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For release on delivery
5:00 p.m. local time (Noon, EDT)
May 9, 1996

European Currency Union

Remarks by
Lawrence B. Lindsey

Seminar convened by the
European Economics and Financial Centre
at the House of Commons
London, England

May 9, 1996

European Currency Union

I am deeply honored to have been asked to be here today, in this, the mother of
Parliaments, to discuss some of the issues regarding the development of the European
Currency Union.

There are few more important issues facing this Parliament and the people

of the United Kingdom. Today I shall attempt to provide some general historical and
economic perspective on the issue of currency unions, with particular regard to the
experience in the United States, in the hope that this might have some applicability to the
particular situation now before you.
Let me begin with a number of disclaimers. Although I am a Member of the Board
of Governors of the Federal Reserve System, I do not speak either for the System or for any
of my colleagues.

The views expressed today are entirely my own. Indeed, to my

knowledge the Federal Reserve has never taken any position on the issue of European
Currency Union. Nor would I support the development of such a position. This is rightly a
matter for the people and legislatures of the nations of Europe, and not one in which we
should become involved.
Let me also confess to some obvious personal limitations. I am not a European and
so do not possess a European historical or political perspective. Clearly, at least some of the
impetus behind the move to a single currency zone is to provide yet another continent-wide
institution which would more closely integrate the nations and people of Europe. In turn,
much of the driving force behind such integration is to prevent the kind of conflict and
destruction which characterized European history in the first half of this century, and

hopefully to also help bridge the chasm which the Iron Curtain created in Europe during
most of the second half of this century. As someone who never experienced the horror of
the World Wars, I am ill equipped to fully appreciate the importance of this history as a
motivating force.
Having cited the limitations of my perspective, let me turn to those issues on which I
might shed some light. First, there does exist a literature on what constitutes an optimal
currency zone. The key motivating force behind this literature is to consider ways in which
macroeconomic differences among regions might be mitigated in the absence of currency
movements. Second, I hope to provide some historic insight on the battles which led up to
an American currency union, to help provide some insight into the political difficulties which
we faced. Third, I would like to provide some personal perspective which I, as a policy
maker, feel with regard to monetary policy issues, in the hope that this might shed some
light on the possible concerns which a member of a European central bank might feel.
Economic Stabilization and Optimal Currency Zones
To begin, let us consider the most commonly stated advantage of multiple currencies.
In any dynamic modern economy there are bound to be regional differences in economic
performance. These differences might involve transitory factors which cause different
regions to be experiencing different stages of the business cycle at any given point in time as
well as long term structural differences in the performance of the key industries which
characterize the local economy.

A natural objective for economic policy is to assure that

such differences become self correcting: that is, to assure that automatic stabilizers be in
place which provide stimulus to economies which are performing below par and which
constrain demand in economies with well above normal growth.

Movements in exchange rates — which presuppose the existence of different
currencies ~ can act as such as an automatic stabilizer. It is important to stress that such
stabilizing properties need not involve discretionary monetary policies on the part of the
various regions involved. Properly used, a locally based discretionary monetary policy might
well help to localize regional business cycles and thus to augment the stabilizing properties of
which I am speaking. But, I wish to abstract from the issue of discretionary policy and focus
just on what would automatically occur.
To do that, let us assume that there are two countries ~ call them A and B ~ which
actively trade with one another and enjoy the free movement of capital. To abstract from
discretion in monetary policy, let us assume that each country has adopted Nobel-laureate
Milton Friedman's fabled monetary policy computer which expands the money supply at a
constant rate and that the rate in each country is exactly the same. For whatever reason,
country A begins to experience a recession. As nominal income slows, money demand in
country A declines relative to money supply and the prevailing interest rate drops. In turn,
this lowers the relative attractiveness of the country's fmancial assets. This in turn lowers
the exchange value of country A's currency.
At this point, the automatic stabilizing properties of the exchange rate begin to kick
in. In the international market, the price of goods produced in country A begin to fall
relative to those produced in country B. Thus, country A's exports to country B become
more competitive there while country B's exports to country A become less attractive. The
exports of country A therefore increase while its imports decline. This produces a net
stimulus to aggregate demand in A and helps to mitigate the recession there. The exchange


