MONETARY POLICY AND FINANCIAL INNOVATIONS IN FIVE INDUSTRIAL COUNTRIES

ALw by Stephen F. Frowen BUSINESS, TIME AND THOUGHT: Selected Papers of G. L. S. Shackle (editor) CONTROLLING INDUSTRIAL ECONOMIES (editor) MONETARY POLICY AND ECONOMIC ACilVITY IN WEST GERMANY (editor with A. S. Courakis and M. H. Miller) A FRAMEWORK OF INTERNATIONAL BANKING (editor) UNKNOWLEDGE AND CHOICE IN ECONOMICS: Proceedings of the George Shackle Conference (editor)

Monetary Policy and Financial Innovations in Five Industrial Countries The UK, the USA, West Germany, France and Japan

Edited by

Stephen F. Frowen and

Dietmar Kath

St. Martin's Press

New York

© Stephen F. Frowen and Dietmar Kath, 1992 Softcover reprint of the hardcover 1st edition 1992 978-0-333-46184-6

All rights reserved. For information, write: Scholarly and Reference Division, St. Martin's Press, Inc., 175 Fifth Avenue, New York, N.Y. 10010 First published in the United States of America in 1992 ISBN 978-1-349-21686-4 ISBN 978-1-349-21684-0 (eBook) DOI 10.1007/978-1-349-21684-0

Library of Congress Cataloging-in-Publication Data Frowen, Stephen F. Monetary policy and financial innovations in five industrial countries: UK, USA, West Germany, France, and Japan I Stephen F. Frowen and Dietmar Kath. p. em. Includes index. ISBN 978-0-312-03523-5

1. Monetary policy 2. Monetary policy-United States. 3. Monetary policy-European Economic Community countries. 4. Monetary policy-Japan. 5. Money supply-European Economic Community countries. 6. Money supply-Japan. I. Kath, Dietmar. II. Title. HG230.3.F77 1992 332.4'6-dc20 90-8924 CIP

Contents vi viii xii

List of Figures and Tables Notes on the Contributors Introduction

1 National Monetary Policy in an Open World Economy Claus Kohler

1

2 Federal Reserve Policy since October 1979: A Justified Response to Financial Innovations? Thomas Mayer

16

3 The Control of Monetary Aggregates in the Federal Republic of Germany under Changing Conditions Norbert Kloten

32

4 Financial Innovations and the Stability of the Demand for Money in Germany since 1974 Stephen F. Frowen and Heinrich Schlomann

59

5 The Effects of Financial Innovation and Deregulation on French Monetary Policy Robert Raymond

82

6 Monetary Control in Japan Tatsuya Tamura

101

7 Financial Innovation: A View from the Bank of England JohnS. Flemming

120

8 Capital Flows and Exchange Rates: Some Implications Gordon T. Pepper

129

9 British Monetary Policy: October 1990 C. A. E. Goodhart

142

Name Index

161

Subject Index

163 v

List of Figures and Tables Figures

3.1 West German money stock and central bank money stock, 1975-89 3.2 West German money stock M3 and production potential, 1962-88 3.3 West German interest rate movements, 1974-89 6.1 Money supply and GNP in Japan, 1956-86 (percentage change from same period of previous year)

35 38 48 110

Tables

3.1

West German monetary targets and their implementation, 1975-89 3A.l Weights of West Germany's main components in M3 and the central bank money stock (CBMS) and their relative share (end of 1987) 4.1 OLS-estimation results for the West German nominal demand for money: Ml 4.2 OLS-estimation results for the West German real demand for money: Ml 4.3 OLS-estimation results for the West German nominal demand for money: M2 4.4 OLS-estimation results for the West German real demand for money: M2 4.5 OLS-estimation results for the West German nominal demand for money: M3 4.6 OLS-estimation results for the West German real demand for money: M3 4.7 OLS-estimation results for the West German nominal demand for money from 1974 to 1980 4.8 OLS-estimation results for the West German real demand for money from 1974 to 1980 4.9 OLS-estimation results for the West German nominal demand for money from 1981 to 1987 (1st quarter) vi

