Number 159 September 2001
A return to the convertibility principle?
Monetary and fiscal regimes in historical perspective.
The international evidence
Michael D. Bordo and Lars Jonung
"...With the establishment of the EMU and the ECB, the interaction between monetary and fiscal polices is now a major policy issue in the Euro-area, dealt with in detail in the Maastricht and Amsterdam treaties and in the Stability and Growth pact. This paper provides a background to this issue by exploring the long-run relationship between monetary and fiscal policies. We examine a large set of data covering major economies, including eleven out of the fifteen present members of EU, during the past 115 years. The evidence suggests the existence of a close interaction between the monetary regime, that is the behaviour of the central bank, and the fiscal regime, that is the tax and spending behaviour of governments as reflected in the evolution of budget deficits and public debt.
In the past, a monetary regime based on the commitment to convertibility of the domestic currency into specie, the 'convertibility principle', was the prevailing pattern in the world economy. According to this principle, the fiscal regime is subordinated to the monetary regime. The major exception to this pattern occurred during major wars and their immediate aftermath when fiscal demands determined monetary policy. Since the mid 1960s and especially after the breakdown of the Bretton Woods system in the period 1971-73, monetary policy has abandoned the 'convertibility principle' and in many countries has been geared towards domestic stabilization goals, especially that of full employment. This led to a build-up of inflationary pressures in the 1970s which has been largely rolled back since the early 1980s. In the same period bond-financed fiscal policy has been used as a stabilization policy tool, when many countries accumulated debt to income ratios sufficient to threaten monetary stability.
The establishment of the EMU and the creation of the Euro should properly be regarded as a return to the convertibility principle. The European central bank (ECB) declared in 1998 price stability as the primary goal of its policy. The present twelve members of the Euro-area are committed to support this goal by a policy of fiscal prudence. In short, the new European monetary regime is designed to dominate the fiscal regime in order to guarantee the credibility and sustainability of the goal of price stability..."
"..The return to the convertibility principle implies a return to a rule or rule-like behaviour in which monetary policy is geared towards the goal of low inflation and the level of debt is to be kept sufficiently low to avoid threatening monetary stability. In many ways the advent of inflation targeting or ”price stability” as the primary goal of monetary policy has great similarities with the gold standard period. However, there is an important difference. The monetary system is today based on a managed fiat system - not on an automatic specie system. The anchor is thus a managed not an automatic one.
The establishment of the EMU and the creation of the single currency, the Euro, should properly be regarded as a return to the convertibility principle. The European central bank (ECB) declared in 1998 price stability – a rate of inflation below two per cent per year over the medium term – as the primary goal of its policy. The present twelve members of the Euro-area are committed to support this goal by a policy of fiscal prudence. The fiscal policy process is co-ordinated through the Stability and Growth Pact and other procedures to guarantee that the budgetary policy of any single member or group of members is consistent with the overriding goal of price stability. In short, the new European monetary regime is designed to dominate the fiscal regime in order to guarantee the credibility and sustainability of the goal of price stability.
For the future our prediction is that if fiscal balance is achieved in most major economies, monetary regimes based on either an internal commitment norm like price stability or an external commitment to a foreign currency will prevail. Thus, a nominal anchor, similar to what was once embodied in the specie convertibility principle will again keep monetary and fiscal policies in check..."