rate regime has thus helped act as an automatic stabilizer in the economy.
The existence of two currencies not only acts as a stabilizer of investment flows on a
cyclical basis, but perhaps more importantly on a longer term structural basis as well. Let us
imagine that country A's economic difficulties are not the result of a swing in the business
cycle, but stem from a long run structural decline in the industries in which country A
specializes. Again, under an unchanged monetary policy, the cost of longer term borrowing
and investing in country A might be expected to decline relative to the cost in countiy B.
This might tend to mitigate any structural decline by leading to increased international
investment in new industries. Under a single currency regime, it would be impossible for
interest rates to vary across countries.
Under a single currency, much of the adjustment in the attractiveness of relative
investment would tend to result from emerging differences in the price of real assets ~
particularly structures and land. Yet, if countries were pursuing a policy of long run price
stability, this would require a decline in nominal asset prices. Such price declines are quite
disruptive and tend to inflict significant damage in the financial services industry as the value
of collateral underpinning the lending of these institutions declines. In the United States we
experienced difficulties in this regard in the 1980s and early 1990s. The problems were
particularly intense in regional settings. Examples include Texas and Oklahoma following
the oil price collapse of the mid-1980s, the end of the so-called Massachusetts miracle in the
late 1980s, and the decline in California real estate prices in the early 1990s.
Under a multiple currency regime such asset price declines would tend to be
mitigated. Instead of nominal price declines, much of the economically mandatory real


decline in asset prices would be manifest in exchange rate adjustments. Thus, if there were
such a thing as a "California dollar", the decline in California real estate prices in the early
1990s might have been as great in terms of U.S. dollars, but less in terms of the local
California currency. Instead, we would have witnessed a depreciation of the California
dollar relative to the U.S. dollar.
Regional variations in economic performance can be quite significant. For example,
the United States now has an unemployment rate of roughly 5 1/2 percent. We are in the
sixth year of an economic expansion, and so in theory, all regions of the country have had
time to benefit from the expansion. Yet, in February, 11 states had unemployment rates of 4
percent or less, suggesting extremely tight labor markets, while 3 states, including California
which comprises almost one-seventh of our economy, had unemployment rates of 7 percent
or more, a rate which is more typical of an economic recession. Obviously, the automatic
stabilizing effect provided by exchange rate variations which is described above is not
applicable to the regional economic disparities within the United States.
The key question regarding an optimal currency zone is whether or not alternative
stabilizing mechanisms exist. The literature has focussed on two such mechanisms: labor
market mobility and fiscal transfers. Let us consider each in turn.
Labor Market Mobility
The United States is characterized by an extremely mobile work force.

The U.S.

Census Bureau estimates that roughly 17 percent of all Americans move in a typical year.
This figure is particularly high for relatively new job holders. For example, 35 percent of
individuals aged 20 to 24 and 30 percent of individuals aged 25 to 29 move in a typical year.


Roughly one third of those movers changed their county of residence and more than 40
percent of these changed their state of residence in a typical year. In total, 3 percent of the
national population, some 7.7 million people, changed their state of residence in a typical
This is a major portion of the interregional adjustment in our economy both with
respect to longer term structural issues and with respect to the business cycle. For example,
during California's economic difficulties in the early 1990s, the rate of outmigration was
quite significant. The Census Bureau reports that nearly 1.2m people outmigrated between
1990 and 1994. Many of these people moved to the Rocky Mountain states. Utah, for
example saw a 24 percent increase in the number of jobs during the same period, with an
increase of nearly 200,000 jobs. Colorado added 300,000 jobs, a 20 percent increase.
The effect on a state's population can be dramatic. For example, California's
population grew at an annual rate of about 2.2 percent during the 12 year period 1980-1992.
Had this trend continued during the recession years of 1993 and 1994, the state would have
had 850,000 more people in 1994 than actually lived there. The state of Massachusetts lost
16,000 residents between 1989 and 1992. Had the state kept pace with national population
growth, it would have had an increase of 200,000 people. Neighboring Rhode Island and
Connecticut had smaller populations in 1994 than in 1989.
This kind of labor force mobility helps mitigate the aggregate job loss during
recessions. Although much of the price of adjustment is borne by workers who are forced to
relocate, the beneficial effects of such labor mobility clearly show through in the overall
level of unemployment in the country as well as in the level of aggregate output. More