42 56 63 64

66 67 69 70 72

73 74

List of Figures and Tables 4.10

OLS-estimation results for the West German real demand for money from 1981 to 1987 (1st quarter) 4.11 Results of the Chow-test for alternative estimates for West Germany: 1980 (4th quarter) The shifting structure of French sectoral financial 5.1 surpluses and deficits, 1979-88 5.2 Gross issues in the French bond market, 1972-89 5.3 Net bond issues/GOP in West Germany, UK, France, USA and Japan in 1985 and 1988 (%) 5.4 Distribution of gross bond issues in France, 1975-89 5.5 Net bond issues in France in 1984 and 1988 5.6 Main features of French money market securities 6.1 Japanese money supply forecasts, 1978-89 (in percentage changes over previous year) 6.2 Changes in various types of Japanese financial assets between 1980 and 1986 8A.l Impact of a rise in the US budget and trade deficit

vii 75 77 83 86 86 86 87 88 90 105 115 140

Notes on the Contributors John S. Flemming is an Executive Director of the Bank of England. He was previously (1965-80) an Official Fellow in Economics and Bursar of Nuffield College, Oxford, and since 1980 has been a member of the Council and Executive Committee of the Royal Economic Society. Since 1986 he has also been a member of the Advisory Board on Research Councils. Mr Flemming was Editor of The Economic Journal from 1976--1980. His principal contributions cover aspects of capital theory, intertemporal decisions and decisions under uncertainty, together with some empirical and policy applications. Apart from contributions to learned journals and collective volumes, he published Why We Need a Wealth Tax (with M. D. Little) (1974) and Inflation (1976). Stephen F. Frowen was Bundesbank Professor of Monetary Economics in the Free University of Berlin. On his return to the United Kingdom in 1989 the title of Honorary Research Fellow in the Department of Economics was conferred on him by University College London. Professor Frowen was previously Professor of Economics at the University of Frankfurt and for many years held senior teaching posts at the University of Surrey, following an appointment as Research Officer at the National Institute of Economic and Social Research. He has published extensively in monetary economics and banking and was Editor of The Bankers' Magazine (now Banking World). He has been a visiting professor in several European countries. He is the Editor of Unknowledge and Choice in Economics (1990), Business, Time and Thought: Selected Papers of G. L. S. Shackle (1988), Controlling Industrial Economies (1983), A Framework of International Banking (1979) and Monetary Policy and Economic Activity in West Germany (with A. S. Courakis and M. H. Miller, 1977). He is also the translator into English of Knut Wicksell's Value, Capital and Rent (with a foreword by G. L. S. Shackle (1954, reprinted 1970). Charles A. E. Goodhart is the Norman Sosnow Professor of Banking and Finance at the London School of Economics. Before joining LSE in 1985, he worked at the Bank of England for seventeen years as a monetary adviser, becoming a Chief Adviser in 1980. Earlier he had viii

Notes on the Contributors

ix

taught at Cambridge and the London School of Economics, and was an Economic Adviser in the Department of Economic Affairs (1965-6). He has written a couple of books on monetary history and has recently revised his graduate monetary textbook, Money, Information and Uncertainty (2nd edn, 1989). He published a collection of papers on monetary policy, Monetary Theory and Practice (1984), and an institutional study of The Evolution of Central Banks (1988). Dietmar Kath is Professor of Economics at the University of Duisburg in the Federal Republic of Germany. He graduated at the University of Hamburg in 1961, took his PhD at the University of Hamburg in 1966 and his higher doctorate at the University of Freiburg in 1974 with a study on 'The Interest Rate Structure of Financial Markets'. His main research interests in the field of monetary theory and policy include the term structure of interest rates, exchange-rate systems and balance-of-payments problems. He has published widely in these fields and is also Co-Editor and Co-author of one of the most successful German textbooks: Economic Theory and Economic Policy. He has been a visiting professor at the Universities of Bonn, Siegen and Passau, and since 1977 has been an elected member of the Monetary Committee of the German Society for Economic and Social Sciences. Norbert Kloten is President of the Land Central Bank of Baden-Wiirttemberg and an ex officio member of the decisionmaking West German Central Bank Council. He graduated at the University of Bonn and later became a Visiting Lecturer at the Johns Hopkins University (Bologna Center) in Italy. In 1960 he was appointed Professor of Economics at the University of Tiibingen and was awarded an honorary degree by the University of Karlsruhe in 1980. He combined the Tiibingen Chair with membership of the West German Council of Economic Experts (Sachverstiindigenrat) from 1969 to 1976, being its Chairman from 1970 to 1976. He remains Honorary Professor at the University of Tiibingen and is also a member of the Board of Academic and Non-academic Associations, of the Trilateral Commission and other organisations. He has published widely on the principles of economic policy and in the field of monetary and international economics, on regional and development problems, as well as on the methodological aspects of science.

