

On the other side of the debate, central bankers have noted that the close similarity in the use of central bank instruments and the reaction of central banks to news and shocks under inflation forecast and monetary targeting, suggesting that strategy choice does not seem to matter much for the day-to-day conduct of monetary policy; see e.g. Freedman (1996), King (1996).

In the same vein, Clarida and Gertler (1996), Bernanke and Mihov (1997), Clarida et al. (1998), and Mishkin (1998) all argue that the Bundesbank’s conduct of monetary policy looks much like what one would expect under an inflation target. But Groeneveld et al. (1996) point out that inflation targeting seems to have made little if any difference for empirical inflation and interest rate dynamics in the countries that adopted this strategy in the 1990s, and Almeida and Goodhart (1996) find no significant change in the conduct of interest rate policies of six inflation-targeting central banks. Are all monetary strategies the same, and do monetary policy strategies not matter after all?

But why, then, do central banks make efforts to identify and defend their monetary strategies? The answer we develop in this paper focuses on political economy. Our analysis deviates from the conventional analysis of monetary strategies in two regards. One, we emphasize that central banks are no unified actors. Instead, monetary policy decisions involve many different individuals with different preferences and different views of the economy. Two, we emphasize that many of the shocks central banks face are not exogenous but rather the result of deliberate actions of other actors in the economic policy game. Central banks can use monetary strategies to structure internal decision making problems and to shape the form of the policy conflict with other actors.

Read the paper for details. It is minus all the mon pol theories which we are so used to reading on central banks and price stability. Things like time inconsistency, anchoring inflation expectations,  targets, independence etc ect are given a complete miss here. What we instead get is an interesting insight into the choices Bundesbank has and makes given the political constraints.

The monetary targeting may have economic reasons but one of the main reasons why it succeeded in Germany is because there was wide political acceptance to the framework. There was a lot of dissent as well but it was seen as a useful way by both political parties and Bundesbank officials to tell the people about the mon pol strategy. Again not that economics does not matter, but politics has a major role. A central bank no matter how independent it is basically created by govt machinery.

This is something which most central bank/mon pol economists ignore. Well all would want to have a independent, transparent central bank only looking at price stability. But the political economy situation is different for all economies. Some economies go through hyperinflation and see the immediate need to have a central bank which is independent. Some never face it and don’t value it as much (like India for e.g. India has had inflationary episodes but none of the hyper variety). Then who would look at banks, financial system? There are many actors in an economic system and central banks are needed in all aspects of economic activity (whether they like it or not, RBI has to look at agriculture economics and developments).

So, when I am evaluating monetary policy of a central bank, I would also want to look at these political factors. By doing it the Svensson way, the central bank may be seen as inefficient, but political economy wise, it may have little choice. Monetary Policy economists need to look at a central bank differently. It really is not as simple as it is made out to be.

4 Responses to “Political economy of Bundesbank Monetary Targeting”

  1. Political economy of Bundesbank Monetary Targeting « Mostly Economics - Pasarici.NET Blog Says:

    […] is the original post: Political economy of Bundesbank Monetary Targeting « Mostly Economics Share and […]

  2. A snapshot of European Systemic Risk Board « Mostly Economics Says:

    […] Mostly Economics Mostly on research work in Economics and Financial System with focus on India « Political economy of Bundesbank Monetary Targeting […]

  3. Political economy of Bundesbank Monetary Targeting « Mostly Economics Says:

    […] Continued here: Political economy of Bundesbank Monetary Targeting « Mostly Economics […]

  4. Indian political system – why don’t we see the risks? « Mostly Economics Says:

    […] elects professional economists and lets them take a call. When one reads papers on Bundesbank (see this and this), you can clearly see how much politics was involved in setting it up. Likewise, it was […]

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