precisely, there is very little in the way of an alternative to this relocation as a means of
regional macroeconomic adjustment. Longer term, this relocation is even more dramatic.
For example, between 1960 and 1990 the proportion of the U.S. population living in
California rose by 37 percent. The proportion living in Florida almost doubled. By
contrast, the proportion living in New York fell by more than one quarter.
In Europe, cross national migrations simply do not approach this magnitude. Of
course, the European Community has taken dramatic steps toward ending the formal barriers
which existed for citizens of any of the member states to live in and take part in the civic
lives of their country of residence. But significant informal barriers remain. Linguistic and
cultural differences no doubt are major impediments to widescale cross-country migration.
Over time, one might expect these differences to diminish. One could well imagine retirees
from northern Europe seeking out sunnier climates along the Mediterranean much as their
American counterparts move to Florida. As the multilingual workforce expands, more
workers might find the attractions of higher pay and the excitement of living in a different
culture alluring. But this does not describe Europe today. As an alternative to exchange rate
variations as a form of macroeconomic adjustment, Europe simply cannot rely on crossnational labor force mobility to the extent that it can be in the United States.
Fiscal Transfers
The second major source of interregional macroeconomic stability which can exist in
a single currency zone is a regime of deliberately countercyclical fiscal transfers. In the
United States, a uniform national income tax provides the major form of this transfer
mechanism. For example, between 1987 and 1991, California contributed an estimated 16.6


percent of additional federal tax revenues. During this period the California economy was
growing more quickly relative to that of the nation as a whole. As a result, it's contribution
to federal tax receipts rose from 12 percent of the total to 13.4 percent of the total. From
1991 to 1994, the state's share of increased federal tax revenue fell to just 8.1 percent and
its share of the national burden declined to 12.5 percent.
A similar story can be told about the state of Massachusetts. During its boom years
of 1985-1989, the state's contribution to federal tax collections rose at a 36 percent faster
rate than did total tax collections from the nation as a whole. During the Massachusetts
recession from 1989-1992, the federal tax payments from Massachusetts actually declined in
nominal terms, while total federal tax collections rose by roughly 10 percent.
The fiscal transfer value of these changes can be significant. For example, had
California's tax share stayed unchanged between 1991 and 1994, its 1994 federal tax
payments would have been $11 billion higher than they actually were. This $11 billion
decline is equivalent to roughly $350 per capita. The corresponding effective fiscal transfer
in the case of Massachusetts during its 1989-1992 recession amounted to nearly $550 per
capita in 1992 alone. Per capita personal income in the United States was roughly $21,800
in 1994. Thus, the fiscal transfer effect of the variability in federal tax payments was
roughly 1 1/2 to 2 percent of personal income. Perhaps an even more relevant comparison
of the potency of this transfer is a comparison to personal income tax collections, which
amounted to about $2300 per capita in 1995. Such a comparison indicates that a significant
portion of the automatic stabilizing properties of the progressive tax system in the United
States actually manifest themselves in a regional redistribution of the income tax burden.


And, it should be added that this inter-state fiscal stabilizing effect is in addition to the
nationwide stabilizing effect which is rendered by a progressive tax system.
The key to success of any automatically stabilizing tax regime is an elasticity of tax
revenues with respect to income which is greater than unity. In plain language, it is
necessary that tax revenues rise and fall more than in proportion to income. This need not
necessitate a formally graduated bracket structure. For example, the corporation income tax
is essentially a flat rate tax in the United States, but corporate profits vary more than
proportionately with income. Hence tax receipts have a similar high degree of variability or
elasticity. The progressive bracket structure of the U.S. personal income tax interacts with a
high GDP elasticity of many of the types of income on high-income returns to produce the
magnitude of countercyclical stabilizing properties just described.
By contrast, Europe has no such automatic fiscal transfer mechanism. As I
understand it, fiscal contributions to the EC are to some extent tied to VAT receipts. Yet,
these receipts are a function of consumption expenditures which normally have a GDP
elasticity less than one. European expenditures do involve some transfer oriented programs.
For example, both the Common Agricultural Policy and the Regional Fund involve
expenditure policies with a regional orientation. Of course, the United States also has
expenditure policies with a regional orientation. But neither American expenditure policy
(with some minor exceptions) nor those of the European Community should be considered
deliberately countercyclical in their effects, or even in their intent. Instead, most such
expenditures involve some combination of long term structural support for declining or
depressed regions or industries. Again, Europe appears to lack the kind of automatic