X

Notes on the Contributors

Claus Kohler is Professor of Economics and Director of the Institute for Empirical Economic Research in Berlin. He was an Executive Director of the Deutsche Bundesbank and a member of the Central Bank Council from 1974 until he joined the Board of the Treuhandgesellschaft in October 1990. He holds degrees from the Humboldt and Free University, Berlin and began his academic career at the Technische Universitat Berlin as a Lecturer in Economics. From 1966-74 he was Professor of Economics at the University of Hanover. During his earlier banking career he held leading positions with banks in Berlin and finance companies. He was a member of the German Council of Economic Experts from 1969 to 1974 and more recently has been Honorary Professor of Economics at the Universities of Hanover and Frankfurt. He has published widely in the areas of monetary economics and applied economics and is the author of Der Geldkreislauf (1962); Orientierungshilfen fur die Kreditpolitik (1968); Geldwirtschaft, Vol. 1: Geldversorgung und Kreditpolitik, 2nd ed. (1977); Geldwirtschaft, Vol. II: Zahlungsbilanz und Wechselkurs (1979); Geldwirtschaft, Vol. III: Wirtschaftspolitische Ziele und wirtschaftspolitische Strategie (1983); and lntemationalokonomie (1990). Thomas Mayer is Professor of Economics at the University of California, Davis. He was born in Vienna, Austria, in 1927 and received his PhD from Columbia University in 1953. His main fields of interest are monetary policy and applied monetary theory. He is the coauthor of Monetary Policy in the United States (1968), Intermediate Macroeconomics (with D. C. Rowan, 1972), Permanent Income, Wealth and Consumption (1972), The Structure of Monetarism (with P. Cagan, B. Friedman et al., 1978), Money, Banking and the Economy (4th edn, 1990), Revealing Monetary Policy (1987) and Monetarism and Macroeconomic Policy (1991). He also edited The Political Economy of American Monetary Policy (1990). He is currently working on a book on the methodology of economics. Gordon T. Pepper, CBE, is an honorary visiting professor in the Department of Banking and Finance and director of the Midland Montagu Centre for Research in Financial Markets at the City University Business School in London. He is a member of the Economic and Social Research Council. He is also a director and senior adviser of Midland Montagu, which is the international and investment banking arm of the Midland Group. Professor Pepper was previously chairman of Greenwell Montagu & Co. and, before that, joint senior partner of W. Greenwell & Co. He was the joint

Notes on the Contributors

xi

founder of the gilt-edged business of W. Greenwell & Co. and the premier gilt-edged analyst in the United Kingdom from 1972 until 1981. He is a fellow of the Institute of Actuaries and the Society of Investment Analysts and earned his MA in economics from Trinity College, Cambridge. Robert Raymond is General Manager of the Research Department (Direction Generate des Etudes) at the Bank of France. Since 1975, his main field of responsibilities has been monetary policy. After reading law and economics, he joined the Bank of France in 1951 as an inspector. Following a few years spent in banking supervision, he was seconded from the Bank of France to the Federal Reserve Bank of New York in 1966. From 1968 to 1975, he was appointed to the Foreign Department (Direction Generate des Services Etrangers) at the Bank of France. At the same time, Mr. Raymond performed several functions outside the Bank of France, notably for the French five-year plan. He has also been professor at several universities in Paris and abroad. Since 1981, he has chaired the group of monetary experts on the Committee of Governors of EEC central banks. He has written several books as well as many papers, articles and reviews in the field of monetary policy. Heinrich Schlomann is a Research Associate of the Johann Wolfgang Goethe-Universitiit Frankfurt am Main, Institute of Social Policy, concerning the project 'Social Security' of the Special Collaborative Programme 3: 'Microanalytical Foundations of Social Policy'. He graduated from the University of Hanover with a major in Economics. His diploma thesis was on theoretical aspects of the demand for money and related empirical evidence for the Federal Republic of Germany. Presently he is working on his doctoral thesis on the distribution and accumulation of wealth in Germany, with special reference to precautionary savings of the elderly. Tatsuya Tamura is Director of the Policy Planning Department of the Bank of Japan. Following a series of managerial positions, he became the Bank of Japan's Chief Representative in Europe in 1986 prior to his posts first as Director of the Bank's Government Bond Department and subsequently as Director of the Research and Statistics Department. Mr Tamura earned his BA in law from the University of Tokyo and his MA in economics from the University of Pennsylvania. In the early 1970s he was one of the co-authors of the so-called White Paper on Japan's Economy.