stabilizing properties which a unified fiscal mechanism affords the United States to
potentially act as an alternative to exchange rate variations.
In summary, a review of the economic literature on optimal currency zones suggests
that Europe does not at this time possess the alternative stabilizing mechanisms which would
normally define such a zone. At present, trans-national labor force mobility does not come
close to the levels found in the United States. Furthermore, the potentially stabilizing
properties of a currency zone-wide fiscal process are not now in place. These are not, of
course, insuperable obstacles. One might imagine, for example, that national fiscal policies
within the currency zone could be designed to provide both automatic and discretionary
stabilizing mechanisms. However, such national fiscal flexibility seems inconsistent with the
convergence criteria laid out in the Maastricht agreement. Alternatively, one could argue
that the political and economic advantages of a single currency outweigh the costs involved in
losing regional or national economic stabilizers. This is, as I mentioned earlier, an issue for
the people and Parliaments of Europe to decide, not for members of the U.S. Federal
Reserve Board.
As an observer from the other side of the Atlantic, the more relevant consideration in
my mind is that these alternative stabilizing factors are likely to increase over time. For
example, I am certain that the people of Europe will find their mobility on the increase and
the traditional cultural barriers to migration on the decrease. Furthermore, assuming that a
single currency and other moves toward a more federal Europe take place, it would seem
likely that fiscal policy would become more centralized within the Community. As this takes
place, it will be quite natural for policy makers to design both tax and expenditure policies


with stabilization properties as more central objectives. To say that Europe does not at this
time seem to meet the properties as an optimal currency zone does not mean that this will
never be the case.
Historical Perspective
Indeed, a look at American history suggests how important the passage of time is to
acceptance of centralized monetary authority. Let us therefore turn to a brief review of the
American experience to understand how contentious central banking and monetary issues can
be in an emerging political union, and how similar issues might be confronted today.
America is often held up as a prime example of a successful currency union. As I noted
above, it does have many of the characteristics required for a successful optimal currency
zone. But, a look at history suggests that this development was not as easy, or as
straightforward as some might suggest.
From the inception of the American republic, the issues of monetary policy and
central banking have been a keen part of the political debate. One of the key issues faced by
our Founding Fathers, and one which ultimately will have to be faced in Europe assuming a
single currency is developed, deals with the assumption of the debt obligations of pre-existing
political entities which have been subsumed by new governmental forms. On this issue, the
new Republic left nothing to chance. The Constitution — which in general is a remarkably
brief document noted for the many issues it omits to settle -- was explicit on this issue.
Article VI begins: "All Debts contracted and Engagements entered into, before the Adoption
of this Constitution, shall be as valid against the United States under this Constitution as
under the Confederation."


In short, the new government promised to pay off all debts of the old government.
This is an interesting decision both because of the potential problems that did not develop,
but which we should consider, as well as for the resulting political decision to set up the
First Bank of the United States. First, what could have happened? Following most of the
major revolutions of the past two centuries, the new government repudiated the debt of the
government it replaced. One of the key mechanisms of this repudiation involves a currency
reform, often involving the substitution of one currency for another. Currency is, in effect,
the non-interest bearing debt of the sovereign state. A sovereign state can always pay off
debts (denominated in its sovereign currency) simply by printing more of it. The lender
takes an inflation loss, but is made whole in nominal terms. Once a sovereign state loses its
ability to cover its own debt through money creation, some other "sovereign" must assume
that responsibility.
In large part to develop the confidence in the new government of the world financial
markets of the time, Secretary of the Treasury Alexander Hamilton also adopted a policy of
assuming the debts of state governments as well. Many of these were effectively bankrupt.
They had issued currency along with the old Congress of the Confederation generically
known as "Continental Dollars". During the period of Confederation, the phrase "Not worth
a Continental" emerged -- reflecting the deep discount at which these notes traded relative to
specie of the same nominal value. Hamilton, by redeeming Continentals at par, produced
windfall profits for speculators who bought up these Continentals, and was widely criticized
for this action.
Hamilton's problem was a generic one. Two states decide to merge and fix an


exchange rate between each of their currencies and some new, jointly agreed upon currency.
State A enjoys tremendous confidence in the international community and has issued many
bonds outstanding in its currency with 5 percent coupons. State B is not so fortunate because
of an inflationary and profligate past and has issued many bonds yielding 10 percent in its
currency. Selecting an exchange rate at the point of currency conversion is only part of the
problem. The nominal value of the bonds of each country are therefore set, and are payable
at maturity in the new currency. But that means that bonds denominated in the same
currency (with equal inflation and default risks) now are paying decidedly different interest
rates. Holders of the old State B bonds will presumably make windfall gains as their bonds,
with their higher coupons, rise in price. In Hamilton's case, an exchange rate of one-for-one
was selected, i.e. par. Holders of debt obligations (including currency) of the most fiscally
and monetarily profligate states received the biggest windfall because their obligations were
traded at the biggest discount to par value.
Hamilton accomplished this arrangement by creating the First Bank of the United
States. This bank had some of the characteristics of a modern central bank, but far from all.
It was, in essence, the fiscal agent of the Treasury. In its fiscal and monetary mission the
bank was a clear success. The new Republic was put on a secure financial footing. As a
political issue it was a failure. The bank charter lapsed. The unpopularity of the Hamilton
program helped drag down his faction -- the Federalist party -- to defeat at the hands of
Thomas Jefferson's Republicans, the historical antecedents to the modem day Democrats.
Many Republican voters were small farmers who, in their view, had been cheated out of
their continentals by big city speculators who supported Hamilton. The political side effect


of this was to give the concept of a central bank - and central monetary authority ~ a bad
A second crisis in the development of the so-called single currency zone in the United
States came in the early 19th Century. At that time, state legislatures had the exclusive
authority to issue banking charters. To turn a phrase, such charters were quite literally "a
license to print money". More precisely, the banks could issue banknotes which were a
more convenient mechanism for making payments than were specie. It should go without
saying that the recipients of these charters were politically well connected. In the state of
Maryland some politically well connected bankers, not satisfied with their legislatively
granted license to print money, demanded that the legislature grant them protection from
foreign competition - namely, to give their banknotes some advantage over banknotes issued
from other banks. The legislature complied. It imposed a tax on non-Maryland issued bank
notes. The tax varied with the size of the note but on average amounted to about 2 percent.
In effect, dollar bank notes issued by Maryland banks would cost $1 while dollar bank notes
issued by non-Maryland banks would cost $1.02. Needless to say, that tax would probably
be sufficient to be decisive in the market.
Chief Justice Marshall wrote the opinion for the U.S. Supreme Court which struck
down the Maryland tax on banknotes in 1819. Marshall's ruling in that case, McCulloch vs.
Maryland, included a phrase which is still popular today, and with which many in this room
might be familiar: "The power to tax involves the power to destroy." Obviously this
decision made the path toward a true single currency zone possible in the United States.
Such a zone could not exist if the market value of currency was dependent upon the state of


issuance. But, the historical fact remains that 32 years after the Constitution was adopted,
such practices were still being tried by the state legislatures of the new Republic.
Three issues dominated the national political debate in the decades leading up to the
U.S. Civil War: slavery, tariffs, and the Second Bank of the United States. In the 1830s, the
commercial interests of the East were agitating for the extension of the charter of the Second
Bank of the United States, the rudimentary equivalent of the American Central Bank. The
populist forces of the South and West were opposed. The debate was particularly intense
with the Congress generally favoring the continuation of the bank and President Andrew
Jackson opposed. Indeed, the debate became so intense that it managed to leave its
permanent mark on the city of Washington. Those of you who have visited my nation's
capital may recall that the city's designer, Pierre L'Enfant, intended a city of broad avenues
with beautiful vistas. One such avenue was Pennsylvania Avenue which connected the White
House, the President's residence, with Capitol Hill, where Congress meets. At that time the
building which now houses the Treasury Department was about to be built. The story goes
that President Jackson became so enraged at the pro-bank U.S. Senate that he marched out of
the White House and planted his cane in the middle of Pennsylvania Avenue, insisting that
the corner stone of the Treasury be laid there. While historians have probably modified the
likely profanity that was actually spoken, Jackson's orders were to build the Treasury, "To
block my view of that damn place." Today, traffic in the city of Washington still suffers
from this debate about the centralization of monetary policy which took place in the fifth
decade of the Country's existence. (One can only conjecture what Monetary Union will end
up doing to the streets of Brussels.)


Monetary authority did become more centralized during the United States' Civil War.
In 1862, the convertibility of Union currency into specie was suspended as money creation
was used to help finance the War. The new notes were called "greenbacks". The War also
led to the creation of the National Banking system, which served primarily as a means to
mobilize national saving to help finance the Union's cause. After the War, a punitive 10
percent tax was levied by the federal government on the issuance of all state banknotes. But,
the notes of national banks were periodically not considered the same as money. Milton
Friedman and Anna Schwartz recount that in the decade after the Civil War these notes often
traded at a discount to greenbacks.