Introduction Financial innovations have been a worldwide phenomenon since the 1970s, reaching a climax during the 1980s. The objective of the present volume is to analyse the response to these developments closely linked with the liberalisation of money and capital markets and the consequences for the conduct of monetary policy. Also considered is the stability of hitherto-established relationships between economic variables on which the reliability of monetary policy measures depends. The volume further covers some of the international aspects involved and the important implications of dominant and persistent flows of long-term capital across the exchanges which have emerged in recent years. This book is the result of a conference on 'Financial Innovations, Deregulation and the Control of Monetary Aggregates' which was organised by both editors at the University of Surrey in Guildford (England). It contains most of the papers presented on that occasion, each in a revised and completely updated version. The papers by Charles A. E. Goodhart and Gordon T. Pepper included here replace those originally presented at the conference. The macroeconomic consequences of financial innovations on individual countries diverge greatly and depend on the degree to which the institutional framework of financial centres differs. The principal concern of the conference was therefore to examine the hypothesis that under divergent institutional conditions the impact of financial innovations and deregulations on individual money and capital markets will not be homogeneous. For this purpose the financial developments in five leading industrial countries- the UK, the USA, West Germany (at that time), France and Japan - were analysed theoretically as well as empirically by professional economists and central bankers from these countries, all of whom are experts in the fields of both monetary theory and monetary policy. There are three main topics which may be chosen for a general summary of the papers collected in this volume investigating the impact of financial innovations and deregulations:

First, the increasing instability of central monetary variables and aggregates at the domestic level; second, the wider exchange-rate fluctuations at the international level; and xii

Introduction

xiii

third, the reduced controlability of monetary aggregates by domestic central banks.

A finding emerging from most of the papers is that at the domestic level financial innovations lead to greater interest-rate volatility and stronger fluctuations in the velocity of circulation of the money supply. However, there are some indications in the papers by Norbert K.loten and Stephen F. Frowen and Heinrich Schlomann that this general conclusion has only limited applicability for the Federal Republic of Germany. Until the unification of the two parts of Germany in 1990, there was no conclusive evidence of shocks or structural breaks in the West German demand for money function. But, as Norbert K.loten makes clear in his paper, there was little need in West Germany for further deregulations in the financial sector, and the introduction of additional financial innovations remained at a low key. Thomas Mayer, basing his arguments on monetary developments in the USA and within the framework of an IS/ LM analysis, concludes that financial innovations can be interpreted as impulses on the LM-curve. But, as he explains, one can find arguments for a steepening as well as for a flattening of the LM-curve. A steeper LM-curve would be due to a lower, and a flatter curve due to a higher, interest elasticity of the money-demand function. At the international level there appears to be a broad consensus with regard to the impact of financial innovations on capital movements and exchange-rate stability. The views on these issues expressed by some of the contributors could be compressed as follows: First, international capital movements are attracted by positive interest-rate differentials; second, as new instruments for international lending and borrowing as well as for financial investments are devised in order to utilise comparative interest-rate advantages, an expansion of international capital movements is set in motion; and third, innovations of international financial instruments are therefore responsible for the dramatic exchange-rate fluctuations experienced since the late 1970s.

Concerning the consequences of financial innovations for monetary control and for monetary targeting, a distinction has to be made between the domestic and the world economy. Looking first at the domestic monetary policy aspects of financial innovations, it would be justified to say that monetary aggregates would tend to become

xiv

Introduction

less effective variables for monetary targeting. Both Thomas Mayer and Charles A. E. Goodhart raise the question whether monetary policy should perhaps be shifted to a nominal GNP-target in line with the Tobin proposal; that is, instead of using a money-supply aggregate for control purposes, the central bank should switch to a velocity-corrected monetary aggregate (M times V). Such a concept could be called the 'effective quantity of money'. Any change in money velocity should be neutralised by opposite movements in the aggregate itself, so that the product of the two remains at its target level. Both authors reject this possibility for different reasons. With regard to the international aspects of financial innovations and their policy implications, it is argued that the strong fluctuations in exchange rates resulting therefrom offer additional problems for both domestic and international monetary policies. Claus Kohler as well as Gordon T. Pepper point out that fluctuations in exchange rates are mainly the result of speculative capital movements, i.e. capital transactions primarily induced by speculation. In other words, capital movements of this nature are in no way linked to the international flow of goods and services. Kohler therefore proposes to dampen exchange-rate fluctuations by a coordinated intervention in foreign exchange markets on the part of central banks representing the world's major international currencies. By such coordination according to Kohler - international financial investors and those engaged in international trade would be provided with an 'anchor' for their policy decisions. The editors would like to express their special debt of gratitude to the Goethe-Institute, London, and in particular to its former Director, Dr G. Coenen, for generous financial support for the conference. They also take this opportunity of expressing the warmest gratitude to Mr T. M. Farmiloe and Mr Keith Povey for their tremendous editorial support. June 1991 STEPHEN F. FROWEN

University College London and St Edmund's College, Cambridge DIETMAR KATH

University of Duisburg