At particular disadvantage were banknotes issued at

"country" banks where redemption risk was perceived to exist.
In 1879, the U.S. went on a specie-based standard, ending the greenback era. The
central bank of the United States, the Federal Reserve, was created in 1913. But, it was not
until 1934 that this monetary authority had fiduciary responsibility for the currency. It thus
took 147 years from the founding of the Republic before we had a true "single currency"
zone with a discretionary monetary policy controlling the creation of money. I recount this
history because it serves as an important reminder, both of the value of time in creating
lasting institutions, and of the inevitable political uncertainties involved in any matter having
to do with money. Let me turn then to some of the inevitable political issues involved in
central banking and assess the need for a balance between independence and accountability in
any such institutions.
The Importance of Central Bank Independence
Central banks are one of the key institutions for the proper functioning of a liberal


political and economic regime. Yet the precise position of a central bank in such a regime is
ambiguous. The demands of democratic governance argue for accountability of the central
bank to the desires of the electorate. At the same time, the importance of a stable and
dependable medium of exchange to the smooth functioning of a market economy cannot be
underestimated. This latter requirement may necessitate some capacity for the central bank
to resist short term political demands. The tension between political democracy and
economic liberty exists in many forms in our societies. Yet few of us would freely choose to
dispense with either democracy or economic liberty. We must therefore view this tension as
an inevitable one, and do our best to harness this tension in a healthy way which produces
sound public policy.
The raison d'etre of central bank independence centers on the issue of inflation and its
effects on both short term and long term economic performance. While economists are
prone to disagree on the details of the interaction of inflation and the real economy, I believe
that a consensus now exists on this subject. In the short term, it is quite likely that
temporarily higher levels of output and employment can be obtained by money creation.
But, in the longer term there is no tradeoff between inflation and output. Indeed, the price
of temporarily lower unemployment is often likely to be permanently higher inflation.
The tension between short term and long term economic developments sets the stage
for the first of two arguments in favor of maintaining central bank independence from the
political process.

While much economic theory is premised on the existence of omniscient

planners interested only in social welfare maximization, elected governments are in fact
comprised of ordinary human beings with their own individual interests. The desire to be


reelected is quite a normal part of their individual preference functions. It is therefore only
natural that their willingness to trade off short term costs for long term benefits may vary
with the period until the next election.
In economic modelling terms, we might characterize this behavior as a variable rate
of discount on policy decisions. As election time nears, the rate of discount rises sharply.
Short term benefits become quite attractive, even at the price of high longer term costs.
Similarly, short term pain for the electorate rises sharply in cost, in spite of potential longer
term benefits. Thus, the attractiveness of purchasing temporarily higher growth even at the
price of permanently higher longer term inflation greatly increases as election time nears.
Alternatively, after a government receives a mandate, its rate of discount on policy
decisions falls markedly. The objective is the next election which may be four or five years
distant. Being able to run as a government which reduced inflation may well have some
political benefits. A rational politician therefore might well choose to tighten monetary reins
just after an election, thus reducing inflation, while planning to stimulate the economy in the
run-up to an election. Elections therefore would tend to dictate the timing of the business
cycle with rapid periods of expansion preceding and during election years and periods of
slower growth following elections. Indeed, in America there is a long literature on the socalled "political business cycle", which began with work by Nordhaus and MacRae in the
mid 1970s.
Such behavior would be harmless political fun if there were no costs associated with
economic cyclically. While some theories suggest that some degree of business cyclically is
inevitable, even beneficial, an excess of cyclically - particularly cyclicality which is


artificially induced - will tend to lower the long term output of an economy. Output is
foregone during downturns and is inefficiently produced at times of excess capacity. From
the perspective of maximizing economic efficiency and long term economic output, limits on
the ability of a government to time economic circumstances may prove beneficial to the long
term level of economic well being in a society.
The second argument for maintaining central bank independence is that a democratic
government may permanently choose a rate of inflation in excess of the socially optimal
level. The reasoning here centers on the assumption that inflation represents a means of
transferring wealth from creditors to debtors. While the theoretical existence of perfectly
rational expectations would make systematic, peipetual transfers of wealth impossible, the
mere presence of an assumption that such a transfer would take place may be sufficient for
an electoral bias toward inflation.
The political case for inflation is most clearly seen in a democratic society in which
debtors outnumber creditors. The reality, or even the widespread assumption, that a wealth
transfer is taking place would make inflation popular among the majority of the electorate.
Further, the existence of economically irrational views such as "money illusion" makes the
constituency for inflation potentially even bigger. As a central bank governor, I am
particularly struck by the number of retirees who yearn for a return to the high-inflation,
high-interest rate days of the late 1970s. Although the real returns to saving are essentially
unchanged, and the real after-tax returns are higher in the present low inflation environment,
these individuals felt most comfortable consuming the cash flow generated from the inflation
driven depreciation of their stock of wealth.


The political imperative for inflation becomes particularly challenging when the
government is the largest debtor in the society. Here, some form of "political illusion" may
be involved. Inflationary finance may prove attractive to the government of the moment
when it is viewed as less painful politically than either tax increases or spending cuts. This
incentive may be particularly strong around election time due to the high rate of discount
applied to policy decisions, as discussed above. In its most extreme form, governments may
be tempted to monetize their outstanding debt rather than ask current taxpayers to bear the
interest burden of political decisions of past office holders.
Even though these failures in the political market may give us some theoretical
comfort that we are doing the right thing when we resist political pressure to inflate, caution
is always appropriate when a policy maker assumes that his or her perception of the social
optimum differs from majority will. Therefore, the first practical condition for central bank
independence must be popular support for the concept of an independent central bank. In
essence, the advantages of independence must be sufficiently manifest to the body politic that
they or their agents must approve legislation for an independent central bank, and continued
political support must be sufficient for that independence to be sustained.
The Federal Reserve is a creature of the Congress which established it. At any time
legislation could be enacted which abolishes us or alters our status. Indeed, legislation to
make such changes is frequently introduced, though it rarely moves far in the legislative
process. The ultimate reason for this is a widely held perception that whatever the quality of
American monetary policy by the Federal Reserve, direct or even increased political control
would not enhance the situation.

Practical political support, I believe, rests principally on


the central bank carrying out its mission in a reasonably successful manner. That mission, as
outlined above, is to resist and hopefully correct the potential failures in the political process
regarding monetary policy. It is therefore vital that the central bank strive to maintain the
public appearance of independence, as well as its statutory and practical reality. If it were
perceived that the Central Bank were in fact merely doing the will of the directly elected
agents of the public, there would be no case against monetary authority being vested in those
political agents.
Aside from acting independently, I believe that central bankers have a responsibility
to explain to the public what they are doing and why. There is a widespread perception that
we are monks who are secluded in our cloister. I think that perception is belied by our
travel schedule and our regular interaction with groups from different parts of the country
and the world. Regular interaction with the public not only informs the central banker about
what is actually happening in the economy, it reassures the public that public policy is being
made in a rational way which has the national interest as its goal. I believe that genuine twoway communication between the public and central bankers is vital to both central bank
performance and central bank independence.
Another practical condition for central bank independence is respect for the
independence and integrity of the other institutions of government. It is unlikely, indeed
almost unthinkable, that a truly independent central bank could exist in a society in which
other aspects of political and economic power were centralized in one place. Machiavelli
commended his Prince, an autocrat, to be sure to "control the currency and the courts". No
sensible autocrat would do otherwise. Thus, the existence of checks and balances within the


government, and within society, are key to the independence of the central bank.
In the end, the tension between accountability and independence is one which cannot
be escaped. The challenge which you will face here in Europe, should you opt to move
toward a single currency, is to design rules for your central bank which successfully balance
accountability and independence. This may be particularly difficult as the political structure
of the Community is itself evolving. Ultimately, responsibility is to the pubic at large.
Responsibility and accountability to intermediary institutions which do not themselves possess
the legitimacy given by public accountability will not suffice.
As a rule, we tend to view accountability and independence as polar opposites. But in
a democracy, this is not entirely the case. Any central bank or monetary policy institution
which stresses only its independence and ignores its ultimate accountability to the body
politic may soon find its independence at risk. It will have lost touch with its ultimate
mission ~ serving the public at large. The basis of central bank independence is the role we
can play in correcting some imperfections in the normal democratic process. But this
independence is granted democratically by that process. Maintaining our independence is
what we will be held accountable for and remembering that we are accountable is, in the
end, the key to our independence.